Knowing your monthly amortization payments is a very crucial factor in knowing whether you will earn passive income from your real estate investment or not.
In a nutshell, your monthly rentals should be greater than your monthly amortization payments and all other expenses for you to have positive cash flow and passive income.
Many people know what amortization is, but there are also many who hear about it all the time, but don’t really understand it, and are too shy to ask, what is amortization?
What is amortization?
In simple terms, amortization is the amount a borrower pays monthly to pay off his debt to a lender. The amount loaned is called the principal while the payment to the lender for the use of his money is called interest. The monthly amortization is a constant amount which is composed of payments for both interest and principal.
How is interest computed?
The interest is computed based on the diminishing balance of the principal loan amount. Diminishing balance means that the principal loan amount becomes smaller each time a portion of the principal is repaid.
How is the amortization divided between principal and interest?
Since the interest on the loan is usually on the diminishing loan balance, and the amortization amount is constant, a bigger portion of the amortization goes to interest compared to the principal during the early part of the loan term because the loan balance is still big at that time.
There may be times during the early years of the loan term that you may think that you have been paying for so many years already but when you look at the loan balance, only a small portion of the principal has been paid.
In contrast, during the latter part of the loan term, a bigger portion of the amortization will be going to the principal since the interest will be lower due to the already diminished loan balance.
How is the monthly amortization computed?
The formula for monthly amortization is:
Monthly amortization = Principal x Amortization factor
For example, you want to buy a property priced at Php 1 Million. The downpayment is 20%, and the payment term is 20 years at an annual interest rate of 11.5%. What would be the monthly amortization you need to pay?
First, determine the Principal amount. Since the selling price is Php1,000,000 and the downpayment is 20% or Php200,000, the loan amount would be:
=Php1,000,000 – Php200,000
=Php800,000
Next, get the amortization factor. In the example, the payment term is 20 years and the annual interest rate is 11.5%. The amortization factor, based on the corresponding Amortization Factor Table, is 0.0106642963.
*Check our complete list of amortization factors through this link: Amortization Factor Rates
Since you know the principal amount and the amortization factor, you can now compute the monthly amortization payment:
Monthly amortization = Php800,000 x 0.0106642963
= Php8,531.43704
How is the amortization factor computed?
If you don’t have internet access and you have a calculator, or you simply want to calculate manually, the formula is as follows:
Amortization factor=I/(1-(1+I)^-M)
where:
I = the monthly interest rate or annual interest rate divided by 12
M = the loan payment term in months
Source: Engineer Enrico Cruz of Urban Institute
Is there an easier way?
Of course, we all want the easier way! You will probably just use the above formula if you intentionally want to shake your brain.
The easiest way to get the amortization amount is to use an amortization or mortgage calculator. We have one here and you can find it on the following page: http://www.foreclosurephilippines.com/mortgagecalculator, or you can see it below (Jay embedded it in this page). Just plug in the following data:
- The Selling Price , Loan balance or Principal amount.
- The down payment, if any.
- The payment term or how long you intend to pay the loan
- The annual interest rate of the loan. You get this from the bank where you intend to buy the property or the bank where you intend to get financing.
Note: We are working with a wordpress plugin developer to develop our very own mortgage calculator with all the features we believe are essential. Something to look forward to…
Update as of February 19, 2014: Jay just created his own mortgage calculator and you can access it from the link above, or you can see it in action below.
How can we compute which part of the amortization goes to the principal and which part goes to the interest?
Knowing how much of each monthly amortization goes to the principal and how much goes to the interest will make you want to finish paying your debt faster.
Basically, you just compute the monthly interest by multiplying the monthly interest rate by the diminishing loan balance. The monthly interest rate is derived by dividing the annual interest rate by 12 months.
Then, subtract the monthly interest from the monthly amortization to get the amount that is applied to the principal.
The amount that is applied to the principal each month is deducted from the principal balance (naturally) so the principal goes down by a certain amount every month.
To see the portion of the amortization which goes to the principal and interest, as well as the diminishing balance of the loan, you can make an amortization table using a simple excel file which will have rows starting at Month 0 and columns with the following headings:
Month | Monthly Amortization = Amortization factor x Beginning Balance at Month Zero | Interest = Previous Balance x Monthly Interest | Principal = Monthly Amortization – Interest | Balance= Previous Balance – Principal |
Just input the formula to get the values, or you can download a sample excel sheet below:
Hope this helps.
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Cherry Vi M. Saldua-Castillo
Real Estate Broker, Lawyer, and CPA
PRC Real Estate Broker License No. 3187
PRC CPA License No. 0102054
Roll of Attorneys No. 55239
Text by Jay Castillo and Cherry Castillo. Copyright © 2008 – 2013 All rights reserved.
Full disclosure: Nothing to disclose.
PS. My husband Jay said he will create a sample amortization table to illustrate what I have written above, when he’s not too busy answering inquiries. Please watch for it!
Image courtesy: of renjith krishnan / FreeDigitalPhotos