Create Personal Wealth Beyond Your Small Business, Part 4

Amortization: Your Enemy; the Banker’s Friend

I have to digress a bit to property cover the next aspect of Small Business Wealth Creation.  I want to show you the detrimental effects of loan amortization, how lenders benefit from it, and give you a strategy to “turn the tables” on your lender.

One of the greatest financial inventions is “compound interest.”  Albert Einstein is said to have called compound interest: “The eighth wonder of the world!  Those who understand it profit from those who do not.”  I can not verify the source of the quote, but whoever it said it was dead right.  Let’s examine amortization and how you can turn the tables on your lenders.

When the “Lowest Rate” Is More Expensive

You see, amortized loans were created by bankers and are structured so that the payments made in the early years (according to the amortization schedule) go primarily to pay interest.  In the first year of a 25 or 30 year amortizing loan, approximately 3% of the monthly payment goes toward reducing the principal balance, depending upon interest rate.  So for the first several years, your payments do nothing but go to your lender’s bottom line.

Thus, the typical repayment of a commercial mortgage with a 10 year call is only something like 20% to 23% of the original loan amount even though a 33% to 40% of the loan’s term has passed.  So to emphasize the point, this means that the majority of that money you made in payments went into the lender’s pocket and you still have to pay back a large portion of the loan!

If you have ever taken the time to look at either an amortization schedule or a Reg “Z” Truth In Lending Disclosure, it is frightening just how much you end up paying the lender for the privilege of using his money.  This is the “earning” power of amortization from the lender’s standpoint.

However, if you can pay one extra dollar in principal in the first month of a 25 year fully amortized loan at 7%, you save $141.49 in interest costs over the life of that loan!  This can be verified using a simple present value calculation.  (No wonder banks have their names at the top of the largest building in all of the major cities across the U.S.)  So when evaluating the true cost of a loan, you need to look past the “rate” to amortization, points, and other fees.  This concept is called “Total Loan Cost” and is the theory behind those Good Faith Estimates and Reg “Z” disclosures that you get when you borrow money on your home.  However, typical of government intervention, almost no one short of a Ph.D. can understand the forms.

Using Debt To Save Money On Debt

There have been some recent advances in money management software that will allow you to “break the bank” when it comes to amortization.  With proper money management, you can drastically reduce the lifetime cost of your loan with almost no impact on your current standard of living. 

The traditional approach to reducing the overall cost of a loan is to add an additional payment per year (OK) or to add principal to the monthly payment (Better).  This usually results in reducing the term of a loan by 25% to 33% depending upon the interest rate.  The problems with these methods include:

1. The need for discipline in consistently paying more per year or per month.
2. Interest cost reduction is maximized in the early years of amortization, thus the gradual approach doesn’t take advantage of this aspect.

There is a company called United First Financial that offers a sophisticated web-based amortization management software program that is combined with a credit line to take extreme advantage of the amortization disparity of the early years.  (In the interest of Full Disclosure, Excelsion Mortgage does represent the UFirst Money Management Account software for its clients).  The program uses the credit line as a “reverse checking account” to allow you to make greater principal reductions in the early years of a real estate loan’s life without affecting your lifestyle.

The results are astounding in that most loans are paid off around years 7 to 11!

The principle is simple:  The credit line is used to pay ALL of your bills, instead of your checking account.  Income pays down the line, bills increase it.  The software manages the timing of payments and income to increase principal reductions on the mortgage while minimizing interest expense on the LOC (line of credit).  Since you can never have a negative balance on the LOC, the software tells you when it is safe to made additional payments to the mortgage based upon your spending pattern.

You can use a home equity line of credit, a business line of credit, or even a sophisticated credit card like those offered by American Express.  As long as the credit line offers check writing capability with no extra fees, it will work with the Money Management Account software.  You can see an example of how this program works on a $2,000,000 loan used in conjunction with a $150,000 LOC at our sister site:  www.ExcelsionMortgage.com/MMA.

Now you no longer need to be the victim of Bank-orchestrated larceny!  If you combine a fully amortizing loan with flexible pre-payment terms, sophisticated money management software, and a low-cost line of credit, you can be commercial loan debt free in a very short time, saving you literally hundreds of thousands to millions of dollars in interest expense.  That money goes into your pocket, not the bank shareholder’s pockets.  The pieces of the Small Business Wealth Creation Program are coming together.  In the next article, I’ll discuss the steps that you can take to put this program together quickly and effectively.