Understanding Mortgage Interest

In today’s low interest environment, it costs $5 a month for every $1000 of a 30-year mortgage at 4.5% fixed interest rate. At this rate, two-thirds of initial payments will be interest, and the rest will be principal.

A mortgage payment includes two components: principal and interest. Though the monthly mortgage amount is always the same, the principal and interest portions change every month based on a Constant Yield method. The interest is always calculated on the outstanding loan balance. Hence, the interest is higher than the principal during the first half of the mortgage term, and vice versa for the second half.

The amortization example shown is for a $750K 30-year fixed loan at a 4.5% interest rate. You can see that the initial interest portion is about two-thirds of the mortgage.

        First interest payment = ($750K x 4.5%) / 12 months
                                                 = $2,813

The total interest paid over the life of the loan is $618K. A quarter point change in interest would change the total interest by $40K. The interest portion of the mortgage for a primary or secondary residence is tax deductible. The total tax benefit, assuming a 33% tax rate, is $204K. Please refer to “TCJA Changes to Real Estate” for a more detailed tax analysis of a mortgage loan.

We are at a historically low mortgage rate environment. In the last 50 years, mortgage rates have ranged from 15+% in the early 80s to sub-4% today.

It is quite handy to think of the mortgage cost in terms of every $1000 borrowed. For example, it costs $5 a month to borrow $1000 at a 4.5% 30-year fixed interest. You can see from the table that the cost changes by ≈8 cents for every 1/8th of a point change in the interest rate.

Monthly mortgage related expenses are often expressed as PITI (Principal, Interest, Property Tax and Insurance). Property tax in California is about 1.2% and the home insurance is ≈$100 a month. Assuming a 20% down payment and a 4.5% interest rate,

      Monthly PITI = (Home Price x 80% x $5 P&I) / 1000 + (Home Price x 1.2%) / 12
                              = 0.5% of Home Price

Hence, PITI is about 0.5% of the property value with a 20% down payment in today’s low interest environment. To understand the criteria banks use to approve your loan, please read our blog “How Much Of A Mortgage Loan Can You Qualify For?

We specialize in tax-free retirement strategy and investments such as IUL, Annuity and LTC. Prefer a quick and complimentary consultation? Just email us at Karthik@FinCrafters.com

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