A common concern about mortgages is that at the start of a new loan term, most of the monthly payment goes to interest vs principal reduction. While this is true, there is a reason for it.
Mortgages are generally amortized in a way that results in equal payment throughout the life of the loan (assuming there are no interest rate changes). The amount of principal being repaid increases over time and the amount of interest declines but the payment stays the same. This helps provide budgeting consistency but does not mean the amortization schedule is set in stone.
You receive an amortization schedule at closing when you close on a mortgage but this is just a preliminary schedule. It reflects a breakdown of your payments if you make just the scheduled payments. In actuality, your interest charges are still calculated based on the balance you owe. That means your interest charges will decrease if you make additional principal payments.
You might be asking, why don’t they just split up the principal repayment evenly throughout the life of the loan? Wouldn’t this result in less interest being paid? This is known as straight-line amortization. You take the loan amount divided by your loan term and that gives you the monthly principal amount that needs to be paid. You then add the interest charge for the month and you get your total monthly payment. This would result in less interest being paid but the difference may be less than you would think and it comes with the downside of higher payments at the beginning of the life of the loan.
For example, let’s say you have a 30-year mortgage for $500,000 with an interest rate of 6.75%:
- Your first payment with the straight-line method, would be $4,201.39. ($1,388.89 in principal & $2182.50 in interest).
- Your first payment with the equal payment amortization method would be $3,242.99 ($430.49 to principal and $2,812.50 in interest).
By the end of the first year:
- Your payment for the straight-line method would be $4,115.45 ($1,388.89 in principal and $2,726.56 interest)
- Your payment on the equal payment amortization would be $3,242.99 ($457.89 in principal and $2,785.10 in interest)
It would take until month 124 or 10 years and 4 months until the straight-line payment would be equal/less than the equal payment. The overall interest charges on the two loans would be $507,656.25 and $667,476.57, respectively.
A difference of approximately $160,000 is nothing to shy away from but it does come with the tradeoff of increased payments at the beginning of the loan. There would likely be additional underwriting guidelines that would have to go into effect if this was how mortgage payments were calculated.
The main takeaway from this should be that your amortization schedule is not permanent. Interest is recalculated based on the loan amount you owe. If you make additional principal payments on your loan, you can speed up the repayment and decrease your overall interest expenses.
If you have questions, please contact our office to discuss your mortgage needs with one of our experienced Mortgage Loan Originators at (760) 930-0569.
