Articles about Homebuying
Excluding property taxes and insurance, a traditional
fixed-rate mortgage payment consists of two parts:
(1) interest on the loan, and (2) payment towards
the principal (the unpaid balance of the loan).
Many people are surprised to learn that the amount
you pay toward interest and principal varies dramatically
over time. This is because mortgage loans work in
such a way that the early payments are primarily interest,
and the later payments are primarily towards principal.
In the beginning... you pay interest:
To help calculate monthly payments for loans based
on different interest rates, lenders developed what
are known as "amortization tables." These
tables also make it fairly easy to calculate how much
of each payment is interest, and how much goes toward
the principal balance.
For example, if you calculate the principle and interest
for the first monthly payment of a 30-year, $100,000
mortgage loan at 7.5% interest, according to the amortization
tables, the monthly payment on this loan is fixed
at $699.21.
The first step is to calculate the annual interest
by multiplying $100,000 x .075 (7.5 %). This equals
$7,500, which we then divide by 12 (for the number
of months in a year), which equals $625.
If you subtract $625 from the monthly payment of
$699.21, we see that $625 of the first payment is
interest, and $74.21 of the first payment goes toward
the principal . If we subtract $74.21 (the first principal
payment) from the $100,000 of the loan, we come up
with a new unpaid principal balance of $99,925.79.
To determine the next month's principal and interest
payment, we just repeat the steps above.
Thus, we now multiply the new principal balance (99,925.79)
times the interest rate (7.5%) to get an annual interest
payment of $7,494.43. Divided by 12, this equals $624.54.
So during the second month's payment $624.54 is interest
and $74.67 goes toward the principal.
Note: In Canada, payments are compounded semi-annually
instead of monthly.
Equity:
As you can see from the above example, even though
you pay a lot of interest up front, you're also slowly
paying down the overall debt. This is known as building
equity. Thus, even if you sell a house before the
loan is paid in full, you only have to pay off the
unpaid principal balance--the difference between the
sales price and the unpaid principle is your equity.
In order to build equity faster--as well as save
money on interest payments--some homeowners choose
loans with faster repayment schedules (such as a 15-year
loan).
Time versus savings:
To help illustrate how this works, consider our previous
example of a $100,000 loan at 7.5% interest. The monthly
payment is approximately $700, which over 30 years
adds up to $252,000. In other words, over the life
of the loan you would pay $152,000 in interest.
With the aggressive repayment schedule of a 15-year
loan, however, the monthly payment jumps to $927--for
a total of $166,860 over the life of the loan. Obviously,
the monthly payments are more than they would be for
a 30-year mortgage, but over the life of the loan
you would save more than $85,000 in interest.
Bear in mind that shorter term loans are not the
right answer for everyone, so make sure to ask your
lender or real estate agent about which loan makes
the best sense for your situation. |
