In teaching long term debt to my first year accounting students, I have used the following technique in teaching the amortization of mortgages with much success. The calculations are mechanical and monotonous, so the challenge is to capture the students' interest while delivering the required content. This I do by introducing the concept at a personal level and then making the connection back to the partnership or corporation level. See the lesson plan (Exhibit 1), which is included for reference and/or modification.

I introduce the topic of long-term debt by posing the following question to my students: "How many of you intend to own a home someday?" Virtually all students will raise their hands in response. "Then you will probably need to get a mortgage." I then proceed to explain what a mortgage is and I ask my students if they would like to know how banks qualify mortgage applicants and how to save $70,000 or more and get rid of a mortgage years ahead of schedule. These questions usually generate an enthusiastic response. To ensure their full attention, I say, "If you learn nothing else from this course but what I am about to teach you, you could potentially save yourself $70,000 to $100,000 in your lifetime. So listen very carefully."

First, I explain how a monthly mortgage payment is calculated by reference to an Interest Rate Factor Table (Exhibit 2) that I provide for the students. The information was extracted from the Harmon Homes Real Estate Guide, but can also be obtained from loan amortization tables which are widely available in any bookstore. For a typical 30-year mortgage of $100,000 with an interest rate of 8%, the monthly mortgage (principal and interest) payment would be $734. I explain to the students that, if they faithfully made their payments for 30 years, they would pay the bank a total of $264,240 ($734 x 360 months) for the privilege of borrowing a $100,000. Therefore, over the life of the loan, they would end up paying a total of $164,240 in interest! This revelation usually elicits gasps of disbelief.

A discussion of mortgages inevitably leads to questions such as, "How much does someone need to earn to get a $100,000 mortgage?" In response, I provide the students with the banking/mortgage industry's standard eligibility criteria and explain how it would be applied (Exhibit 3). Generally, the lending institution will not lend more than 28% of an applicant's gross income (that is, before tax). In addition to the housing ratio, the lending institution will also apply a total debt limit to determine if an applicant would be overextended if the loan were approved. Generally, total debt is limited to 36% of an applicant gross income.

I then illustrate how slowly a mortgage decreases (amortizes) in the early years by doing a partial amortization table on the blackboard (Exhibit 4). It should be noted that although mortgage payments are made monthly, in my illustration I show payments as if they were made in a single sum each year. In doing so, I am sacrificing some accuracy for the sake of brevity, but for the purposes of my class, it is accurate enough. I point out to my students that after 10 years and $88,000 in payments, the principal balance would still be $88,295 (a decrease of only $11,705).

I follow up with a chalkboard illustration of how much faster the mortgage balance would decrease if they had (or could find) an extra $2,000 per year ($166.67/month) to add to their mortgage payment (Exhibit 5). Students ask, "Is it legal?" My response is "Of course it is, but it is not in the bank's interest to advertise it. Banks make more money the longer you take to pay." I also explain that prepayment penalty is prohibited by law in New Jersey. However, in New York, it is entirely up to the lending institution, so they should check their loan agreement for prepayment penalties.

What I am suggesting to the students is this: if they have a small amount to invest, the best place to put it is in their mortgage. If their mortgage rate is 8%, their guaranteed rate of return is 8% compounded without the risk of principal loss. Some students voice concern over losing their tax deduction. My response is to ask a student to give me a dollar in exchange for 28 cents. Usually the class will protest, "No way! Why should he do a stupid thing like that?" I ask the class, "Why not?" The unanimous answer is, "He is going to lose 72 cents." I then conclude by saying, "Then why would you pay the bank $1 of interest so that you can get back a 28 cents tax refund from Uncle Sam? Aren't you losing 72 cents for every $1 of interest that you pay the bank? In fact, isn't it cheaper to pay the 28 cents in taxes and keep the savings in your own pocket?" These are thought provoking questions that run contrary to advice given by most CPAs to their clients.

At the end of the class, I assign the entire class a project to be completed outside of class. I ask the students to prepare a loan amortization schedule under three different scenarios: payment of a loan (student chooses their own principal, interest rate and term) with an additional $2,000, $3,000 and $5,000 annual principal payment. Based on their amortization schedules, they are to identify the time it took to pay off the loan, the total interest paid, and the interest savings resulting from the additional payments made under each scenario.

At the end of this exercise, the students would have learned how to prepare an amortization schedule and also how a mortgage works. I also have saved myself from a routine lesson on the mechanics of preparation and avoided boring the students. Connecting this lesson back to the partnership or corporation level and the corresponding journal entries to record the debt, the monthly payment, interest expense and the amortization of the loan is a snap. This strategy works best with the more mature students in my evening classes as many already own homes and/or are in the process of obtaining or refinancing a mortgage.  

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EXHIBIT 1
LESSON PLAN

1. Ask the students the following question: "How many of you intend to own a home someday? If so, you will need to obtain a mortgage?"
   
   
2. Explain what a mortgage is and how to calculate a monthly mortgage payment:
   1. Explain the use of the Interest Rate Factor Table (Exhibit 2)
   2. Show the calculations of a sample mortgage
   3. Explain to the students how to calculate total interest paid over the life of a loan
      
      
3. Explain how banks and lending institutions determine the amount of mortgage that an individual can support (Exhibit 3).
   
   
4. Show students how the principal balance of the mortgage declines by setting up an amortization schedule as follows:
   1. Illustrate amortization for the sample mortgage through year 10 with no additional payments (Exhibit 4).
   2. Illustrate amortization for the sample mortgage used in 4 a) above with $2,000 additional payment/year (Exhibit 5).
   3. Point out the difference in the balances in year 10.
      
      
   
   
   NOTE: Point out to the student that mortgage payments are made on a monthly basis. Therefore, the simplified illustration which shows payments on an annual basis would understate interest savings over the life of the mortgage.
5. As an out-of-class project, ask students to:
   1. Select a mortgage using an amount, term and rate of their choice
   2. Set up an amortization schedule for each of three scenarios:
      - $2,000 additional payment per year,
      - $3,000 additional payment per year,
      - $5,000 additional payment per year.
      
   3. Determine for each scenario, the total interest paid, the year the mortgage will be paid off, and the amount of interest that was saved by payment of the additional sums.

 

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EXHIBIT 2
INTEREST RATE FACTOR TABLE

This chart will help you calculate your monthly principal and interest payments for both fixed and adjustable rate loans at various interest rates over 15 and 30 year terms. Start by finding the appropriate interest rate, then look across to the column indicating the desired term of the loan. That number is the interest rate factor. This is the dollar amount required each month to amortize $1,000 over the specified term. To calculate your principal and interest payment, multiply the interest rate factor by the total loan amounts in 1000s.

Example:	Mortgage amount:	$120,000
	Interest rate:	9 _%
	Term:	30 years
	Factor per $1,000:	$8.23
	Monthly payment:	$8.23 x 120 = $987.60

This is a calculation of principal and interest only. It does not include property taxes, insurance, association dues, or other charges.  

FACTORS PER $1,000
INTEREST RATE	15 YEARS	30 YEARS