Home Mortgage – The Great American Rip-Off
The typical American family lives in a home worth $250K with a 30-year mortgage.
On average, they live in the home for 9 years.
After 9 years of mortgage payments, 50% of the interest has been paid, but less than 20% of the principal has been repaid.
Where did all of the money go?
When we purchased our first home, we did all the right things financial experts recommend. We rented an apartment until we could save a 20% down payment for a house. We bought the worst house in the best neighborhood we could afford. And we shopped around for the best interest rate on a loan.
We were even excited to get our first annual mortgage statement to see just how much of our home “we owned.”
There’s got to be a mistake on the mortgage statement
When we opened the statement, we were sure there was a calculation error. We had paid a lot in interest. But the principal – barely a dent.
That’s because the bank calculates mortgage payments using a formula for compound interest. The bulk of the interest is paid up front.
If for any reason the loan is terminated early (sale of the house or refinance of the loan), the bank wins.
And we, the customers, lose.
The Secret Your Bank Doesn’t Want You to Know
I’m convinced that most people in America don’t understand their home mortgage, even though it’s probably the single largest investment they will ever make.
We certainly didn’t understand the ins and outs of a mortgage, even after several home purchases and 2 botched refinances.
Banks have led us to believe that home ownership is the American Dream. But for many of us, a home mortgage is the Great American Rip-Off.
And here’s why. Regardless of the term (the length of the mortgage contract), the bank gets paid virtually all interest up front. It takes half the term of your mortgage before you start making a dent in principal repayment.
Formula for Mortgage Calculation (If you don’t like math, feel free to skip this section)
The most common type of home mortgage in America is an annuity mortgage. The bank (or other lending institution) calculates a fixed monthly payment that includes an interest payment on the loan and a repayment of the principal.
The formula used to calculate the monthly payment is:
PMT = P [ i(1 + i)n ] / [ (1 + i)n – 1]
Where PMT denotes the monthly payment. P symbolizes the principal. The interest rate (as a decimal) is represented by i. And the number of payments is expressed by n.
It’s a complicated formula. Fortunately, there are plenty of online calculators to do the math for you.
The Average Homeowner pays an above average amount of interest
According to the National Association of Realtors, the median tenure of a family in a home is 9 years. The average term of the mortgage is 30 years. And the median price of homes currently listed for sale in the United States is approximately $250,000, per Zillow.
Example of the mortgage of the average family in America
Home Price – $250K
Down payment – 20% ($50K)
Principal – $200K (Home Price Less Down Payment)
Mortgage Term – 30 years
Interest Rate – 4%
This example assumes the buyer made a 20% down payment to avoid PMI (private mortgage insurance). For simplicity, the closing costs (which of course, the bank loves) were paid out of pocket by the buyer. And the homeowner is responsible for paying their own insurance.
Using an online calculator from usmortgagecalculator.org, the principal and interest on the loan total $393,739.01 .
If the loan is held to term, the interest on the loan will total $143,739.01.
But remember, we’re looking at the average family who stays in the home for 9 years. Here’s the amortization schedule for the first 9 years of the loan.
After 9 years, the average family would have paid $65,734.89 in interest. This amount correlates to 46% of the total interest due over the 30 years.
Only 19% of the principal has been repaid! In other words, after 9 years in the home, the average home owner owns less than 20% of it.
And the situation is even more dire if the family closes the loan before nine years, by choosing to sell the home or refinance the loan before the end of the term.
What if you’re above the average of the average homeowner?
Financial advisors often recommend making extra payments to decrease the term of the mortgage and save boatloads of money in interest.
Let’s call this savvy home owner above average.
Example of an above average home owner who makes an extra mortgage payment each year
Here’s the amortization schedule for the first 9 years of the loan, including one extra mortgage payment each year.
After 9 years, you would have paid $64,192.83 in interest. While this does reduce the amount of interest you pay over the life of the loan, during the first 9 years you increase the amount of principal repayment by only 5% (from 18.69% to 23.76% Loan Paid to Date).
After 9 years in the home, the above average home owner owns less than 24% of their home.
Not really a boatload. More like a kayak.
Another little secret
If you want to make a large payment on the principal, you might consider loan recasting or re-amortization. Loan recasting is less expensive than refinancing and involves paying off a lump sum of the principal and requesting to have the monthly payments reset according to the original interest rate and loan terms. This will lower your monthly payment. Most banks charge a fee (typically $200 to $300) for this service.
Banks love refinances
If interest rates have dropped dramatically since the origination of the loan, experts recommend refinancing to a lower interest rate. Especially if the difference in rates is 2% or greater.
In our experience, refinancing has been a bum deal. We have owned several homes and on 2 of these homes, we refinanced the loan. On paper, refinancing the loans seemed to make sense. However, neither refinance worked as well as we had hoped.
On both occasions, we made a critical error.
We refinanced 30-year mortgages, after we had already paid on the loan for a few years, into new 30-year mortgages. Even though the interest rate on the new loan was so low that we would have broken even within a couple of years, we didn’t consider how much interest (by percentage) we had already paid on the existing loans.
Lesson learned. If you are refinancing, make sure you refinance to a shorter-term mortgage than your existing loan.
How to Avoid the Rip-Off
Here are a few recommendations to reduce the amount of interest paid on a home mortgage:
1) Most real estate agents will encourage you to stretch your budget. They may say things like “as your family grows, you will need a bigger house.” Or “don’t worry about the payments now, your salary will increase to meet the payments.”
Resist this temptation. Instead of stretching your budget, consider shrinking it. Or at least shrink your idea of what your new home will look like.
2) A 20% down payment should be the MINIMUM. Consider renting until you can afford a large down payment.
3) The best scenario is to buy a home with no loan from the bank. Unfortunately, that’s not realistic for most of us. Instead, think about purchasing a more affordable, smaller home or a fixer-upper, so you can limit the amount of money you need to borrow.
4) Forget about the 30-year mortgage. With a 15-year or shorter-term mortgage, you automatically decrease the number of years before you start seeing a principal reduction. Remember, it takes ½ of the loan term (regardless of the length of the term) before you see any significant reduction in principal.
5) If you have too much house, consider renting out a portion of it.
6) There’s a reason banks love refinances of existing loans. That’s because as soon as you take out a new loan, the entire cycle of paying the bank first starts over. Not to mention the administrative fees the bank collects.
7) If interest rates drop dramatically and you want to refinance, be sure to do a break-even analysis. Twice.
Think carefully about the cost of the refinance and the amount of money you’ve already paid to the bank in interest. And think realistically about how much more time you will stay in the home.
The Final Picture
Here’s one more graphic based on the example of the average home owner. While it’s a pretty chart, the picture it paints is very ugly. The orange bars at the beginning of the loan show how much more the bank is getting in interest than the average homemaker is paying toward principal.
But by understanding how the bank calculates the monthly payment on a mortgage and knowing a few tips on how to reduce the interest paid, smart homeowners can avoid the big rip-off facing the average homeowner.