What would you do if you discovered that 95% of your paycheck was being flushed down the toilet? That happened to me about 6 years ago. That was the day that I discovered how expensive compound interest can be, and that was the day that I determined that I would learn how compound interest works and I would put money to work for me.
About a year earlier, I bought my first home, right at the max of the real estate boom. This was back in the days of sub-prime mortgages, and interest rates were double what they are today. About a year later, I was sitting at my new knotty alder kitchen table, paying the bills. I had a 1st and a 2nd mortgage on my home, 80/20, to avoid PMI. As I was going through the bills, I looked at the statement for the 2nd mortgage and I saw that I was paying $477 in interest, and only $17 in principal. Who would be crazy enough to pay 96% interest on a loan? Apparently, I was.
Here I was, a hot-shot MBA, business owner, homeowner, and I was paying 96% interest on my 2nd mortgage. My stomach literally dropped. I was sick. I remembered the well-known quote, often attributed to Albert Einstein or Benjamain Franklin, though neither actually said it.
Compound interest is the greatest mathematical discovery of all time. Those who understand the principal of compound interest are destined to collect it. Those who don’t are doomed to pay it.
I still clearly remember that day. Financially, that was probably the best day of my life. I don’t know if I made any money that day, but I realized that day that I never wanted to be doomed to paying compound interest again. I determined that I was going to understand the principal of compound interest better than anyone, and that was the embryo of Homes in Order.
Hello:
I don’t understand how you are paying 96% interest. You are paying 11.5% interest, not 96%. After 11 payments, the loan balance is $49,815.00. x 11.5% = 5,728.00 interest per year/12 months = 477.00 interest per month.
Thanks for the comment!
This is a fabulous question, and one that most people don’t understand. Click on the calculator image on the right column, and it will take you to the calculator. Type in $50,000 for the loan amount, then 11.5% for the rate, and 30 for the amount of years. Now, scroll down to the Amortization Table. As you can see, the payment is $495.15 per month. Of that payment, $479.17 is interest. That means, that 96.8% of your payment is interest. And it’s not just for the first payment. If you scroll down, you’d be paying over 95% interest (see percent interest column) for 47 payments, if you only made the minimum payment.
So, you’re right — your interest rate is 11.5%. However, most people think that if you have an 11.5% rate, you only pay 11.5% interest. The key to remember is this: I had a loan compounded over 30 years! I would pay a lot more interest than the rate (11.5%). By making only the minimum payment on this 11.5% loan, over 30 years, I would have paid $128,252.46 in interest, for a $50,000 loan.
It’s compound interest!
I hope that helps! Thanks again for the comment.
Jeremy
Also, you’re right on for how you calculate interest. To calculate the interest payment on this loan, the formula would be $50,000*.115/12=$479.17. If you look on the amortization table, that’s exactly what the payment for the first month is. Then, you have to recalculate that every month.
That’s what amortization does. And when you amortize over 30 years, the principal payment is tiny at the beginning. Anyway, check out the calculator. Also, I just did another follow-up post that will be coming out Monday about this. Thanks for the comment!