“Why am I paying so much interest?”
Ask anyone who has just purchased a home what their reaction was when they opened their first mortgage statement – chances are that’s exactly what they thought. I know that was my first reaction. It seemed like 3/4 of my monthly payment was going just to pay the interest!! My second reaction was “Aha, the bank is screwing me over by getting ALL of their interest up front!” That seemed to be logical conclusion, since most people re-finance within a few years of getting their first loan anyway. Why shouldn’t the banks “front-load” their loans — just another devious scheme by the banks to get more money, right?
There’s a reason for this…
While it may seem at first blush that the banks are “front-loading” their loans with interest, it’s actually not the case. Here’s why: When the payments on a typical amortized loan are calculated, they’re broken down into a pre-defined number of equal payments (key word being equal here) that are comprised of both principal and interest. Since the banks are entitled to the interest due on the principal balance, the amount of interest will always be higher at the beginning of the loan period because the principal is higher. As you pay down more of the principal, the interest amount drops — consequently, toward the end of your loan period, your payment is made up mostly of principal, not interest.
There’s a great explanation of this whole process on Jack Guttentag’s outstanding “The Mortgage Professor’s Website.” Click here for the article:
“First-Time Home Buyers” is a new category on the site that’s a resource for first-time home buyers in San Carlos, and for those who have general real estate questions.
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