Mortgage companies amortization practices

7 Replies

I doubt anyone has questioned this in the forum before. I couldn't find the answer, so I'll pose it here.

How did society allow mortgage companies to evolve a strategy whereby mortgages all have front-loaded interest payments? Wouldn't having a balanced approach allow the loan to cost considerably less over the life of the loan, and possibly shorten the life of the loan as well?

I'm not saying I don't understand that that's just the way it is. I do. That doesn't mean I have to like it or wouldn't like to see how it's always been done changed.

Amortization is simple.....you pay interest on the outstanding balance owed, period.  If you want to pay extra principle, you owe less money, you pay less interest.  How would you propose to change it?

I would propose paying 50% toward principle and 50% toward interest from the very first payment, or something closer to 50%, at least. In other words, for a $1000 mortgage payment, $500 goes to principle, $500 to interest. If you are reducing the amount of principle outstanding faster, there would be less interest to pay over the life of the loan. By forcing borrowers to pay practically all interest near the beginning of the loan, the amount repaid is far higher than it needs to be. Doing it my way means the principle is reduced faster without having to pay anything over the standard monthly payment. The way it is now, you have to pay a regular payment that is nearly all interest PLUS paying extra toward the principle. That is a far less feasible method for most who are buying a home today unless their down payments were much higher than usual, making their monthly standard payment very low.

I'm just an investor who has had many loans over the years, definitely no expert, but it's not really front-loaded, just that you have a much higher balance the first year than the 10th or 15th.  It would make no sense for a bank to loan someone money at 4% but then not collect the 4% on the balance but some other formula that lets you pay less than 4% the first years to make the principal payments more uniform.   How would it work if you sold in 2 years?  Would you owe them the balance of the 4% interest each year that you didn't pay? 

In my first car loan, many years ago, they actually were  allowed to front-load the interest in the payments, so paying it off early didn't help at all as the full last year was nothing but principal, and they didn't have to disclose it clearly, just small print I didn't understand at the time.  I think the market has become much more consumer-friendly, where it's rare to have to pay prepayment penalties if you refi or sell within so many years, you're allowed to pay extra payments directly to lower your principal instead of extra payments going partially to interest (like they still do on my son's student loans which drives me nuts) and fees are much more transparent than they used to be.     

What you are describing is a non-accrual loan, where interest is not applied toward all amounts outstanding, these are not customary loan terms and a lender that is in business would never agree to such terms lending cash, they might in lending based on equity, like seller financing. However, the interest rate a function of time over one year will be reduced and you'll have tax consequences if the yield falls below market rates. You'll get into issues of forgiveness of debt and imputed tax rates. 

There are also notes that have more than one principal part, where different amounts are blended into one loan. You may have an accelerated amortization on one part and a longer amortization on another part. You might buy a business operation with financing from the seller. You could have three parts, one for the real estate, one for the business operation and another part to payoff machinery or inventory. Explaining any further here would be like handing an Uzi to a child, so, I won't. Some are too creative for their own good.

Such are matters of advanced creative financing arrangements, very handy for estate planning, having more than one beneficiary, lender or partnerships with unequal interests.

This won't ever be accepted in mortgage financing as it would reek havoc on the entire financing system all the way through securities to investors buying the bonds that fund home loans. No out of the box thinking allowed there! :)  

Thanks, Stephen, Good article.

And thanks to all of you who responded. There are some evidently well-experienced and knowledgeable folks that frequent this site.

I am just the opposite, but willing to learn everything I can. One thing I know for sure: I should have been investing in real estate several decades ago and learning about it for a decade before jumping in.

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