This is part 2 of my short series on “What’s the ROI?”. The series is written in 4 parts, Analyzing Cashflow, Principal Reduction, Appreciation, and finally the ROI Calculation. If you have not already read part 1, I suggest doing so.
Principal Reduction is one of the most commonly overlooked areas of profit, though arguably it is just as important as cashflow or appreciation. Principal Reduction comes from the portion of your mortgage payments that is not eaten up by interest. For the first few years this will only make up a small portion of your payments. As you pay down the mortgage, the principal of the mortgage shrinks. What is left is called Equity. This is something that adds to your overall net worth, and should be used in any calculations of the same (including loan applications and such).
The biggest difference between the equity you gain from Principal Reduction, and Cashflow, is that equity is a lot more difficult to either spend or leverage. Most usually only benefit from their equity when selling a property, and using it to ‘trade up’. You’ve probably done this yourself, when you moved into a bigger house. There are some ways that one can leverage this equity without selling, though we will leave those for another time.
In order to calculate the first year ROI for your principal reduction, you will need some information. First, the total amount of the mortgage (after downpayment). Next you need to know your interest rate. And finally, what your monthly payments are, excluding any insurance, taxes, or fees. You can get a lot of these numbers from an online mortgage calculator at your bank, if you’re just trying scenarios.
Consider this scenario:
Monthly Payments: $856
Interest Rate: 3.80%
For the purposes of demonstration, and since we’re only doing a 1 year projection, we will use a simple interest calculation:
Total interest per year = Interest Rate x Mortgage
= 0.0380 x 175000
Total Monthly interest = $554
Total Principal Reduction for year 1: (Monthly Payments – Total Monthly interest) x 12
=($856 – $554 ) x 12 = $3624
The difference between the Total Monthly interest and your Monthly payments will nicely approximate your principal pay-down. The annualized number, $3624, is the number we will use in the final ROI calculation, in part 4 of this series. For now, thanks for listening, and remember – if you make a map, you don’t get lost!
Part 3: Appreciation will be coming next.