Amortization - an Analysis

The principle of home loan amortization is simple - a constant home loan repayment is applied over the bond term to reduce the outstanding capital to zero. This home loan repayment amount includes a portion interest and a portion capital repayment.

The interest portion is greater at the beginning of the bond period when the outstanding capital is at its highest and gradually reduces as the outstanding amount is repaid.

The bond repayment amount is calculated by applying a factor to the original outstanding bond amount. Although the bond repayment is normally calculated using a financial function (PMT function), it is the result of a mathematical equation based on the applicable interest rate and bond period. The formula is as follows:

PMT = PV x ( r / [ 1 - { 1 / ( 1 + r )^n } ] )

where PMT = bond repayment amount; PV = original bond amount; r = interest rate; n = bond period.

Essentially this equation is used to calculate a constant bond repayment amount which is applied over the entire bond period and includes interest on the outstanding bond amount as it is repaid over time.

The effect of this equation is however not as straight forward. There is a common perception amongst home owners that capital repayments are a lot more proportionate than they actually are. Some home owners fall victim to this erroneous thinking and are quite often surprised at how little capital has been repaid after a number of years have elapsed. This is best illustrated by an example:

Let's assume that a R1 million bond is repaid at 15.5% interest over a period of 20 years. Refer to the Excel Amortization Table link for the detail calculations. The following table is a summary of the data:

After one year of bond repayments, 99.20% of the original bond amount is still outstanding. The reason for this high percentage is that almost the entire bond repayment during the first year of repayment is interest.

Similarly, after 10 years of bond repayments, the capital has not been reduced by much because 82.35% of the original loan is still outstanding. The outstanding capital is only reduced significantly after 15 years.

This is the nature of home loan amortization - an attribute which unfortunately too many home owners are not familiar with. Additional home loan repayments early on in the bond term could result in significant interest savings and should be considered based on home owners' available cash flow.

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