By Ryan C. Wood
Do you know how much your home will cost you? That is the total cost of the loan? Did you look at the total amount of interest you will end up paying if you make each and every mortgage payment for 30 years? What if you refinance in year three? How will that change what you are paying? One of the nastiest parts of purchasing a home is that your mortgage payments are heavily weighted to pay interest first rather than principal. When a house value is continuing to increase this is not a huge issue. If the value of the home is slowly increasing or the market is stagnated your investment by buying the home is actually decreasing each month. The mortgage meltdown crisis should tell you enough about how things work.
Too big to fail versus too small to matter is how it went down. Just ask any bankruptcy attorney that lived the mortgage meltdown.
The thing is though most people will never be able to pay cash for a house. Spreading out payments over 30 years makes the loan affordable and allows more people to purchase homes that could not otherwise. Purchasing a home and the resulting fixed monthly mortgage payment is usually a huge financial win for housing costs. Rent increases with inflation and other market conditions significantly over time. This is why rental properties are such a great investment under most circumstances. Once you purchase a home though hopefully your wages increase but your housing costs stay the same.
What If Mortgage Payments Were Half Interest and Half Principal From the Beginning?
Here comes the fun with numbers part to illustrate the huge difference. Let us take a $1,000,000 homes since that only gets you one bedroom with a bathroom on the Peninsula in the Bay Area where I am located. With a 20% down payment to avoid private mortgage insurance the mortgage loan will be $800,000.00. To pay off the $800,000.00 loan at a fixed interest rate of 3.7% and amortized over 30 years the total amount paid will be $1,427,615.00. Of that total interest paid is $525,615.00.
$800,000.00 at 3.7% interest with 360 monthly payments
Total Payments: $1,325,616.14
Total Interest: $525,616.14
The first mortgage payment is about 67% applied towards interest and 23% applied to principal. Over the life of the 30 year mortgage these percentages slowly change. At the 6 year mark 60% is applied to interest and 40% is applied to principal or $1,471.24 towards principal and $2,211.02 towards interest ($3,682.26 total monthly payment). The middle mark of the loan term or the 181th payment is 43% principal and 57% interest. The last payment of 360th payment is a mere $11.32 towards interest and $3,670.95 to principal and the loan is paid in full. The 360th payment is 0.30% interest and 99.70 % principal.
At 2.75% interest: Total Interest Paid: $375,734.60
At 3% interest: Total Interest Paid: $414,219.62 +38,485.02
At 4% interest: Total Interest Paid: $574,956.05 +$160,736.43
At 4.5% interest: Total Interest Paid: $659,253.69 +$245,034.07
Let us assume we are in year 7 and you have now paid $316,674.36 in total principal and interest. Of this you have paid approximately $174,173.00 in interest through 86 or seven years of mortgage payments. We will come back to this below when examining the result of a refinancing the mortgage to a new fixed 30 year loan to get a better percentage rate of pull out equity that has accrued in the seven years since purchase.
So how do mortgage lenders ever lose money? Everything they do is resulting in interest income from funds on deposit and getting money from the Federal Reserve at a lower rate.
Why Are Mortgage Payments Primarily Applied to Interest and Not Principal In the Beginning?
This type or amortization provides for equal payments throughout the entire 360 month or 30 year term of the mortgage. As a bankruptcy attorney I can tell you that this probably a necessary evil and helps people keep things straight. There is a huge percentage of homeowner are just getting by each month and pay different amounts each month for their mortgage. Why you ask? The vast majority of people buy too much house and cannot pay a down payment totaling 20% or more to avoid private mortgage insurance. They make it worse by choosing to not pay property taxes and insurance directly but via the monthly mortgage loan payment. You will then be dependent upon the servicer or mortgage company to recalculate the property tax and insurance as the property taxes increase. Therefore the mortgage payment must increase too. The problem is many servicers and mortgage companies fail to timely and regularly recalculate the taxes and insurance so this results in large changes in the monthly payment to catch up on already paid property taxes. This system is ripe for fraud and miscalculation.
Does Anyone Save Money When Refinancing A Mortgage Loan?
Did you calculate the amount of interest paid versus principal prior to refinancing your mortgage loan? Or is the enticing thought of paying less each month or obtaining the cash from pulling out equity from your home too much to pass up?
So taking our example above you paid $174,173.00 in interest during the first 7 years of your mortgage loan and decide to refinance at a lower percentage rate. We shall use 2.70% instead of 3.7%. After 7 years of payments the principal owed at that time and the amount refinanced is $683,076.57. Your new refinanced loan with a new term 30 year term at 2.70% will cost you a total of
$683,076.57 at 2.7% interest with 360 monthly payments
Total Payments: $997,395.73
Total Interest: $314,319.16
Just comparing the loans on their face you will save $211,296.98 total. But did you take into account all the interest already paid? Yes, you reduced the principal and you are refinancing the lower principal amount too. How much did you really save though? When taking into account the interest already paid totaling $174,173.00 already you will save about $37,123.98 over the total life of the 30 year loan.