Some mortgage borrowers have only two things in mind: “How much can I afford?” and “What will my monthly payments be?” They max out their finances on mortgage debt and use an interest-only or negative amortization mortgage to minimize their monthly payments. Then, they rely upon home price appreciation to eclipse the risks associated with a constant or increasing mortgage balance.
In many cases, if these homeowners are fortunate enough to accumulate some equity in their homes, they max out their finances again through a home-equity loan or cash-out refinances and then use the proceeds to make additional purchases, pay down consumer debt, or even make additional investments. Sound risky? It is. In this article, we’ll show you how to make sure you have a mortgage you can afford and to build equity by paying it off quickly.
Making Mortgage Math Add Up
Every mortgage has an amortization schedule. An amortization schedule is a table that lays out each scheduled mortgage payment in a chronological order beginning with the first payment and ending with the final payment. (To read more on amortizations, see Understanding the Mortgage Payment Structure and Make A Risk-Based Mortgage Decision.)
In the amortization schedule, each payment is broken into an interest payment and a principal payment. Early in the amortization schedule, a large percentage of the total payment is interest, and a small percentage of the total payment is principal. As you pay your mortgage, the amount that is allotted to interest decreases and the amount allotted to principal increases.
The amortization calculation is most easily understood by breaking it into three parts:
Part 1 – Column 5: Total Monthly Payments
The calculation of the total monthly payment is shown by the formula below.
A = periodic payment amount
P = the mortgage’s remaining principal balance
i = periodic interest rate
n = total number of remaining scheduled payments
Part 2 – Column 6: Periodic Interest
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The calculation of the periodic interest charged is calculated as shown below:
The periodic interest rate (Column 3) x the remaining principal balance (Column 4)
Note: The interest rate shown in Column 3 is an annual interest rate. It must be divided by 12 (months) to arrive at the periodic interest rate.
Part 3 – Column 7: Principal Payments
The calculation of the periodic principal payment is shown by the formula below.
The total payment (Column 5) – the periodic interest payment (Column 6)