Let’s talk about mortgages!  

Okay, we all don’t have one but if you do, or ever might, there are some things you should all know.

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Listen to “Murphy on Money – Ep8 – 3 Things We Should All Know About Mortgages” on Spreaker.

Honestly, there is quite a bit of confusion when it comes to mortgages on several topics and I want to dive into together.   

  1. How interest is calculated.
  2. Term and the effect on interest paid.
  3. The Mortgage Interest Tax Deduction. 

1)  How interest is calculated.

I have heard that interest is front-loaded and I have heard that it’s paid first. While you certainly pay more in interest in the early years of a mortgage that’s due to the higher outstanding loan balance.  In a standard mortgage (I’m not talking about interest only mortgages) each payment is broken up into at least two parts, 1)interest, 2) principal, and sometimes 3) escrow & private mortgage insurance (PMI).    Let’s focus on parts 1 and 2.

The easiest way to look at interest is to break it down into monthly interest payments.  Let’s say I have a fixed-rate mortgage at 3.6%.  3.6% divided by 12 months is 0.3% per month.  This is roughly how the mortgage interest due per month will be calculated.  The interest due on the first payment will be calculated like this

Loan Amount * 0.3% = First Month’s Interest

Then the remainder of the payment will be applied toward escrow, PMI (if you have it), and finally principal.

Real life example time…

Okay, so the payment is the same every month $750. Of that, I have a monthly Escrow of $159.46.  In July’s payment, I paid 147.70 in interest.  How is that calculated?  My rate of 3.25% divided by 12 is 0.27% per month.  So that 0.27% is multiplied by the remaining balance of June.   So of the $750, I pay interest and escrow first and the remainder of the $750 (which is only $442.84) goes to the principal (outstanding balance of the loan).  

You can see in my numbers that each month I pay less interest because I reduce the outstanding balance. Because the payment amount is constant over the life of the loan, as my interest paid goes down each month the amount of money left that goes toward principal increases.

2) Term and the effect on interest paid

This one is a doozy.  Let’s look at the difference between if 250K is borrowed at 3.6% fixed-rate under a 15-year term and a 30-year term.  

Monthly payments:

30-year: $1,136.61

15-year:  $1,799.51

The payment is $622.90 more per month because of this some people may choose the 30-year mortgage… but let’s look at the difference in interest paid on the life of the loan if payments are made as scheduled…

Total interest:

30-year: $159,180.82

15-year:  $73,911.53

Wowzers!  Paying that larger payment saves $85,269.29 in paid interest!  It’s incredible really.  Whenever possible, a 15-year mortgage is the better option. You pay a slightly higher payment but better to “pay yourself” in a larger payment than to pay all that interest to a bank!

Someone shared this Mortgage Amortization calculator with me in the past.  I share it with you here because I think playing with it can be quite informative. If you like spreadsheets check it out and let me know what you think.

 3) The Mortgage Interest Tax Deduction

If you ever hear someone say,

“You shouldn’t pay off your mortgage because you get a mortgage interest tax deduction…”

Just know that person either cannot do simple math or they have no idea what they are talking about.  If you’re paying that person for their advice, you should reconsider.

Let’s break it down.  What is a tax deduction/write-off?  It means that you get to reduce your earned income by an amount and not have to pay taxes on that amount.

Let’s say I had a mortgage and over a year I paid $6,000 in interest.  Over the same year I made $76,000 in taxable income… but wait! I paid $6,000 in mortgage interest.  So my taxable income is only 70,000.  Yessss!!! Winning right?  Or am I?  Well looking at the 2016 tax codes found here, I was able to calculate that without the tax deduction my taxes that year would have been $10,542.50, but now that I paid $6,000 in mortgage interest my taxes are only $9,572.50!… wait a second…  let that soak in..

Yes, the deduction saves me not $6,000 in taxes but only $970!    So when people say, “You shouldn’t pay off your mortgage because you get a mortgage interest tax deduction.” What they are saying is pay the bank $6,000 so you can keep from sending the government $970. Not exactly winners math if you ask me.    Don’t get me wrong.. if you are eligible to take a mortgage interest tax deduction, by all means, take it!  But certainly, don’t keep a mortgage around just for the write-off… That is absolutely absurd.

 

Those are three areas which I’ve found to be confusing.  I hope this was helpful!

 

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