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What's a
mortgage?
A mortgage is just the fancy word for the
loan you get from a bank when you buy a house. It's
also called a note. Mortgage, loan, note, debt, it's all
the same thing.
When you buy a house you typically make a down
payment (5-20% of the purchase price) and get a mortgage
from a bank to pay for the rest. You really own the
house, not the bank, but you're indebted to the bank for
a while. A residential mortgage usually lasts 15 or 30
years, and commercial mortgages are typically 20.
If you don't make your payments, the bank can
repossess your house.
Before the bank loans you the money they'll have
the house you want to buy appraised. That
means they have a professional give an estimate of how
much the house is worth. They're not going to loan you
$150,000 to buy a house that's only worth $100,000,
because if you stopped making payments then when they
repossessed it they'd only be able to sell it for $100k,
and they'd be out the excess that they loaned you.
That's also one of the reasons why they require you to
make a down payment. Even if the house is worth $150,000
they're only going to loan you $135,000 or so, because
they figure they're going to have some expenses in
selling the house if they have to repossess.
Figuring the
payments on a mortgage
Mortgage payments use compound interest, not
simple interest. So you have to use a spreadsheet to
find out the amount of a mortgage payment. Just type this
into Micro$oft Excel:
=-PMT(InterestRate,NumberOfPeriods,LoanAmount)
Of course you need to plug your own numbers in. For a
$800k loan at 8% interest for 20 years we'd have:
=-PMT(8%,20,800000)
And the answer is $81,482 a year. Of course, loans are
paid back monthly, not yearly. So to add that to our
formula we'd divide the interest rate by 12 months, and
figure that we have 240 months instead of 20 years:
=-PMT(8%/12,240,800000)
And the answer is $6,692/mo.
Principal vs.
Interest
When you make your monthly mortgage payment,
part of it pays back the actual money you borrowed
(principal), and part of it is the profit the bank makes
(interest). You can't tell by looking at your
$6,692/mo. payment how much is principal and how much is
interest. You have to use a spreadsheet to calculate it,
which we'll do in a minute.
The ratio of principal to interest changes over the
life of the loan. On a new loan most of the payment is
interest and very little is principal. As the loan
matures the proportions change, so by the end most is
principal and very little is interest. The reason for
this is that the amount you pay in interest is based on
how much money you owe the bank. When the loan is brand
new you owe the bank a lot, so you pay a lot of interest.
But as you pay back the loan over time you have less and
less of the bank's money, so you pay less interest.
Here's how it looks in a table. Remember that our payment
on our loan is $6,692/mo.
|
Month
|
Interest
(8% times the balance,
divided by 12 months)
|
Principal
(Payment minus
Interest)
|
Balance
|
|
(start)
|
|
|
$800,000
|
|
January
|
$5,333
|
$1,358
|
$798,642
|
|
February
|
$5,324
|
$1,367
|
$797,275
|
|
March
|
$5,315
|
$1,376
|
$795,898
|
Notice that the balance is reduced by only the amount
of principal we paid, not by the total amount we paid.
Also notice that as we pay down our balance, less and
less of our payment goes towards interest and more and
more goes towards principal. Ten years into your loan you
haven't paid off half of it, you've paid off only 32% of
it.
Paying it off
early
Most loans allow you to make extra principal
payments (a prepayment) whenever you want, which
go completely towards reducing your balance. Let's say we
find $100k in a filing cabinet in February and we want to
use it to pay down our debt. Using our example from
earlier it would look like this:
|
Month
|
Interest
(8% times the balance,
divided by 12 months)
|
Principal
(Payment minus
Interest)
|
Extra Principal Payment
|
Balance
|
|
(start)
|
|
|
|
$800,000
|
|
January
|
$5,333
|
$1,358
|
|
$798,642
|
|
February
|
$5,324
|
$1,367
|
$100,000
|
$697,275
|
|
March
|
$4,648
|
$2,043
|
|
$695,232
|
Note that not only does our balance plummet, but also
starting in March a lot more of our payment goes towards
principal and less goes towards interest. We'll now pay
off our loan a lot faster than we would have
otherwise.
