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CH 10] Calculating Business 10-13

are paid when due, and the payment to cover the property insurance, thus insuring that the
property is properly insured. The lender does this because they are making a substantial
investment with the borrower and want to be certain that when catastrophe strikes the balance
of the loan can be paid off. The total regular payment includes principal, interest, taxes and
insurance (PITI). The calculations of taxes and insurance are not a part of the principal and
interest discussion so we shall leave that where it is.
In the early stages of any loan, the borrower should plan on paying back much more interest 10
than principal. The reason for this can be explained as follows:

Example: You have a $400,000 loan on your property in the Los Angeles Area at a 5
percent interest rate, monthly payments of $2,147.29 for a 30 year loan paying
Principal and Interest. In order to determine what proportion of this payment is
interest and principal for the first payment perform the following:

Solution Algorithm

(1) Calculate the monthly interest rate,
5% per year ÷ 12 months per year = 0.05/yr ÷ 12mo/yr = 0.004167 interest rate for
one month
(2) Multiply the principal balance for the month by the monthly interest rate. For the
first payment:
$400,000.00 x 0.004167 = $1,666.80 interest.
(3) The amount that is paid for principal is:
Total monthly payment – interest payment = principal payment
$2,147.29 − $1,666.80 = $480.49 payment towards principal.

To calculate the remaining balance after this first payment you will subtract the principal
payment from the principal balance.
Principal Balance – Principal payment = remaining Principal Balance.
$400,000 − $480.49 = $399,519.51.

By following this solution algorithm for thirty years, (12 x 30 =) 360 payments and the entire
loan and interest will be paid off leaving a zero balance to the borrower, and at the end of 30 Net Income: is the
years which is their 360 payment. residual amount of
th
earnings after all
Let’s look at this loan and payments again from a different perspective. A 30 year loan of deductions have
$400,000 paid with a 5% interest rate will allow the borrower to pay $2,147.29 with each been accounted
monthly payment. Before entering into this loan contract the borrower has considered the for such as 401k
income and expenses of their budget, and relying on that analysis, has decided to keep the savings, state and
payments at 29% of their net take home income. They know that over time their monthly income federal taxes,
will increase and thus the percent of their income used to pay the mortgage on their home will social security tax,
decrease. The monthly net income to afford this payment must be ($2,147.29 ÷ 0.29 =) at least Medicare tax,
automatic payroll
$7,404.45 each month. Caveat: If the monthly income is not $7,404.45 or more then do not deductions for
borrow $400,000 but something less. Negotiate with the seller for a lower selling price, or purchases, etc.
negotiate with the lender for a lower interest rate or a longer loan term, or simply find a less
expensive home.
The total interest paid on this loan over 30 years to the lender will be $373,023.14. This
interest charge amounts to approximately ($373,023.14 ÷ $400,000.00 x 100% = ) 93% of the
principal, and when added to the loan value increase the total cost of principal and interest to
($400,000 + 373,023.14 =) $773,023.14. Comparing your interest payment and principal
payment above, you should note that most of the payment for approximately the first 16 years
and 2 months goes mostly toward the interest charges. After that time, most of the payment
goes toward paying off the principal, refer to Figure 10.3. Do remember that with each regular
payment a part of the payment goes first to pay the interest and the balance of the payment goes
to pay the principal amount of the loan until the loan is paid in full and all interest that would
be due has been satisfied.
Now is the time to remind yourself of the advantage to compound interest. Compound
interest is a marvelous thing as it represents money working for its owner, a truly capitalist
benefit. A mortgage loan payment is just that, a payment of compound interest over time, and it
can be thought of as an annuity. For time, do recognize that the longer the time the more
interest is earned. There is nothing inherently evil about compound interest as it represents

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