After successfully completing this topic, you will be able to
• describe an amortized mortgage and amortize a level-payment plan mortgage when given the principal amount, the interest rate and the monthly payment amount, and
• distinguish among the various types of mortgages.
An amortized mortgage is gradually paid off by equal level payments. The payments include both principal and interest. After paying the mortgage for the full term, the loan is fully paid. In the early years, most of the payment is interest. In the level payment, the amount of interest decreases and the principal amount increases as the loan matures. A sample of a mortgage amortization schedule is shown in Figure 13.1.
$300,000 for 30 years @ 5% Monthly Payment—$1,610 Total Payments—360 Total of All Payments—$579,767
Total Interest Paid—$279,767 Payoff Date—Dec. 2048
Partial listing only.
decreases each month.
|Principal increases each month.||Balance|
|Totals for 2019||$14,899||$4,426||$295,574|
|Totals for 2020||$14,673||$4,653||$290,921|
30-year and 15-year terms
Conventional mortgage loans are most often written for 30 years, but some borrowers prefer to use a 15-year mortgage because it pays off more quickly and saves interest. The issue is that the payment is significantly higher. For example, the loan in Figure 13.1 has a fixed monthly payment of $1,610. If the borrower decides on a 15-year loan, the payment would be $2,372, 47% higher.
Students should learn how to amortize a loan in order to answer questions on the course test and on the state exam. The student will be given three variables in the question.
The student may have to find the sum after the second payment: interest, principal, or balance.
Problem: A property has an 8% mortgage with a balance of $100,000 and monthly payments (which include principal and interest) of $733.76. How much of the second monthly payment will apply to principal?
Remember “PIP BRAM.” Set up your worksheet, then work across. We’ve done the first month. Please continue through the second month.
from col M
col P – col p
col B – col p
col B X col R
col A /12
Adjustable rate mortgages (ARM’s) are the most widely used alternative to the standard fixed payment loan. The interest rate on the mortgage can go up or down during the loan period.
The interest on the loan is tied to a published index. The interest is computed by adding a “margin” to the index. The margin is also called the “spread.” Changes in the index change the interest rate (and payments). The loan is fully amortized in 30 years if the normal payment schedule is followed.
Index—There are several indexes that are used for adjustable rate mortgages. The key is that the index must be beyond the control of the lender and that it be published during the year.
Margin—The margin is a percentage added to the index. The margin represents the lender’s profit. While the index changes, the margin stays the same over the life of the loan.
Calculated interest rate—The interest and the margin are added together to give the calculated interest rate on an adjustable-rate mortgage.
Adjustment interval—The adjustment period depends on the lender and the program selected by the borrower. Most loans adjust once each year (1-year adjustables). There is also a 3-5 year adjustable, meaning that the first adjustment is made in year 3, the second in year 5, then annually thereafter.
|Example of an adjustable rate mortgage |
Assume that a borrower has an adjustable rate mortgage tied to the 1-year treasury bill average rate (index) with a margin of 2.5%. If the index is 3.5%, the calculated mortgage rate will be 6%.
Interest rate caps—If the index rises rapidly, a borrower may find it hard to keep making the mortgage payments. For that reason, Fannie Mae and Freddie Mac require that the lender limit the increases to no more than 2% annually, and 6% over the life of the loan. The limits are called “caps.” FHA is more conservative in favor of the borrower, and the interest rate changes cannot increase more than 1% each year, and 5% over the life of the loan.
Payment caps—Some conventional loans that are not sold to Fannie Mae or Freddie Mac have payment caps, but not interest rate caps. A payment cap limits the amount that a borrower’s payment can increase (for example, 2% per year), but does not limit the amount the interest rate can increase. This can be bad for a borrower. If the interest rate changes by 4% in one year, the payment cap stays at two percent, but the borrower will owe the difference in the unpaid interest. That’s called negative amortization.
Teaser rates—Sometimes lenders will offer an ARM with a low beginning rate in order to entice borrowers. In the example above, the margin was 2.5%, the index was 3.5%, so the calculated mortgage rate was 6%. If the lender sees that not many borrowers are interested, the lender might make the first-year interest rate 4%. The borrower takes the loan. At the end of the first year, assuming the index has not changed, the borrower’s interest rate will jump up 2% to 6%.