All loans are not created equal

Posted: Oct 16, 2007 9:54 AM

The strange title of this column hopefully will help you to understand the concept of different loans to solve different situations that arise in the mortgage industry. For years borrowers assumed that a mortgage was to finance a home purchase and it didn't matter what type of loan they took. It is now fairly evident that a mortgage loan is a terrific financial planning tool and, in most cases the bedrock of the borrowers financial well being.

I am going to take various loans and build a chart to demonstrate how mortgage loans work ,and more specifically how the payment is distributed between principal and interest. The more that goes to the principal the lower the balance and the greater the equity in the house.

                                  Monthly Payment        Principal       Interest  

30 year fixed   6.25%         $1,847                 $   285         $1,562     
20 year fixed   6.125%       $2,171                 $   640         $ 1,531     
15 year fixed   5.875%       $2,511                 $1,042         $ 1,489   

The biggest surprise to borrowers when looking at a chart, as the one above, is interest paid is greatest on the longer loans. This is because the interest rate is higher and actually has nothing to do with the amortization. What they should be surprised at is the amount of the payment going to the principal, not the interest, as the amortization gets shorter. I have been told by many borrowers they didn't want to be "house poor" by taking a 15 year loan over a 30 year loan. In reality it is just the opposite

                                               Monthly Payment           Total Payment
                     30 year fixed          $1,847                             $664,920
                     20 year fixed          $2,170                             $520,800
                     15 year fixed          $2,511                             $451,980   

The picture above says it all! The only way to get ahead is to reduce the amount of interest by reducing the amount of payments over time. Forget the tax advantages and the time use of money as that pertains to few borrowers. The majority of borrowers need to be better financial planners in order to have the retirement they wish.

Looking at a popular loan, the interest only loan , which is actually just a loan option, you will see the thoroughness of the mortgage instruments and how they work. You can have an interest only option on arms or fixed loans that allow you to pay interest only for 5 to 10 years, depending on the terms of the loan.

The interest only term I will use for this example will be 10 years . The loan will be amortized over 30 years. The interest only payment for the first 10 years will be the interest portion of the 30 year fixed above, keeping the interest rate the same for this example.. The payment would be $1562 a month.

What happens at the end of the 10 years is a new loan that has a 20 year amortization. The interest only loan with have a payment of $2192 for the next 20 years. That is slightly higher than the 20 year payment shown above because the interest rate is 1/8 higher.

My objective is to show you how most loans work in regards principal and interest. The one that is right for you depends on many factors which include your age, income, financial situation , goals, etc. The more you understand about the inner workings of loans the better your choice s become, giving you the maximum benefit and chance of reaching your goals.