I often find that even when counseling, many people are not aware of the most basic features of loans.
It is very common to say “I have paid over $ 7 million on a 12 million forint loan in five years and I still owe $ 11,487,384 according to the bank. Where did all that money go ?! “
I would like to explain in this article the concept of a steady repayment of capital, annuity and interest, and I hope that by the end of the article it will be clear to everyone why they are not reducing their debt. (For the sake of simplicity, this article is about forint loans, for currency loans you have to take into account exchange rate changes, but the principle is the same.)
When borrowing, there are three ways to determine the repayment
In a monthly installment called the Equity Repayment Plan, or in an annuity.
In the third case, the capital is not repaid to the bank for 5-10 years at all, only interest is paid, and the capital is collected in a home savings or unit-linked insurance and repaid only after 5-10 years. I have written a lot about it here (apartment saving) and here (life insurance), in this article we will only look at the two basic cases.
First, let’s look at the first option, the even repayment of capital. In this case, the capital is repaid in equal installments from month to month, plus the amount of interest charged on the outstanding loan money for the month in question.
As we repay the capital
The interest becomes less and less each month, as we have to pay less and less.
Let’s look at the monthly repayment of a 20-year, $ 12 million home loan, if the interest rate is 12% per annum.
We see that our initial monthly repayment installment is HUF 170 thousand, consisting of HUF 50 thousand capital repayments and HUF 120 thousand interest. (Yes, a 12 million loan has a monthly interest rate of 120 thousand forints at the current 12% forints.)
This decreases steadily over the 20 years. During the term, we will repay the entire principal plus an additional interest of HUF 14.3 million. At the end of the fifth year, our capital debt is HUF 9 million, after 10 years HUF 6 million and so on.
The problem with this form of payment is that the monthly installment is extremely high for the first few years and many people don’t like the monthly installments. (And the bank is better off the longer you have capital.)
Annuity helps with this
In this case, our credit is calculated by paying the same amount each month until maturity. Since we pay a lot of interest at the beginning of the term due to the high capital debt, a negligible part of the monthly repayment installment goes only to the capital repayment.
This, in turn, also means that during the first few years our debt will hardly decrease, so that the interest burden of our loan will not change significantly.
In this case, our monthly repayment installment is only 132.130 HUF, but our capital repayment is only 12.130 HUF, which increases only slowly in the first 5-6 years. (If this loan were 25 years old, we would only have $ 6,387 in monthly capital repayments.)
In a table I summarized how much interest goes on at different maturities, and how the capital debt develops over the maturity.
We will be enriched with very informative information by looking at the two tables above. The monthly repayment installment of the 25-year loan is HUF 126,387, while the interest paid during the maturity is HUF 25,916,100.
Of course, we also have to count on inflation, which is now 4-5%, but let’s not complicate our lives now. As we can see, the shorter the maturity, the barely higher monthly repayments would save one-third of the interest.