First things first….what the heck is a mortgage?
Mortgage - The charging of real property by a debtor to a creditor as security for a debt, on the condition that it shall be returned on payment of the debt within a certain period.
That might not have made a whole lot of sense so let’s break down the actual word. Take the first part - Mort – which means “death” (think mortuary) and the second part – gage – meaning “pledge” (think engage, which could also mean death. Just kidding. I don’t think my wife will appreciate that one).
Wait a second. So mortgage means “Death Pledge”? What? That’s hilarious!
Actually, the reason it’s called a “Death Pledge” is because the pledge ends (dies) either when the obligation is fulfilled or the property is taken through foreclosure. In other words, it’s a pledge that has a defined end and is not on going.
Most people think that a mortgage is a debt, but actually it is the lender’s security for a debt. It is a transfer of an interest in land (or the equivalent) from the owner to the mortgage lender, on the condition that this interest in that land will be returned to the owner when the terms of the mortgage have been satisfied or performed. In other words, the mortgage is a security for the loan that the lender makes to the borrower.
Okay, we now know what a mortgage is. Ever heard of that little thing called amortization.
Amortization – The process of decreasing, or accounting for, an amount over a period.
Amortization is a way to reduce the amount owed on a loan over time. The debtor generally makes a fixed payment and each month, that payment is split into a monthly principal and monthly interest payment. The bulk of the initial payments are segmented towards interest because of the large risk that the bank takes on by writing the loan. Over time, the loan payments you make will go more and more towards principal and less and less towards interest. Unfortunately, it takes between 17 and 22 years (depending on interest rate) on a typical 30 year loan for the payment to have equal principal and interest reduction.
Let’s look at an example to make this a bit more visual. Pull up this amortization schedule and keep the tab open. We are going to be referencing it regularly.
As explained in the schedule, the Mortgage amount we will be using is $200,000; the interest rate will be 6.007%; and the payment amount will be $1,200. As you can see the first payment due will be in February for $1,200. The amount that is used to reduce principal is $198.83 and the remaining $1,001.17 goes towards interest. That’s over 83% of your payment going towards interest.
Now, take a look at the bottom of the schedule. If you multiply 1,200 times 200,000 you come up with 432,000. In other words, this $200,000 loan, if paid on schedule, will cost you over $432,000. Why is that? A Real Estate Loan utilizes what Einstein called the “ninth wonder of the world,” compounded interest.
Compound interest – Interest that is paid on both the principal balance of the loan and on any accrued (unpaid) interest.
Each month when your payment is due, you are charged on the outstanding principal balance of the loan. So, in our example, after the first payment you only paid down $198.83 of principal. Now you owe $199,801.17 and you are charged interest on that amount. Then the next month you are charged on the remaining balance and so on.
The way the figure out the amortized payment ($1,200 in our example) is calculated by assuming that you will make equal monthly payments and never pay any additional payments. But, if you do make extra payments to reduce your principal, your monthly payment will still stays the same. (I’ll get into the advantage of paying extra in the next section) But, at the end of the day you want to pay down the principal as fast so you can pay less interest overall.
So, we’ve covered what a mortgage is, what amortization means and what compounded interest is. Let’s learn take a look at the amortization schedule now and really get into it.
We’ve already talked about the first line:
Feb. 2000 |
$1,200.00 |
$198.83 |
$1,001.17 |
$1,001.17 |
$199,801.17 |
We also talked earlier that it takes 17 to 22 years (depending on interest rate) to make your payment equal parts principal and interest. Here is that same amortization schedule in July of 2018.
July 2018 |
$1,200.00 |
$599.44 |
$600.56 |
$185,772.30 |
$119,372.01 |
The principal payment is $599.44 and the interest payment $600.56. We’ll call that equal. 18 years and 6 months into this loan your payments are finally equal parts principal and interest.
But the average person refinances or moves every 7 years or so. Lets take a look at the numbers of the 7 year mark of this loan.
Feb. 2007 |
$1,200.00 |
$302.45 |
$897.55 |
$80,998.82 |
$178,998.71 |
You’ve made a total of 84 payments totaling $100,800; You’ve reduced your principal by $21,001.29 and paid $80,998.82 in interest. Let’s say the value of your house actually goes up 3% per year (sorry, had to finishing laughing). That means that your house is now worth $245,974.77. At 80% loan to value you can borrow $196,779.82 to pay off your $178,998.71 balance and have $17,781.11 as a cash out option. But guess what? You’ve started your amortization schedule over again. Woops!! That stinks!! Hope you like paying interest.
Let’s learn how to pay down your mortgage fast! —–> Pay Down