When interest charged is high the following applies: You might have noted that if you are paying a bond off over twenty years you are paying only a SMALL amount less than if you were paying it off over 19 years. One reason why 40 year bonds are not offered is that the difference in monthly payment between a twenty year bond and a forty year one is so small that it is well worth paying the little extra to make it a twenty year bond.
To get to grips with the process of amortisation one may consider this typical situation: John takes a twenty year bond of $100 000 at the beginning of January. At the end of January the first payment becomes due. By this time he owes $100 000 plus interest for the month on the $100 000. He now pays in his monthly payment and part of this payment goes to pay off the interest for the month and part to reduce the $100 000.
If the interest rate is very high only a small percentage of John’s monthly payment goes to reduce the $100 000 – most goes to pay off the interest he has been charged for the month. Calculation will show you that only a very small amount has come off the $100 000 after the first year if the interest being charged is very high (say 20%).
The process of interest charge on the amount still owed and the ensuing bond repayment is called the amortisation process.
The effects of compounding are large and can be illustrated when you pay in a lump sum to reduce the amount owed on your bond. If you pay in a lump sum and keep your monthly payments the same you will pay off your bond sooner. Say your original time to pay it off was 20 years, but because you made a lump sum payment you pay it off in 15 years (keeping your monthly payments the same). If you look to see what you would have owed after 15 years had you not paid the lump sum, you can show using some mathematics, that you have benefited as if your lump sum you paid in was earning interest at the rate at which you were borrowing.
For a free computer program that calculates aspects of bond repayments you can go to http://www.4shared.com/dir/6vUP2Vn9/sharing.html and downloadPayabond.exe