Mortgage loans are a good thing. They provide us the opportunity to purchase and occupy a home before we have all the funds to do so. This opportunity does come at a price. The price is the amortized payment schedule, which means each month part of the payment goes toward both the principal balance and interest payment (cost of the loan) until the homeowner pays the loan in full.
Is it possible that the old standard of calculating home loans is killing the real estate market and our economy in general? Maybe it is time to think about a new way of calculating home loan payments.
The federal government first introduced amortized loans during the Great Depression because people were losing their homes. They weren’t able to make the balloon payment that were common at the time.
Although we would like to think the Fed created amortized loans to get more money out of us, in actuality it was trying to help people keep their homes. This era was a time when the wealthy predominately owned homes, and about 60 percent of the population rented their residences. Things were tough, and even the wealthy struggled to pay their mortgages.
Visit this website for a complete reference of the 1932 and 1934 Act.
Mortgage loans are a good thing. They provide us the opportunity to purchase and occupy a home before we have all the funds to do so.
This opportunity does come at a price. The price is the amortized payment schedule, which means each month part of the payment goes toward both the principal balance and interest payment (cost of the loan) until the homeowner pays the loan in full.
While researching this subject, what I found oddly interesting was the genesis of the term “amortizing” a debt. The word derives from the French term “amortir,” which is the act of providing death to something (like maybe your wallet).
Let’s review how to calculate an amortized mortgage payment:
The payment of an amortized loan is calculated by adding the total loan amount (principal) to the total interest that the homeowner will pay over the life of the loan and then dividing by the total months (30 years x 12 = 360 months).
Let’s use the following example:
A $100,000 mortgage loan (the principal amount) with 4 percent interest and a 30-year term. Now we need to figure out the total interest. The formula is (Interest = Principal x Rate x Time). The easiest way to calculate total interest is to use an amortization table. Visit this website to view an amortization table.
According to the amortization table, the total interest the homeowner will pay on the loan following the full 30-year term is $71,869.51. That is quite a chunk.
Now to calculate the monthly payment:
Total Principal ($100,000) + Total Interest ($71,869.51) = $171,869.51 / Total Number of Payments (360) = $477.42. This is known as the P&I part of the mortgage payment (principal and interest).
Here’s the catch:
The homeowner pays the majority of the interest upfront. You see, each payment is calculated based on the outstanding loan principal. The homeowner’s first month’s payment is $477.42 with $333.33 going to interest and $144.09 paying down the principal. That means the following month’s interest is calculated from the new principal of $99,855.92 ($100,000 – $144.09). That’s why it takes so long to pay off the loan.
Here’s my idea:
Let’s say the homeowner agrees to pay back the total amount of $171,869.51 over 30 years. Each month, $238.71 would go toward the principal and the same amount toward interest (50 percent/50 percent). Within seven years, your principal balance would be $79,948.36. Using the amortization schedule of 1932, after seven years your principal balance would be $86,059.47. Using my plan, the homeowner would have $6,111.11 more equity in the home.
We have become a transient society, and we need a mortgage plan that reflects the times in which we live. On average we move every seven years. The reason many people do not move is because they do not have enough equity in their home. This lack of equity might be because there is too much money going to the interest payment upfront and not enough toward the principal balance. Knowledge is power.
We need a new plan.
Happy Memorial Day — please say thank you to a veteran.
Jeffrey Hogue has been a real estate innovator and creator since 1993.