Ah, the American dream…a modest house with a white picket fence, a family with 2.5 kids, and a dog. For many, this dream is now attainable only through a mortgage loan provided by a third-party lender. Few people have enough loose cash to pay full price up front for a home and benefit from the option of a mortgage loan.
Mortgages didn’t always have a basic 30-year plan with low interest rates. At their genesis in the 1930s, mortgages were short-term loans spanning five to seven years that only covered 50% of the total home value. The remainder always fell upon the home buyer to pay out of pocket. Historically most mortgage payments only covered the interest on the loan. This meant the borrower was forced to make a whopping finale of a payment at the end of the period to pay off the principal.
In 1934, the Federal Housing Authority (FHA) decided to assist potential home buyers by introducing the more affordable mortgage option of a 30-year, fixed-rate loan, which is now a national standard. This fixed rate loan is often described as “self-amortizing” due to the efficiency of calculating a fixed monthly payment that slowly but steadily pays off both interest and principal for the duration of the 30 year payment period.
Amortization is the method used to pay off both the principal (debt amount) and the interest in one fixed monthly payment. By far, the best aspect of amortization for the home owner is the consistency. Home owners who purchase a home using a fixed rate mortgage (wherein the interest rate is fixed and does not vary over time) know exactly how much to pay every month to their lender and can plan accordingly. The beauty of an amortization chart is that the home buyer can calculate just how much time it will take to pay off the debt at a set monthly payment.
An interesting fact is that every mortgage payment in this plan, despite being equal, contains different amounts of principal and interest. In order for amortization to work beneficially for both the lender and the borrower, the first few payments of a loan are mostly paying toward the interest. As the years go by, a greater portion of the payments will be applied to the principal.
Because much of the principal is paid off toward the end of the loan, homes are considered a long-term investment. If the home buyer decides to sell the home before the completion of the mortgage period, that buyer will receive a smaller portion of the sale price because very little of the principal will have been paid. If the buyer sells the house too soon after purchasing it, they may owe more to the lender than the house is worth. This is called being “upside down.” Because of the way amortization tables work, home ownership is advised for the long term investor or family that wants a long term residence.