Front-loaded loans: bad for borrowers?
Some feel interest burden is a rip-off
By Jack Guttentag, Monday, November 23, 2009.
Flickr photo by MC Quinn.It is often said that the interest on home mortgages is "front-end loaded," implying that the way lenders charge interest is both unfair and self-serving -- possibly even sinister. The following statement is typical.
"Did you know that on your typical 30-year mortgage, it takes approximately 21 years just to pay down less than half of the principal of your loan?
The mortgage industry's big secret has been kept away from the public since the Roosevelt administration. This little-known secret has been taking you (and every other homeowner) for a very costly ride. Your 6 percent LOW-INTEREST MORTGAGE IS REALLY costing you upwards of 60 percent or more!
You might be asking how you could possibly be paying THAT much without knowing it? It is because ALL mortgages are front-end loaded, meaning you're paying off the interest first. So during all of those first years, you aren't paying down the principal. Instead, you're buying the banker a new Mercedes."
Let's begin with the factual foundation for this position, which is not in dispute. The standard mortgage contract calls for full amortization over the term with equal monthly payments of principal and interest. For example, a $100,000 loan at 6 percent for 30 years has a payment of $599.56. That payment, if made every month for 30 years, will retire the mortgage. For convenience, I will call a fully amortizing mortgage with equal monthly payments a "FAMEMP."
A necessary consequence of full amortization with equal monthly payments is that the composition of the payment between interest and principal changes over time. In the early years, the payment is mostly interest; in the later years, it is mostly principal. At 6 percent, it does indeed take 21 years to pay down the balance of the $100,000 loan to $50,000. This is the factual foundation of the front-end-loading argument.
The edifice built on this foundation, however, is entirely erroneous. Lenders collect exactly the interest to which they are entitled throughout the life of a FAMEMP. The interest collected is based strictly on the amount owed them. In month 1, the interest payment is $500 because the lender is owed $100,000 -- in month 253, the interest payment is $250 because at that point the lender is owed only $50,000.
If two 6 percent loans are made at the same time, one for $100,000 and one for $50,000, it is obvious that the interest due on the first will be twice as large as that on the second. But, the same is true of a single 6 percent loan on which the balance is $100,000 at one point in time, and $50,000 at a later point. ...CONTINUED
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Submitted by Teresa Boardman on November 23, 2009 - 6:00am.
This is something that I explain to people . . mostly relatives, friends and clients when they ask about refinancing. Most consumers are oblivious to this fact and don't understand that with that new loan they are starting all over and paying mostly interest.
Submitted by Mario Marrufo on November 23, 2009 - 6:44am.
It is appalling, how much money is being made by these banks, and how they are making it. No matter what the consumer does they are always taken for a ride by these banks.They charge you interest up front, to make sure, that if you refinance, they at least made their money. Then penalize you if you refinance early, or at least they did, not no more.Then they act like they have no money. It's outrageous!!!!
Mario Marrufo
CENTURY 21 EXCELLENCE
mario.marrufo@century21.com
cell 323/632/9023
lic# 01506359
Submitted by Mike Parker on November 23, 2009 - 8:03am.
Mike Parker
mparker@theblackwatercg.com
The interest is calculated based on the "Rule of 78ths," which has covered full amortization installment interest since the original banker figured out how to earn most of the interest in the few years before refi or sale.You can look it up for a full explanation.
It's perfectly legal, perfectly fair, and ubiquitous. Without it, banks wouldn't make loans because they rarely go to maturity and each transaction would be far less profitable. It's called "self-defense."
Submitted by Marcy Spieker on November 23, 2009 - 8:07am.
I certainly do not feel there is anything so "sinister" or "secretive" about the way interest is charged. With all of the required disclosure, including the total pay off amount running the life of the loan, it's hard to say it's secretive. You almost seem to imply that every consumer is too stupid to understand the terms of the loan.
When representing a buyer I always print them off an amortization schedule and discuss their options to minimize the amount of interest paid over the life of the loan.
You are asking a lender to loan you hudreds of thousands of dollars - I guess you either do it by their terms or don't take the loan.
Submitted by Carolyn Enlow on November 23, 2009 - 4:26pm.
It is surprising how many borrowers don't understand loan structures, interest and principal payouts. It frequently gets lost in the qualifying and tax issues.
In these uncertain times we try to educate buyers to influence them toward thirty year loans with payments below their highest qualification and ability, then to make extra payments each month when they can.
Even those buyers that do understand the "front loaded interest" issue are seldom aware of the huge impact of making extra principal payments each month. In the $100,000, 6%, 30 year example above the buyer is paying $116,000 in interest over the loan term. By simply paying an extra $100 a month toward their principal they would reduce their interest by 35% or $40,000 and be done with the loan in 21 years instead of being half-done.