# 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.

What a coincidence, I just wrote about it yesterday. Here – http://www.countdowntotranquility.com/2018/01/shave-year-off-mortgage-just-3600-save-8000/

I don’t understand what you meant by this – “If you make extra payments on a mortgage, many banks add them to the back-end of the loan. This means you are saving almost no interest at all.” I agree that they still expect the same mortgage payment. However, they charge interest only on the remaining principal, and the rest goes towards the principal. Aren’t all mortgages like that? Or did we just luck out?

Cool! I will check out your post right away. I’m for anything that shaves interest off a mortgage!

We inquired about making extra payments several years ago on one of our home loans. We were told that the payment would be added to the back-end of the loan.

On that same loan, my husband received a bonus and we wanted to apply it to the principal. We elected to have the loan recast (at the same interest rate) to have the principal and interest recalculated. This reduced our monthly payment. I remember the fee was around $250. I think the loan originated at a small bank and was then sold to a larger bank.

The comment was based on our experience with that bank. I would encourage readers to check with their lending institution to see how extra payments are applied.

I didn’t know that there was this option of recast. Will need it in case we lose our jobs somehow. We have paid far more than we had to.

Did you get a chance to check out my post? What did you think?

Yes, I did check out your post! Great analysis! And here’s what I wrote in the comments section

Great minds really do think alike, since I posted about the same thing a day later. haha!

And as someone who has paid off the mortgage, I agree with a couple of the comments on your post. Once the mortgage is gone, you sleep SO MUCH better at night! Regardless of the lost opportunity cost in the market.

Regarding the recast option, it is definitely something to consider if you have a large sum that you want to put towards the principal on a loan. Here is a link which explains the recast pretty well. https://www.bankrate.com/finance/mortgages/what-is-mortgage-recasting-and-why-do-it-1.aspx

Didn’t realize you were an engineer until I checked out your about me section. My husband and I are too. You really are busy – blogger, mom and engineer! And I really like your countdown clock on your site. I have my countdown clock on my phone – 865 days until my husband joins me in early retirement!

“3) If you pay off the loan early, the annual interest rate you paid on the loan is much greater than the interest rate you were quoted.”

Can you explain this a bit with some numbers?

Hi Dave,

Thanks for the comment and good catch. I can see how the original wording was confusing. The point I was trying to make, based on the examples, was if you close the loan after 9 years (which according to the National Association of Realtors, most people move at that time,) you would have paid almost half of the interest due over the life of the loan, even though you are less than 1/3rd into the term of the loan.

I have changed the wording to make it more clear. Thanks again!

I just read your post a couple of times more to make sure I understand it right.

To be honest, I don’t know if this is true for all the loans. But I suspect it is. The banks do not calculate the total interest and just charge it to you irrespective of when you pay it off. If that was true, you would owe $343,739.01 the day after you took the loan (the one in your example) However, that is not true. At any point, if you can pay the part of the principal left and the interest on it since your last mortgage payment, you can close the account. Some banks do charge a premium for closing the account early, and it will be described in your mortgage documents. However, that will be much less than the $343,739.01 in your example.

Also, if you get a 30 year loan and pay the mortgage a 15 year loan (with same interest rate) would get you, you would still be able to close it in 15 years. And pay the same interest as a 15 year loan.

The reason the interest payments are so high in the beginning is because of amortization, where you pay the same amount every period. Compound interest is what gets it so high, I agree. But that is because the loan period is so long.

Good point! If you have a 30-year mortgage and pay it down as though it were a 15-year mortgage, it will have the same effect as if the loan were originated as a 15-year loan. It will also save you the expense of refinancing the loan into a shorter term.

The length of the loan doesn’t matter when it comes to amortization. Regardless of the length of the term, you still pay the bulk of the interest up front.

Regarding the effect of making extra payments to save on interest and length of term on the loan. The difference in the amount of interest saved in the two examples is only $1,542.06. Total interest paid on the loan with no extra payment is $65,734.89. Total interest paid on the loan with extra payment is $64,192.83. The difference is $1,542.06. That doesn’t seem like a huge savings especially since the total extra paid on the loan is $8,593.47 (extra monthly payment for 9 years.)

Thanks for your comments – great points to consider!