In case you hadn’t noticed, the cost to rent in the U.S. continues to rise, along with the cost of homeownership (although the cost to own is often much less than the cost to rent). One major difference, however, is cost control. Last year, the average rent changed every month – dropping by as much as 3-4% or increasing by even 6% in just one month. On the other hand, buying a home brings more benefits than just the freedom to paint your walls teal or add a new kitchen island: knowing how much you’ll pay each month for the next 15 or 30 years is extremely valuable. It’s the same reason why baseball teams try and sign young stars to long-term deals. Despite the risk of injury or decline in ability, teams value knowing and controlling their future costs. So should you!
The Amortization Schedule
While your mortgage payment stays the same for the life of the loan, the composition of your payment will change each month. If you look at your statement, you’ll see what is called an amortization schedule, or as it is sometimes referred to, an amortization table. Understanding how your mortgage works is crucial, and deciphering your amortization schedule is a great place to start.
The schedule shows how much you pay each month for the life of your loan – specifically how much you’ll pay in both interest and principal. What you’ll notice right away is that in the early stages of the loan most of your payment will be dedicated to interest, and not to principal; towards the end of the term of the loan this reverses, and your payments are almost entirely principal. How is this calculated? Let’s use some round numbers to demonstrate.
An Example of Mortgage Amortization
For a 300,000 loan (30-year fixed-rate) at 4.5%, the monthly payment would be $1,520 per month (we’re excluding taxes and insurance for this example). To figure out how much of that payment is interest, we multiply the rate and loan amount to get the annual interest – 0.045 x 300,000 = $13,500. Next, we divide that by 12, since these are monthly payments. That comes to $1,125 – your interest for the first month. The remainder ($1,520-$1,125=$395) is your principal payment and your equity after month number one. Month two’s amount follows the same pattern but starting with a lower total balance - $300,000-$395=$299,605.
Mortgage Amortization Over Time
Starting to make more sense? Notice that as the loan is constructed, you will build very little equity in the beginning – just a few hundred dollars each month. However, by the time you get to the last 5-10 years, the equity begins to build much faster. This is a great thing! You’re now investing in your home instead of helping your landlord make his mortgage payment. One sure way you can speed up your equity is by making extra payments – just one extra payment a year can shave years off your mortgage and save you thousands.
Before making any decisions, however, make sure you speak with a trusted mortgage professional, who can walk you through the details of an amortization schedule. Instead of a confusing wave of numbers on your statement, you can learn to love your schedule – watching your equity build as your payments stay the same, year after year!