Unfortunately some loans have a prepayment penalty.
This isn't always the end of the world, however. Many
people hear the word "penalty" and run for the hills, but
really we just need to look at the amount of the penalty
and see whether it's bigger than the amount of interest
we'd save by paying off our loan early.
The worst kind of loan doesn't let you pay it off
early, even with a penalty. You either have to pay it off
on the original schedule or refinance -- if the bank lets
you. They don't have to.
What is
refinancing?
Refinancing is when you take an existing loan
and turn it into a new loan with different terms. There
are a few reasons you might do this:
- Lower interest rate. If interest rates have
fallen, getting a new loan with a lower interest rate
means that your payments will be lower.
- Spread payments over a longer term. Let's
say we got a $150k loan at 8% for 20 years. Our
monthly payment is $1,255. Now let's say that we're 10
years into this loan. Using a spreadsheet like the
table above we'll see that we have about $100k left on
the loan. Now we'll refinance our $100k that's left
over another 20 years at 8% interest and voila, our
monthly payment drops to only $836! The catch is that
we had been only ten years away from paying off
our debt (and eliminating the monthly payments
completely), but now with a new 20-year loan we're an
additional ten years away.
- Combine multiple loans. ICC has twice
refinanced in order to combine multiple loans. In 2001
we combined our house mortgages with the Seneca/HoC
renovation loan, and in 2003 we refinanced to combine
that loan with money we borrowed to purchase
1910 Rio Grande.
You don't have to refinance at the same bank. If you
go to a new bank, then your new bank will pay off your
balance at your old bank. This assumes that your loan can
be paid off early. Obviously if your loan can't be paid
off early then you couldn't refinance at a new bank
because they wouldn't be able to pay off your old
loan.
What's Fixed Rate
vs. Adjustable Rate?
Most mortgages are fixed rate (FRM),
which means that the interest rate is the same over the
life of the mortgage. The other kind is adjustable
rate (ARM), which means that the interest rate varies
over the life of the mortgage. The amount that it varies
is based on weird rules that are particular to each loan,
but they're usually based on some permutation of the
prevailing market rate. So if interest rates go up in
general, an ARM will go up, and if interest rates go
down, an ARM will go down.
If interest rates are low, you want FRM so you can
lock in that low rate. For the same reason, the bank will
try to sell you on ARM because they don't want you paying
a low rate forever. You might take an ARM even if you
don't want one if no bank will give you FRM at a good
rate.
If interet rates are high, you want an ARM because
rates will probably go down eventually and so will the
rate on your ARM. When they do you can try to refinance
at a lower rate with a FRM.
The rule of thumb is: If rates are lower than 10% try
for FRM; if they're higher than 10% then go for ARM.
What's a
balloon?
A balloon is one of those little rubber thingies
you inflate for parties -- what are you, stupid?
Just kidding. Okay, some loans require that the entire
balance be paid off after a certain number of years,
usually five. This kind of loan is said to have a
five-year balloon.
What kind of crazy thing is this? Why would the bank
give you such a wacko loan, and more importantly, why
would you accept it? How could you possibly pay off the
whole balance after five years?
Well, you couldn't. So you'd refinance when the
balloon came due. You know from the refinancing section
above that that lowers your payment, but extends the
amount of time that you have to make payments.
So again, why would you do this? You'd do it if that
were the only kind of loan the bank would give you. Banks
love these kinds of loans because you can never pay them
off so you owe them forever. If at all possible, you'd
get a regular loan (also called a permanent loan),
without a balloon. But if you didn't have much choice
(the only loan that any bank would give you was a
balloon), you'd take the balloon.
One last thing: Usually you can't make prepayments on
a mortgage with a balloon.
Now that you know all about mortgages,
find out what kind of
mortgages ICC has.
or
Get more details about How
to Buy a House.
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