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A Look At Mortgage Interest
By JLP | July 20, 2009
Long time readers of AFM know that I like to look at things differently through the use of spreadsheets. I have kind of gotten away from such posts in recent months. But, after reading comments from various readers I have decided to try to do more spreadsheet posts. They are fun to put together and are a way for me to distinguish AFM from all the other personal finance blogs.
So…
Today I want to look at mortgage interest. You may have seen this graphic before:
This graphic shows the point at which the percentage of a mortgage payment going to principal is equal to percentage going towards mortgage interest. This example is based on a 5.5% 30-year fixed rate $200,000 mortgage.
It’s interesting to note that on a 360-month loan, the percentage of the payment going towards principal does not exceed the percentage going towards interest until payment #210 (about 17.5 years into the loan). At payment #210, you will have paid nearly 76% of the total interest due on the loan, as shown in the following graphic:
This graphic shows that at the end of 10 years, you would be 33.33% of the way through paying off your mortgage, but would have already paid 48.54% of the total interest on the mortgage ($101,351 total interest paid ÷ $208,808 total interest on the loan). The difference (or spread) between the two numbers is -15.20% (33.33% – 48.54%). The spread continues to widen until payment #202 and begins to narrow at payment #207 as the following graphic shows:
BOTTOM LINE
All of this is just another way of showing how interest on loans is front-loaded (81% of the first payment goes to pay interest). You can use this to your advantage by paying more towards your principal at the beginning of the loan rather than waiting until the end of the loan—that is if it is your goal to pay off your mortgage as quickly as possible.
Thoughts?
Topics: Mortgages | 10 Comments »
July 20th, 2009 at 8:26 pm
JLP, please don’t say that interest on a loan is front-loaded. That implies that you are paying more interest than you owe. As your own calculations would show, fixed period, fixed interest rate loans like mortgages and car loans are structured so that each month you only pay the interest you owe on the previous month’s outstanding balance, plus enough principal to make each month’s payment amount the same for the life of the loan.
These loans seem “front-loaded” only because you are not obligated to pay more principal each month. But, as you pointed out, you can easily add your own extra principal payment to pay off your loan faster.
Ignorant people, who don’t know the first fact about mortgages, nor how to calculate interest, like to use the fact that you pay so much interest in the beginning as “proof” that banks are out to screw us through these loans.
July 20th, 2009 at 8:32 pm
Good point, Jimmy. I wasn’t implying anything other than what I wrote.
July 20th, 2009 at 9:49 pm
“Net effective interest” method vs. “simple interest” comes to mind from my schooling many moons ago.
Significant to your readers would be the acceleration of this 50-50 point w/ a 15-yr vs 30-yr loan. If you re-run your numbers w/the revised 15-yr term you’ll see the turning point is much sooner. Thus showing that “time value of money” works even when in debt!
With our 15-yr refi loan, our turning point is within the 1st 6 pmts.
July 21st, 2009 at 3:52 am
#1 and #3 got me thinking of a point I learned with my 15 year loan.
The % paid towards principle the first month on my 15 year loan is the same or close to the % of the loan going towards principle, as the 16 year first month payment on a 30 year loan!!!!!
July 21st, 2009 at 7:10 am
Great article JLP. Is it possible for you to share your spreadsheet with us readers? I am not very good with creating spreadsheets myself and would love to play around with it using my mortgage.
July 21st, 2009 at 10:03 am
Other interesting observations: at 17.5 years on a 30-year mortgage (58% done), you’ve only paid off 39% of the principal balance.
Whereas, with a 15-year note, once 58% done (8.7 years) you would’ve paid off 48% of the principal.
I think the “Percent of Loan Paid” column is misleading, since after the first year on the 30-year mortgage, you have only paid off 1.3% of the principal balance (not 3.3% as you seem to imply). You are basing the column on number of payments, instead of on principal balance (which is what matters when it comes to refinancing, etc).
Nobody says they are “half way” when they reach payment number 180 on a 360 month schedule. You are “half way” when you’ve paid half the balance which is around year #20 for a 30-year loan.
This is exactly the converse to what you are saying with interest (half the interest is paid in the first 10 years) — which means half the principal is paid in the last 10 years.
July 21st, 2009 at 10:19 am
LOL,
Good points, all.
I don’t think it’s misleading. It’s just another way of looking at the mortgage.
July 21st, 2009 at 10:52 am
‘Misleading’ is a bad word choice — sorry bout that.
One other comment: It is interesting that you chose to make your table with interest fixed at $208,808. In reality it is the principal that is fixed at $200,000, with the interest variable up to a maximum of $208,808. It is a personal decision if someone wants to pay $208k in interest, but it is by no means a contractual obligation to do so.
July 21st, 2009 at 1:08 pm
I think the key takeaway is if you really want to save interest on a thirty year loan, you are better paying more towards principal in the very beginning of the loan. In fact, there is a strong argument not to pay off your mortgage in the last years as most of that is merely return of principal. Why pay down principal early. If you owe someone $25, you are better served to pay them next year or later as that $25 is worth less on an inflation basis.
July 21st, 2009 at 4:58 pm
Kirk: The extra $1 you pay towards principal is really just $1 you do not pay (anymore) interest on for the rest of the life of the loan.
So, whether ‘early’ or ‘late’, your $1 is compounded over the rest of the life of the loan at the rate of the note (5.5% in JLP example).
It doesn’t matter if it is the first payment or the last, you still get the same ROR regardless.