Before Purchasing a Home – Understand How Mortgages Work

Purchasing a home is an extremely exciting moment, especially if you’re a first-time homebuyer. This is a critical time for you to make solid financial decisions. You’ll decide if you’re going to pay in cash, whether you should take out a mortgage or not, how large of a mortgage it will be, and whether you plan to pay it off early or not. For many, these decisions might seem overwhelming, but not to worry, as I will walk you through these details.

Home Mortgage

Imagine you’re purchasing a new home, the home you’ve always wanted with an elegant entryway, a chef style kitchen, and a perfect room for entertaining. The price tag on the house is $1M. You’re debating how you should cover this cost, but you know that you don’t want to pay all cash, so you’ll need to get a loan. This loan is called a mortgage. The mortgage is paid off through a series of monthly payments.

3 Factors Determining Your Mortgage

The most important consideration when getting a mortgage is how much your monthly payment will be. Your monthly payment is dependent upon three factors: (1) the amount of the loan, (2) the length of the loan, and (3) the interest rate that you are able to secure for the loan. Let’s review these further.

The Amount of the Loan

The amount that you borrow directly correlates to the size of your monthly payment. For instance, if you borrow $500,000 for 10 years at 4% interest, your payment will be around $5,062 each month.

But if you borrow $1M dollars, for 10 years at 4% interest, your payment will be $10,125 every month.

The Length of the Loan

In general, the longer you take to repay a loan, the lower your payments will be.

For illustration purposes, a mortgage of $1M payable over 10 years, at 3% interest, results in a monthly payment of $9,656.

However, if you pay off the mortgage of $1M over a period of 20 years, at 3% interest, the monthly payment drops to $5,546.

The Interest Rate of the Loan

The higher your interest rate, the larger your monthly payment will be. For instance, a 30-year loan for $1M, at 3% interest, costs $4,216 per month.

A 30-year loan for $1M, at 4% interest, the monthly payment would be $4,774.

Take a moment to review the following tables detailing 5, 10, 20, 30-year terms and various interest rates and monthly payment amounts.

Interest & Principal | Mortgage Calculations

Congratulations on your new home! You’ve now pinpointed the exact house that you want, and you’re ready to buy it. You decide to take out a mortgage with the following terms: 20 years, $750,000, at 5% interest.

The total amount of your monthly payment will be $4,950 / month.

There are two important things you need to consider throughout the entirety of your mortgage.

1. How much money do you owe the bank at any given moment?
2. From your payments, how much goes towards the “principal” and how much goes toward “interest.” These are always two separate factors.

So, let’s look at your particular $750,000 loan. As soon as the loan is finalized, you now owe $750,000. For your first mortgage payment, the interest on the payment will be:

$750,000 * .05 / 12 = $3,125.

So, after you make your $4,950 payment, $3,125 of that will be applied toward the interest only, and $1,825 of that will go be applied toward the principal (total owed). To put it in percentage terms, 63.13% will go toward interest, and 36.87% will go toward the principal.

This is how it appears: $750,000 – $1,825 = $748,175. Only the principal portion of the payment gets applied to the total amount that you owe.

Now, let’s discuss the crucial part. In the second month when you pay your mortgage payment, you will only be paying interest on the $748,175 – not the original $750,000.

So, the interest amount will be less – $748,175 * .05 / 12 = $3,117.40 and the principal will be $1,832.60.

This means that every month going forward, you’re paying in interest and more towards the principal. 62.98% (63.13% prev.) toward interest and 37.02% (36.87%) toward the principal.

At the end of the second monthly period, you will now owe the bank: $748,175 – $1,832.60 = $746,342.40.

Thus, as you progress along in paying down the loan, the interest amount continues to go down, and the principal portion goes up. This is an important concept to understand because the amount you pay every month remains the same, but what gets applied to the loan is different. Next, we’ll look at how we can take advantage of this.

Paying Additional Amounts to Accelerate the Payoff

Let’s fast forward – 6 Years. You’ve been acknowledged for your dedication at work with a promotion and an increase in salary. You’ve been wise and investing your money, and now that you have additional cash, you can begin allocating it toward your mortgage.

So, you decide to start adding $1,500 a month to your payments because you already know that you can pay off this loan faster and reduce the amount you’re paying in interest.

Instead of paying $4,950 each month, you’ll now be paying $6,450. Now you will be greatly accelerating the payoff of your mortgage and reducing the amount of interest you will pay over time.

Looking at the new accelerated payment schedule you see that now, instead of taking 20 years to pay off your mortgage, you will reduce it by 4 years and 2 months. The original payment schedule would have paid $437,920 in interest alone, but now, because of your understanding of mortgages, you will only pay $362,410.

That’s a savings of $75,510 that will continue compounding in one of your other investments.

Key Takeaway

You now understand the concept of mortgage payment calculations and how increasing payments will accelerate the payoff and ultimately save you a great deal of money.

Caveats

Some may argue that there are better places to put your money and earn a higher interest rate. A simple example is an S&P 500 Index Fund, which has historically earned a higher rate than 5%. This does require a specific type of risk taking, as markets can be volatile, and you are not guaranteed anything in the stock market. You are guaranteed 5% on your money by reducing the overall length of the loan. For some, this is good enough. Many people just love having the peace of mind that their homes are paid for which allows them to sleep better at night.

Early Pay-Off Penalties

Some mortgages have early pay off penalties. So please review your loan agreements prior to paying them off early. Even better, make sure this clause is not in your loan agreement if you plan on using an accelerated method.

Conclusion

Now you’re equipped with impactful knowledge to make smart decisions on how you’ll set up your mortgage and even apply accelerated methods to pay off your home, saving tens of thousands of dollars. Taking the time to review your own financials and the various options can provide you all the insight that you need before approaching a bank. Remember the goal is understanding that the monthly payments are comprised of both interest and principal, and that number is determined by the amount of the loan, the length of the loan, and the interest rate. Keep in mind that the interest rate will be the most important factor, followed by the length of the loan. Most people shopping for a mortgage only have their eye on the monthly payment, but educated buyers, meaning you, know precisely what their objective is before getting the loan.

I hope this topic has helped you realize the components of how the payments are determined, and how you can pay off the loan sooner to reduce your overall interest payments, which in turn means savings for you! This too can be viewed as an investment simply by accelerating the reduction of your debt. If you have any further questions on mortgages, feel free to leave a comment below.

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