Do you know how fixed-rate loans are amortized and compounded?
There are four components to a mortgage payment. Of these, only two can be “fixed” for the duration of the loan. Learn how principal and interest (P&I) are calculated and amortized to allow borrowers to spread payments evenly across decades to own property and build generational wealth. Also, get a handy chart to see monthly P&I loan payments based on interest rates and amounts borrowed over 30 years.
Principal & Interest
There are four main components to a mortgage payment. They are Principal, Interest, Taxes and Insurance – PITI for short. Of these, only Principal and Interest are “fixed” for the duration of the mortgage agreement or “note.” The repayment plan of a mortgage is compounded and amortized, which roughly means interest for the entire loan is calculated and the payments are spread equally throughout the loan. In practice, much more interest is paid at the beginning of the debt period while much more principal is paid toward the end of the debt period.
Taxes and Insurance are variable each year. There are separate Information Of Value entries for these topics.
Compound interest
Compound interest means interest is not only earned or charged on the original loan amount (principal) but also on the interest previously added (compounded) to the principal.
The formula for compound interest is often expressed as:
A = P(1+r/n)nt
• A is the Amortized future value of the investment/loan, including interest.
• P is the principal amount (initial investment or loan amount).
• r is the annual interest rate (decimal).
• n is the number of times that interest is compounded per unit (t \ (time), and
• t is the time the money is invested or borrowed for, in years.
Compound interest allows for exponential growth or increase in the value of an investment or debt over time.
Principal
In a mortgage, the principal is the initial amount of money borrowed or the outstanding balance on a loan. It is the original loan amount that the borrower needs to repay over time.
When mortgage payments are paid, a portion of the payment goes towards reducing the principal, and another portion goes towards paying the interest on the remaining balance. The goal is to gradually reduce the principal amount owed throughout the mortgage.
As borrowers continue to make payments, the principal balance decreases, and they build equity in their properties.
Equity
Equity of mortgaged real estate refers to the ownership interest an individual has in their property. It is calculated by taking the current market value of the home and subtracting the outstanding mortgage balance. In other words, it represents the portion of the property the homeowner truly owns.
Equity = Market Value of Home − Outstanding Mortgage Balance
Most conventional loans require mortgage insurance unless or until the borrower has at least 20 percent equity in the property. Mortgage insurance only ensures the lender is paid if the borrower defaults. While it is paid monthly by the borrower, it provides no benefit to the borrower.
As homeowners make mortgage payments and the properties’ values appreciate, equity increases. Equity can also be built through home improvements to increase a property’s value.
Equity represents ownership and the value of ownership interest. It indicates the degree of ownership or financial interest an individual or entity holds in an asset.
Accelerated Payoff
The accelerated payoff process allows borrowers to pay in advance to reduce the principal faster. Read your mortgage agreement carefully to ensure accelerated payments are allowed and there isn’t a penalty for early payoffs. A single extra payment each year can cut a few years of payments off the mortgage.
Mortgage Recasting
Mortgage recasting allows the borrower to pay a lump sum of cash into the mortgage to change their current loan repayment schedule. The loan term and interest rate remain the same. However, the monthly payment is lowered. Fees of $200-$300 are normal for a typical recasting.
Refinancing
Refinancing replaces an existing loan or mortgage with a new one. It usually has more favorable terms. This often takes advantage of lower interest rates, reduced monthly payments, adjusts the loan term/type, or accesses a property’s equity. It also resets the loan to pay more front-end interest to the lender.
Carefully consider the costs associated with refinancing to ensure the potential benefits outweigh the expenses. Closing costs and fees are common in refinanced loans. Additionally, eligibility for refinancing depends on factors such as creditworthiness, home equity, and current market conditions.
The chart to the right lists the amount of each monthly payment based on loan amount and interest rate. It’s ideal to pay a large down payment to reduce the loan amount. To understand the amount of interest paid over the loan period, multiply the monthly payment by 12 months and then by 30 years. For example, a $400,000 loan at 6% requires $863,280 by the end of a 30-year note or $463,280 in interest.
I've Got Your Six!
Mark M. Hancock, GRI, MRP, AHWD
REALTOR, New Build certified
214-862-7212
DFWmark.com
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