Home mortgages, like those from Wells Fargo and Fannie Mae, can be pretty confusing. The simple fact is that you need money to build or buy a house but usually that amount is more than what you have lying around. So you gather up the family, and head to your local bank to ask to borrow a couple of dollars to buy or build a home. No problems so far and then you open the door to all these mortgage terms that makes your head spin.
Fixed rate mortgage, adjustable rate mortgage, amortization, closing costs, PMI / Private mortgage insurance, points and down payment are just a few of the terms you may hear. Well lets try and make sense of what a mortgage is and how it works for regular people.
Simple Perfect World Mortgage
Let’s think about a perfect world scenario where banks weren’t greedy and all they wanted to do is let you borrow money for your home. You walk in and ask to barrow $100,000 and they say sure and ask that you pay it back over the next 30 years. Easy right? $100,000 divided by 30 years and then divided by 12 months. Your mortgage payments would be $277.78 and you could live in your house and everyone would be happy. Your mortgage would be paid off in 30 years.
If Mortgages were only this simple!
We all know that the previous scenario would not happen, unless you have some rich relatives that may have a few extra bucks. They could then give you an awesome, no interest mortgage. Simply put, the banks want to make money off of the money you barrow. So, what they do is add interest to the amount you barrow. But it is not that simple. Think how easy it would be if they just charged you 7 percent on $100,000. That would be an additional $7,000 added to your barrowed $100,000 that would give you a grand total of $107,000 to pay back to the bank. Our payments would go from $277.78 to $297.22 which seems pretty reasonable to me and quite a good chunk of change for the bank!
More Realistic Mortgage example.
But that is not how banks and mortgage companies do it. The way they make their money is by focusing on the terms called principal and interest. The principal is the amount of the loan that you have left after making a payment. For example, if you barrow $100,000 and pay $1,000 your principal is now $99,000 or $100,000 minus the $1,000. They take this principal and multiply one twelfth of your interest rate by the principal amount. So to apply this to our example lets take 1/12th of the 7% interest rate to give us .00583 or .583% and multiply that by our principal amount of $100,000 and you will see that we get $583.33 which is one months interest payment. That’s right; the interest on the mortgage for the first month is $583.33. Now if we paid only the $583.33 each month we would never pay towards our $100,000 principal and the loan would go on forever. This is where the bank uses a formula to figure out how much to add to the $583.33 to reduce the principal ($100,000) to an amount of ($0) zero at the end of the loan.
Mortgages, one step further … Amortization.
Above, I had mentioned that banks make their money by multiplying 1/12th of your interest rate by the principal every month. This is important to keep in mind because if the principal is high then your interest will also be high and the amount you pay on the principal will be low. As your mortgage progresses, your principal amount is reduced and the amount you pay toward the principal is actually increased with less money going towards interest and the bank.
Below you will see the comparison of the 10th month payment and 350th month payment for our example above. Notice how at the beginning, most of the money goes to the bank as interest and just a little goes towards the principal. Then at the 350th payment the majority of your money goes to the principal and a little goes to the interest. Have to make sure the bank gets their money first.
| Payment | Towards Principal | To Bank (interest) | Principal |
|---|---|---|---|
| 10th | $86.37 | $578.93 | $99,158.48 |
| 350th | $624.05 | $41.25 | $6,447.31 |
The bottom line when paying your mortgage is to try and put as much towards your principal as possible. This will ultimately reduce the amount you pay in interest. This is most important at the beginning of your mortgage when the amount going to principal is the so small.