As a general rule, debt is a negative thing that some people should avoid to ensure long-term financial health and success. As the Bible says, "The borrower is slave to the lender." No one wants to be enslaved to another person.
However,
there are circumstances where debt can actually serve as a useful tool in one's
financial tool belt. Whether it's financing a business expansion, pursuing
higher education, or purchasing your first home, debt can help avoid missed
opportunities lost by delaying.
Consider the
many young people who are kicking themselves for not purchasing their first
home prior to the 2020 pandemic—housing prices surged at an unprecedented rate,
leaving many priced out of the market. Similarly, for someone pursuing a degree
as a doctor, pharmacist, or any other professional designation that requires a
degree, the delay in completing the degree could be detrimental to their
future.
Debt, when used wisely, can be beneficial. It can serve as leverage to achieve goals sooner, provided that the borrower has a clear repayment plan and uses the borrowed funds to improve their future or grow their business. The key lies in understanding how debt works—particularly how interest accrues and how repayment is structured over time.
Understanding the Art of Amortization
Once a
borrower determines how the debt is going to be used, it's essential for the
borrower to understand the art of how debt accrues interest and how payments
are applied to pay it off. At the end of the day, the bank or lender will
ensure that they receive full compensation for the time that the borrower is
holding their money. This is where an amortization schedule comes in.
At its core,
an amortization schedule is the anticipated loan payment schedule, assuming
that the borrower makes all their payments by the due date. It breaks down each
payment into two parts: interest and principal. The schedule takes the interest
rate and breaks it down to a per diem (daily) basis. Each day between payments
accrues interest based on the balance of the principal loan, and once the
payment is received, the bank applies the interest portion first and then the
remainder goes to the principal of the loan.
At the
beginning of the loan period, the majority of the payment is applied to the
interest portion owed to the bank. As the payment schedule continues, near the
midway point, the interest and principal portions are about the same. Once the
borrower is on the final stretch, a majority of the payments are
principal-related and very little goes to interest.
The reason banks set up the amortization schedule is to give the borrower a set payment that never changes. This consistency not only gives the borrower reassurance that their payments won't change, it also gives the bank a predictable income stream for their operations.
Why Banks Use Amortization Schedules
Banks design
amortization schedules to ensure consistency and predictability. For the
borrower, it's easier to plan when payments remain the same throughout the loan
term. For the bank, it guarantees a steady stream of revenue and helps them
manage risk effectively.
Understanding how this works empowers borrowers to make smarter financial decisions—especially when it comes to timing payments, making extra contributions, or deciding whether to pay off a loan early.
Frequently Asked Questions About Amortization
1. Why
does paying closer to the "late payment" date result in more interest?
This is because of
the per diem accrual that occurs between payment times. If someone normally
makes a payment on the first of the month, then there are only 30 to 31 days of
interest accrual. However, if someone pays on September 1st and then the next payment
isn't made until October 15th, there are 45 days of interest accrual. In order
for the interest payments to most closely resemble the amortization schedule
given at the time of the loan, payments need to be made by the due date.
2. Is it
beneficial to make extra payments to lower the principal amount?
Yes—if the goal is
to pay off the loan earlier or to see the amount of interest paid drop over
time, making extra principal payments can be a smart strategy.
However, the
benefit depends on the loan's size, term, and interest rate. For example:
- On a three-year car loan under
$20,000, adding just $100 a month could shorten the term by about five to
six months.
- On a $500,000 mortgage with a
30-year term, the same $100 extra per month might only shorten the loan by
about two years.
While the
difference may seem modest, even small additional payments can save thousands
in interest over time.
3. If
someone has a huge windfall, should they pay off a large portion of their
mortgage to pay it off sooner?
It depends. It's
best to seek the guidance of a Certified Financial Planner or Advisor because
it depends on overall goals. As long as there is no prepayment penalty, some
banks will allow a borrower to "recast" their mortgage if they put down a
significant principal payment. It's not guaranteed, so check with the bank
first.
The interest rate and overall goals need to be considered. If someone is close to retirement and about to lose their steady income or has had a major health event, then getting rid of the mortgage may be ideal. However, for someone who has a 3% interest rate and no cash flow concerns, tying up money in the principal of the house is not always the best use of funds.
Debt as a Tool, Not a Trap
Debt doesn't
have to be the enemy of financial freedom. When managed wisely, it can be a
stepping stone toward growth and opportunity. The key is to understand the
structure of debt—how interest works, how payments are applied, and how to use
amortization to your advantage.
For
entrepreneurs, debt can fuel expansion or fund new ventures. For homeowners, it
can provide a way to build equity and long-term wealth. For students, it can
open the door to higher income and career opportunities that would otherwise
remain out of reach.
The danger
lies in borrowing without a plan. Debt used recklessly—especially for
depreciating assets or nonessential purchases—can quickly spiral into financial
strain. But when debt is taken on with intention, managed carefully, and repaid
strategically, it can be a powerful ally.
The art of
amortization is about more than numbers on a spreadsheet—it's about
understanding how money moves and grows over time. Savvy borrowers recognize
that every payment is part of a larger financial picture and that managing debt
well can be just as important as earning or investing money wisely.
By mastering
the principles of amortization, individuals and business owners alike can make
smarter borrowing decisions, save money on interest, and use debt as a tool to
accelerate their goals rather than hinder them.
By understanding and knowing that art of the amortization
schedule, most savvy investors can leverage other people's money to accelerate
their goals.
