Net Worth Challenge

I received a good question from one of our readers and wanted to respond to it through a new post. (In reality, my response to the comment was getting lengthly and lended itself best for being it’s own post!) Thank you for your questions, Tony — you’ll find my answers below!

Tony said,

on March 22nd, 2007 at 3:24 pm

Congratulations on your purchase.

By the way, what is the state and general area of your property for the purchase price of $73,600, if you don’t mind me asking? Around my area, it’s closer to $500,000, ins @ almost $1000/yr (State Farm), prop taxes @ $6000+/yr.

One more question, what is “principal paydown� and how did you come about with it at $68?

Thanks for the congratulations note, Tony. My wife and I are excited — but VERY anxious to finish all the work. Painting has become quite the chore and is taking longer than I predicted.

Our home and our new rental property are located in the Midwest. The typical 3-bedroom, 2-bathroom single family home is around $160K to $180K. Of course, there are similar homes with lower prices (and higher prices) — it mainly depends on the area you’re looking at. But that range is typical for a nice home in a nice area.

Now ours was a lot less for two key reasons: (1) located in an outlying suburb and (2) its one half of a duplex building. The purchese price of our property was $92,000. We made a down-payment of $18,400 and took a loan for the remainder, which was $73,600.

The princial paydown refers to the amount of the bank loan that I am paying off each and every month. The mortgage payment I make to the bank includes two components: (1) interest and (2) principal. Now my payment is fixed, so the monthly mortage payment will always be $466. We can figured out the principal paydown amount using a couple different ways — one would be to create an amortization chart and another would be to use a simple math formula. The math formula is easier to talk about in this comments section, so I’ll discuss that one below.

First, I need to know the interest that will have accumulated by the time I make my first payment. I’ll use that information and add it to the loan amount to find out what my new loan amount is BEFORE I make my first payment to the bank.

73,600 — Beginning balance of bank loan
(+) 399 — Interest, calculated as: 73,600 * (.065 / 12)
—————-
(=) 73,999 — Owed to the bank the day I make my first payment

I’ll then take this number and subtract my fixed payment amount. This will give me the new loan amount AFTER my first payment is made.

73,999
(-) 466 — My fixed, payment amount.
—————-
(=) 73,533 — New amount that is owed to the bank AFTER I make my first payment.

The last step is to calculate how much the loan balance decreased. This is the “principal paydown”.

73,600 — loan amount BEFORE making payment
(-) 73,533 — loan amount AFTER making payment
—————-
(=) 67 — principal paydown

Now, another good question is, what does this number represent? When my wife and I purchased the property, it could be said that we fairly valued the property to be the same as our purchase price. (Yes, this is looking at it in simpler terms) So in this case, we believe the value of the property to be $92,000. Since we took out a loan with the bank, in essence we do not own the entire property yet. Instead, my wife and I only own $18,400 of the property —- which was the amount of money we paid as a down payment. This number is the equity we have in our home. The bank owns the remainder, which is $73,600.

As we make payments to the bank each and every month, slowly but surely our loan balance is going to drop. We are paying down the principal of that loan. After our first payment was made, the bank now only owns $73,533 of the property and we now own $18,467 of the property. So as time goes on, we’ll own more and more of the property as our “equity” in the home increases and the “loan balance” from the bank decreases.

This is probably a LONGER answer than you may have been looking for, but it’s a great refresher for many of us. The other thing to remember is that over time, the interest and principal portions of our fixed monthly payment will change. The amount of interest we are paying will slowly decrease and the amount of principal will increase. Our “principal paydown” numbers will continue to increase with each and every payment. Now how did I come up with the “principal paydown” amount from my previous “Numbers” post? I looked at the principal paydown numbers for an entire year and found the average. Over the course of a year our bank loan will decrease by $822 or, roughly $68 per month.

I hope this answered all your questions. It’s a good excercise for me to go back through the numbers and make sure I have been calculating everything correctly. Thanks for the great question. Let me know if I can clarify anything further. Perhaps I’ll upload an image of our amortization chart (done in Microsoft Excel) in the near future. It’s a great visual that is an alternative to running these calculations by hand.