(Source: By Toni Momberger, San Bernardino County Sun, Calif.) – Amortization, the word, comes from the Latin “mort,” meaning death. It literally means to kill a loan. It commonly means to repay it, combined with interest, over a specified period.
When you shop for a loan — and popular advice encourages this — each lender will calculate your monthly payments based on the cost of the house and the interest rate he’s willing to give you, which is based on your credit score, income and current debt.
The projected payment plan is the amortization schedule.
Because the factors don’t change as you shop, you should get about the same calculations from each lender.
Amortized payments are calculated this way.
First, the down payment is subtracted from the cost of the house, or the principal.
use a $125,000 house as an example. With 20 percent down ($25,000), the buyer needs to borrow $100,000. His principal on the loan will be $100,000. Next, the principal is divided by the number of payments the borrower has chosen to make.
Usually this is how many months there are in the length of the loan. Common choices are 15 years (180 payments) or 30 years (360 payments) for a fixed-rate loan.
It’s not divided evenly, though.
I’ll get back to that.
Then the total amount of interest is figured. The loan officer will calculate the amount of interest that will be paid over the life of the loan.
In our example purchase our borrower has good credit and got a 5-percent interest rate. The first year is 5 grand, and it gets smaller
every year from there.
The total interest expense for the life of the loan (let’s say 30 years) is $94,000.
The interest and the principal are then put together this way.
The total loan — $194,000 — is spread over 30 years.
From the beginning to the end of the schedule, the portion of the payment that is interest declines, and the part that’s principal increases. The total payment every month, though, doesn’t change.
That means the first payment is almost totally interest, with a drop of principal in it, and the final payment is the opposite.
For example, our 30-year $100,000 loan at 5 percent interest has a payment of $536.82 a month. At the beginning of the first year, each monthly payment will have about $120 principal (about $125 by the 12th month).
The rest of each check is interest. Of the final payment — still $536.82 — about $534 is principal, and $2.23 is interest.
At the end of the first year, after paying about $6,500, just under $1,500 will be deducted from the original $100,000 cost of the house.
“Pull your mortgage statement.
Your coupon will show you how much goes to which. It depends on where you are in your loan,” said Joel Beezy of CFG Bancorp in La Verne.
With adjustable mortgages the starting rate is usually low, but it’s short-term. You pay it for a designated period, then one morning you owe all the rest.
For a time borrowers could get negative amortization loans.
This meant buyers got to choose a payment deal: 1-percent interest, fixed-rate or interest only loans.
Interest only loans, like adjustables, were for a designated period. These were not amortized, because the payment did not include any principal.
By definition, the borrower was not killing the loan; contrariwise, he was feeding and housing it.
This kind of loan is not available anymore, and is blamed for several foreclosures.
“Interest only loans were always written due in five, due in 10 years with a balloon payment,” said Beezy. “Maybe for the first 24 months you pay 5 percent on a $100,000 loan.
That’s $5,000 a year, which is $416.66 a month, not amortized.”
When the balloon payment came due, the borrower had two choices: Write a check for the entire cost of the house minus nothing — in our example, $100,000; or some notes said the interest rate would reset to the prevailing rate, fixed for 25 years. What happened, Beezy said, is people bought houses expecting a couple of raises over the immediate five years, and instead got laid off. Meanwhile those $100,000 houses devalued to $80,000 in the two years the interest was being paid.
“Besides being overoptimistic about their future situations, they went into it thinking they would flip it or move up,” said Beezy.
“When your parents bought a home, the primary purpose was shelter. In more recent times, people bought with the attitude that they’d make money on it.”
Shawn Rubadue, a mortgage consultant with Prime-Lending in Corona, explained the 1-percent option.
“It wasn’t the real interest rate on that loan. Say it was 5 percent, but you get a 1-percent minimum payment. You’re negatively amortizing your loan by 4 percent, because they’re going to put that 4 percent on the end of your loan,” he said. “Lenders stopped doing that.”
Once you got to 120 percent debt on the home, the loan converted to a 30-year fixed payment.
“Payments went from $2,000 to $3,700 and no notices were even sent,” Rubadue said. “This was the single greatest contribution to this (flood of) housing default.”
Some people rush the schedule by sending more, once or frequently, than is planned. The extra goes to toward the principal.
Remember the amount of principal in our sample borrower’s first payment of $536 is $120. If he sends in $775, he’s making two extra principal payments.
“Every time I make additional principal payments, I go to the end of my amortization schedule and cross days off,” Beezy said. If he pays an extra $1,500 during the first year, he can cross off payments Nos. 358, 359 and 360.
If you do this, you will pay off your mortgage earlier, and lessen the amount of interest you pay overall.
If you can only do this a couple of times, fine. When you can’t pay extra, that’s fine; you’re on the normal schedule.
“Your payment will never readjust, but the years of the loan will go down, because every payment you make over the loan goes directly to principal,” Rubadue said.
Most banks will allow this, but it’s a good idea when shopping for a lender to ask if there are pre-payment penalties. Some say you can’t pre-pay more than 20 percent of what’s owed.
And don’t worry about getting a loan with one company that immediately gets sold to another bank.
If the first one allows it, it’s in the original contract, and whoever buys your loan has to honor that.
“Bi-weekly payments is the best way to decrease the amortization on your loan,” said Rubadue. “Most people get paid twice a month.
Bi-weekly payments split up monthly payments into every two weeks. Over a year, you actually make 13 payments instead of 12. It takes a 30-year loan and turns it into a 22-year loan.
You knock off eight years of interest.”
Remember that the shorter the original length of a loan, the lower the interest rate will be.
A 15-year fixed-rate mortgage has a lower interest rate by about half a percentage point, and gets a home paid off in half the time, but the 30-year is more common, because the 15-year monthly payments are about 35 percent higher than the 30-year’s.
“In the end, it’s a lot cheaper because the interest is cut off by 15 years,” said Rubadue.
Right now you can get a 10-year fixed for 3.625 percent.
You can figure out a potential schedule yourself with an online amortization calculator or the table at left.
“Any amortization calculator will tell you the amortization within a few pennies,” said John Thompson of Benchmark Mortgage in Arcadia, who was the source of most of the information in this article.
If you’re calculating whether to refinance, don’t forget to subtract taxes and insurance from your current bill before comparing expenses.
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Copyright (c) 2011, San Bernardino County Sun, Calif.
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A service of YellowBrix, Inc. Publication date: 2011-02-23