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How
Mortgage Loans Work
Excluding property taxes and insurance, a traditional fixed-rate mortgage
payment consist of two parts: (1) interest on the loan and (2) payment
towards the principal, or unpaid balance of the loan.
Many
people are surprised to learn, however, that the amount you pay towards
interest and principal varies dramatically over time. This is because
mortgage loans work in such a way that the early payments are primarily in
interest, and the later payments are primarily towards the principal.
In
the beginning... you pay interest
To help calculate monthly payments for loans based on different interest
rates, lenders long ago developed what are known as "amortization
tables." These tables also make it fairly easy to calculate how much
money of each payment is interest, and how much goes towards the principal
balance.
For
example, let's calculate the principle and interest for the very first
monthly payment of a 30-year, $100,000 mortgage loan at 7.5 percent
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
$74.21
of the first payment goes towards the principal
Next,
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 payments, we just repeat
the steps already described.
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
$74.67
goes towards 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 percent interest. The monthly payment is around $700,
which over 30 years adds up to $252,000. In other words, over the life of
the loan you would pay $152,000 just 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 what loan makes
the best sense for your individual situation
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