There are many articles describing rent vs buy comparison, as well as calculators that give you “rent is better” vs “buy is better” given certain inputs. However, in my opinion, the best way to analyze anything, is to first understand the basics, then analyze it without using calculators and tools you don’t understand.
I will be writing a series of posts based on my own research on this topic that will also hopefully be helpful for others as well!
Mortgages
Mortgages can be very confusing, and I even had no idea what they were for the longest time. I want to make a simple article explaining all basics of how a mortgage works.
A mortgage is a secured loan provided by a bank or financial institution to the borrower. It is a secured loan since the home is the collateral. If the borrower fails to pay, the bank can take the home and sell it to recoup the loan.
Interest
The interest on mortgages are generally lower than other money you borrow, such as for a credit card. For example, if you fail to pay your credit card loans, the bank won’t be able to get anything from you. Therefore, to account for this risk, credit cards usually have very high interest rates around 20%. On the other hand, mortgages have relatively low interest rates. The current 30-year fixed rate mortgage rate is currently around 5%.
Mortgage interest is given as APR. Check out my article about APR vs APY. https://hsquaredlife.com/apr-and-apy/
If you have a $100,000 loan, with 5% interest rate, your monthly interest is calculate with an interest rate of \(\frac{5\%}{12}\). The interest for the first month will be \($100,000 * \frac{5\%}{12}=$416.67\)
Amortization
The most common type of mortgage is a 30-year fixed rate mortgage. ‘Fixed rate’ means the interest doesn’t change for the entire duration of the loan. The loan is amortized, meaning your payments will be fixed for the whole loan duration. However, the amount you pay in interest each payment will change.
I will exclude insurance, taxes, etc for my calculations, and focus just on the loan balance. Again, using the same example, with a $100,000 mortgage with a 5% interest rate, your first month’s mortgage payment will be $536.82 (trust me on this amount for now). As calculated before, $416.67 of this will be interest. Therefore, $536.82-$416.67 = $120.15 will be towards the loan principal. The loan will be decrease from $100,000 to $100,000-$120.15 = $999,879.85.
The following month, the payment will stay the same as $536.82. However, the interest will be \($999,879.85 * \frac{5\%}{12}=$416.17\). This is $0.50 less compared this to the interest from the first payment of $416.67. The amount of your $536.82 payment that goes towards the original $100,000 loan also increases by the same $0.50.
Each payment will include interest on the current loan balance, and the rest will be towards the principal. This will continue for 30 years.
Equity
Assuming your home, worth $125,000, has not changed in value. You made a 20% down payment \($125,000 * 20\% = $25,000\), and borrowed the other $100,000. Your equity in the home is \($125,000-$100,000= $25,000\). After your first mortgage payment, your loan decreased to $999,879.85. Thus, your equity after the first month’s payment is \($125,000-$999,879.85= $25,120.15\).
As you pay of the loan your equity increases. The home value can also change, influencing your equity. Though not realistic, if right after you purchase the home for $125,000 with a $100,000 loan, your home value decreases by $10,000 to $115,000, your equity would be \($115,000-$100,000= $115,000\).
Your home equity is how much of the home you “own”.
Different Types of Mortgages
The most common mortgage is a 30 year fixed rate mortgage (FRM), as described above. Another common mortage is a 15 year FRM. Generally, with a 15 year FRM will have slightly lower interest rate compared to that of a 30 year FRM. Since the loan term is shorter, monthly mortgage payments will be higher for a 15 year FRM.
An ARM is an adjustable rate mortgage. An example is a 5/1 ARM. The 5 means the interest rate is fixed for the first 5 years. The 1 means after the first 5 years, the interest rate can change every year.
Finally, interest only mortgages mean you pay only interest for a portion of the repayment. One example would be a 30 year loan where for the first 5 years, you pay only interest. In our $100,000 loan example, your payment would just be
\($100,000 * \frac{5\%}{12}=$416.67\). This is lower than the 30 year FRM payment of $536.82. However, after the first five years, your loan balance is still $100,00. Therefore, payments for the last 25 years will be higher, at $584.59.
Each type of mortgage has its pros and cons, and suit different people.
Finally, what’s the black magic that goes into calculating your mortgage payment? Calculating interest is straight forward, \(balance* \frac{APR}{12}=interest payment\). But, how do you calculate a potential mortgage payment for a loan?? You can use an online calculator like https://www.mortgagecalculator.org/, or read my article (coming soon) on the formula.