Did you know that there are two distinct parts to your home mortgage loan, principal and interest? Did you also know that if you don't closely watch both parts you could lose your house? Not to worry though, for home buyers with a fixed rate loan the monitoring of these two parts is done for you. However, for those who got trapped into adjustable rate loans, or low interest starter loans, you better be prepared to watch those two parts very closely. If you are shopping for a loan, be very leery of those sweet looking loans with low monthly payments. Those are the ones you have to watch. In the last article we briefly discussed amortization and negative amortization, and how potentially dangerous negative amortization can be. In this article we will talk about amortization, and do a little math to illustrate what it is. The reason to look closer at this issue is that amortization is what we call the two parts of a loan. This may sound a harsh, but many people lose their homes because of negative amortization.
The definition of amortization really quite simple, however we need to talk about a few other terms to put it into perspective. First is principal, which is the amount of money you owe on your home loan. If you take out a loan for $300,000, that is your principal. Second is balance, which is the amount you owe at any one time on your loan principal. Third is interest, which is the cost you pay for borrowing the money from a bank for your house. Understanding that principal and interest are two different things is a powerful piece of knowledge that is very helpful when shopping for the right home loan.
Okay, let's talk about the two parts. The monthly payment of loan on a mortgage is divided up between the interest due and the principal. So, what happens is, when you make a payment the money goes to the loan servicing company. The servicing company applies portions to both the interest and the balance. This process guarantees that if your thirty year loan is fully amortized, you will pay off your loan, both principal and interest, in thirty years. The system is simple in function, but is complex in calculation.
Here is a quick, and hopefully painless, look at those calculations, just so you have an idea of what people are talking about when the subject comes up. Let's say that John and Joan Jackson take out a loan to purchase their new home. When their loan is funded, or started, the Jacksons make a commitment to pay back that loan on a monthly basis, say $1798.00 a month. As stated above, a certain percentage (the thick math stuff) goes to interest, and the rest goes to the principal balance. As the balance of the principal goes down the percent that goes to interest also goes down, and more goes towards the balance. That is why you hear people say that you pay a lot of interest at the beginning of a loan. Here is an example of how the payment to interest and principal is divided.
The Jacksons have a $300,000 loan and the payments are $1798.00 a month.
The first month they would be paying $1500.00 in interest and $298.00 towards the principal balance. Halfway through the loan, when they owe $150,000, $750.00 will go to interest and $1048.00 will be applied to the principal. With Jackson's last payment, $8.99 will pay off the last of the interest, and 1789.01 will pay off the principal.
Restated, on the Jackson's first payment 83% goes to paying for borrowing the money, and 17% goes to the loan principal. On the last payment .5% goes to paying for the loan interest, and 99.5% goes to the principal. This example is based on a fully amortized loan in which the Jacksons are paying off the principal and the interest at the same time.
The importance of this subject is paramount. If you get into a loan with a low interest rate starter, or an adjustable rate loan, and it is goes into negative amortization, the results could double your payment. We will look at this next time.
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