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Front-loaded loans: bad for borrowers?

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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.

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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