How Amortized Mortgage Loans Work

October 22, 2012 — 1 Comment
How amortized mortgages work

Do you think they use an amortized mortgage??

Mortgage loans are good because they provide us the opportunity to purchase a home before we have all of the cash saved up, but do you know how amortized mortgages loans really work?  They definitely come at a price and you should try to pay it off before the loan term (easy for me to say, right?).

Most mortgage loans are amortized loans, which means each month your payment goes towards the interest and the principal until it’s all paid off. While I was researching the ins and outs of amortized loans, I found this interesting little tidbit from about.com:

This is referred to as ‘amortizing’ a debt, a term that takes it’s roots from the French term ‘ amortir’, which is the act of providing death to something.

I like amortized loans even less after learning the root word’s meaning! As long as I put death to it before the other way around…

How is your amortized mortgage payment calculated?

The payment is calculated in an amortized loan by adding the total loan amount (principal) to the total interest that will be paid 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: $150,000 mortgage loan, 5% interest, 30 year term.

We already know the total principal ($150,000), but now we need to figure out the total interest which is the hard part. The formula is “I = PRT” (Interest = Principal x Rate x Time). However, the easiest way to calculate total interest is to use an amortization table (I’ve created an Excel version – you can download here).

According to the amortization table, the total interest you’ll pay on the loan if you follow the 30 year schedule is $139,883.68. Yes, that’s almost as much as the original loan! Now to calculate your monthly payment:

Total Principal ($150,000) + Total Interest ($139,883.68) = $289,883.68

Payment = $289,883.68 / total payments (360) = $805.23

There’s your payments, $805.23 per month. Here’s the catch, the way the amortized loan works, the majority of your interest is paid up front. That’s because the genius who invented amortized loans (Charles S. Amort – I made that up) didn’t decide to split the principal and interest evenly on the loan which is what sounds fair to me. Instead, he decided each payment will be calculated based on the outstanding loan principal.

Therefore, the first month’s interest payment looks like this:

First month’s payment = Monthly payment ($805.23) x .0042 (Annual Interest (5%) / annual payments (12)) = $625

That means your first month’s payment is $805.23, with $625 going to interest and $180.23 paying down your principal. Isn’t that a load of crap?!?! That means next month your interest will be calculated off your new principal ($150,000 – $180). That’s why it takes so long to pay off your entire loan.

Pretty simple right? If you say yes, you must be Einstein’s reincarnation because it isn’t simple at all and it’s taken me forever to write this post!

Why is so much interest paid up front?

As mentioned, with an amortized loan you pay interest based on the remaining principal you owe on the house. In the beginning, you’ll owe the highest principal, which means the interest amount of your payment is the highest, and the bank makes its money up front!

Something smells fishy…

Here’s the catch: on average, Americans move every seven years. Amortized loans are set up to take advantage of our mobility because we pay so much more interest up front than we do principal. Let’s take a look at a direct comparison of the ‘seven year itch’ using the same loan mentioned above.

If you paid the payment amount for seven years, you’ll have paid: $49,557 in interest and $18,082 on principal. That’s why amortized loans make me so angry. In a future post I’ll get into the numbers of how helpful it is to refinance if you haven’t already and making extra payments.

In the meantime, get angry with your mortgage and vow to take it out! If you’re in the market for a mortgage, be sure to check out my 2x income rule to determine how much mortgage you can afford.

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One response to How Amortized Mortgage Loans Work

  1. Hi, in your research have you ever discovered who exactly came up with this amortization plan? I have looked but thus far been unable to actually find the cretin who introduced this particular brand of slavery. If you ever do find out, please let me know. Thanks.

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