Many folks, even seasoned finance experts, misunderstand the meaning of “front loaded” interest. They are confused by charts and graphs that show over time the interest portion of an amortizing mortgage loan payment. The chart shows the interest portion starting out high and then curving downward eventually to zero at the end of the amortization term. This appears to show that most of the interest is “front loaded” at the beginning of the loan, and therefore the loan is “front loaded”. The misconception is that the borrower owes an enormous amount of interest on the loan. Actually the borrower only owes the periodic interest for each period that the borrower holds the loan.

You can download the Microsoft Excel 2007 Amortization Chart spreadsheet from here.

Such a graph shows the paid interest starting high and curving downward, because that is a side-effect of the real meaning of “front loaded” interest. The “front loaded” interest describes the Time Value of Money (TVM) concept that defines how each periodic payment is processed for interest first and principal second. For each periodic payment there is a periodic interest rate. The periodic interest rate is simply the annual interest rate divided by the number of payment periods per year.

There are five TVM variables:

  1. Term (the number of periodic payments).
  2. Rate (the annual or periodic interest rate).
  3. Present Value (PV).
  4. Periodic Payment (PMT).
  5. Future Value (FV).

Any one of the TVM variables can be calculated from the other four variables.

Note: From the lender’s view, the Present Value (PV), also called the “Outstanding Balance Owed”, is negative for cash paid out and the periodic payment (PMT) is positive for cash received or negative for more cash paid out. Cash flowing out is negative and cash flowing in is positive. For the borrower, the PV is positive for cash received and each periodic payment PMT is negative for cash paid out. At the end of the note term, any residual amount owing (FV) is called a “balloon” payment, because it usually much larger than a periodic payment.

As each payment period elapses, the lender calculates the periodic interest by multiplying the current PV by the periodic interest rate. The calculated periodic interest is subtracted from the periodic payment. The lender then adds the remaining value (i.e., the “difference”) to the PV. If the periodic payment is larger than the periodic interest, then the difference is positive. Adding a positive value to the negative PV reduces the PV closer to zero. If the periodic payment exactly equals the periodic interest (e.g., an “interest-only” loan), then the difference is zero and the PV is not changed. If the periodic payment is less than the periodic interest, then the difference is negative and increases the negative PV. (Adding a negative number to another negative number calculates a greater magnitude negative number.) This is the fundamental process for calculating compound interest, and for discounting a cash flow from Future Value (FV) to Present Value (PV).

Thus, the TVM is “front loaded”, because the periodic interest is deducted from the periodic payment before calculating the new PV. After the calculation is complete, the loan is now “current”. No more interest is owed, only principal, if any, is now owed on the loan. If the borrower holds the PV for another payment period, then more interest will be owed and the calculation is repeated at the end of the next payment period (i.e., interest is paid in arrears at the end of each payment period).

Another type of loan is called “Back Loaded” interest or a “straight note”. This type of loan is calculated as compound interest with periodic payments of zero and a periodic interest rate that is applied to each payment period on the current PV. Compounding the interest to a Future Value (FV) calculates the Present Value (PV) of the straight note. (Sometimes the compounding is calculated over one period and is thus called “simple interest”.) The borrower then pays a periodic payment equal to the calculated PV divided by the number of payment periods. The interest rate is now zero, because the interest has been rolled into the total balance owed and effectively converted to principal. The borrower actually owes the total interest for the entire note term, even when the loan is redeemed early, because the interest is converted entirely to principal at the start of the note term.

For example, a $100,000 straight note with 10% annual yield for 60 months (5 years):

  1. Start with the $100,000 as the Present Value (PV).
  2. Set the amortization term to 60 monthly periods.
  3. Set the annual yield (interest rate) to 10%.
  4. Set the future value (FV) to zero.
  5. Calculate the periodic (monthly) payment $2,124.70. This will be the principal-only payment on the straight note.
  6. Multiply the periodic payment of $2,124.70 by the number of periods (60) to calculate $127,482 as the total debt principal.
  7. The borrower receives the $100,000 loan, signs a note to pay $127,482 over 60 months in equal principal-only monthly payments of $2,124.70.

Many straight notes are described as “no payments”, meaning that the total PV is owed at the conclusion of the note term (at maturity). However, this is really just a “single payment period” note. If the note term is one year, then the number of payment periods is one and the period is one year. “No payments” actually means “one payment” at the conclusion of the note term.

Take the same example above and change it to no payments for 60 months:

  1. Start with the $100,000 as the Present Value (PV).
  2. Set the amortization term to 60 monthly periods.
  3. Set the annual yield (interest rate) to 10%.
  4. Set the periodic (monthly) payment to zero. There are no monthly payments.
  5. Calculate the Future Value (FV) of $164,530.89.
  6. The borrower receives $100,000, signs a note to pay $164,530.89 after 60 months elapsed.

The true interest paid on the straight note is all rolled into the PV at the start of the note term, and paid in the form of principal-only payments. Straight notes are very useful for managing cash flow while a property is repositioned, stabilized, and then sold for a profit and paying off the straight note.

Hard money lenders also use a variation of a back loaded interest note by rolling in “points” to the initial PV, in addition to requiring interest-only periodic payments. The initial PV is higher than the actual loan amount issued to the borrower, and the periodic interest rate is applied to the total loan amount. At the end of the note term, the borrower sells the property for a profit (or refinances) to redeem the outstanding balance owed.

A proper understanding of the Time Value of Money (TVM) principles can help you to structure your financing, either front loaded or back loaded, to earn more profit from your real estate investments.

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