Many of us are hesitant to take our own money that we’ve saved and put it into an investment, but when it comes to buying a house, costing hundreds of thousands of dollars, most people wouldn’t think twice before taking out that six digit loan. For most people, getting a mortgage means going to the bank to get one. It’s a somewhat stressful process, but the banks make you feel comfortable about borrowing a large sum of money to buy a house because it will help you “grow equity” and you will also have the comfort of owning your own place to live. Of course the banks want you to buy a house! They want to make money off you and a mortgage is one of the easiest ways for a bank to make money.
When you buy a house you are offered a mortgage, where the loan is amortized over a set amount of years. For starters, an amortized loans is much different than an investment loan. A loan that is amortized is assigned a certain amount of time whereby the loan needs to be paid back. Payments are divided into equal monthly payments of both principal and interest. With an investment loan it operates differently because the interest owed is calculated on a daily basis with no set end date for repayment. For investment loans, interest continues to accumulate as long as the amount owing is still outstanding.
An amortized loan makes purchasing a large asset affordable to the general public. The fact that the interest and principal are both paid off at the same time and stretched out over a long period of time offers consumers predictability and stability for anyone who is trying to plan their monthly budget. So what’s the catch? If you understand how amortized loans work, then it’s quite simple. At the beginning of your payments, the majority of the money goes towards paying the interest on the loan not your principal.
To understand this better, let’s take a look at a schedule of payments for a mortgage at $400k amortized over 25 years with a 5 year fix rate term of 3.5%.
A mortgage like this would require a payment of roughly $2000 a month for the 25 year period, but when you look at the schedule of payments you’ll notice that in the first year $10 229.97 goes towards your principal and $13 735.69 goes towards paying off the interest of the loan. So the reality is, even though you are paying almost $24 000 a year towards your house only 43% of that goes towards paying off your house. This trend goes on until year 5 in which the balance starts to shift towards paying more on your principal rather than your interest.
So why do banks love giving out mortgages? It’s quite simple. They are making much more money upfront at the beginning of the mortgage and these interest payments are something that you cannot get back. If you are a US reader, you’ll benefit from the fact that interest payments, even on your primary residence, is tax deductible. Unfortunately for my Canadian readers, this isn’t true and your mortgage payments have to be made on after tax dollars.
Banks won’t tell you this fact when they are trying to sell you a mortgage. They want to give you the biggest mortgage they can possibly qualify you for so that you can buy your dream home and build “equity”, when in fact the bank is taking over 50% of your payments in the first 5 years. It’s why the bank shareholders continue to make more and more money. It’s not a fluke that the top 5 banks in Canada continue to make record profits, as home prices rise higher and higher in Canada. Don’t blame the banks, they are just providing a service for which there is a large demand and it’s a very profitable service.
So why is the first 5 years so important? Well for starters, the average family only stays in their house between 8-10 years before moving. Whether it be a change in job location, or moving to an area with better schools, it’s always tough to predict that the house you buy will be the one you live in forever. This means that during those first 8 years you may have ended up paying a lot just for interest, over 50% in some cases, rather than putting money into the equity of your house. The second big thing? Renewal. Smart home buyers should be aware of the renewal rules of a mortgage, those that don’t … well you better stay tuned for my next post.