Front-loaded loans: a financial conspiracy?

by Julie Rains on 26 September 2007 18 comments
Photo: fugue

A tip from Eric Fedewa sparked a discussion between Wise Bread bloggers (Andrea Dickson and me). He brought a new financial term (front-loading) to our attention that indicates how interest on fixed rate mortgage loans is heavier in the beginning of a term. Our exchanges focused on the front-load concept. Prior to receiving this information, I had written articles on mortgages and even created a downloadable amortization schedule, which shows how interest is allocated on a fixed-rate loan.

Here’s the tip:

“It is not very well known how most mortgages are front-loaded. If you purchase a home with a 30 year, fixed rate, mortgage, it is amortized over a 30 year, or 360 payment term. You may be very concerned about the rate of this loan and work very hard to get the interest rate down, BUT what most people don't know is that the interest is FRONT-LOADED. That means you pay more of your payment towards interest in the first years, and very little in your last years, so it all averages out to the APR, but if you sell or re-finance your home before the 360th payment, you are paying more than the APR you signed up for... The way to win is either a simple-interest loan or to pay more than your payment each time and the loan gets paid down amazingly fast...”

and our conversation (edited for clarity and my previous misspelling of "amortization")

Andrea

I remember freaking out when I saw the breakdown for my mortgage (how much of my payments would go to interest, especially initially), but isn't paying all the interest up front actually better for the payer in the long run? I can't see how it would be, but that's what I heard from a friend who is good at finances.

Julie

The 'front-load' method sounds like some sort of financial conspiracy but it's just the way the math works in a fixed-rate amortization schedule.

Andrea

Well, not to be a pain, but do you know why the math works that way? There's nothing that I ever learned in math that can explain why I should put the first few years of house payments towards interest, which doesn’t increase the equity in my house at all.

Julie

You know I was thinking about all that and I guess it helps me to put it all on paper (spreadsheet) and just look at the numbers. And then move them around (make my "what-if’s" I changed the interest rate, the loan amount, the number of years on the loan, etc). But as far as the concept, your loan balance is highest at the beginning of the loan because you haven't made any payments; your interest is calculated based on the principal. So as you pay the loan down, there is less principal, and so there is less interest (and therefore more of the monthly payment goes to the principal and less to the interest). The monthly payment is a fixed amount, spread out over time, nice and neat so the numbers work out so that the loan is paid right on time according to the term of the loan (30 years or 15 years or whatever the term is).

I suppose there could be some other way to structure a loan but that would be the way a typical loan would be -- an auto loan, fixed-rate mortgage: I paid more interest at the beginning and now am paying very little interest near the end.

If you were a Chief Financial Officer of some Fortune 50 company, you may be able to structure the loan for your company differently; say for example, you might ask for a loan that has no interest applied for the first 2 years. So if your company paid on the loan during the first 2 years, then the entire payment would be applied to the loan principal and then when the 2 years were up, you would pay interest on the loan amount only (principal balance that remains) - unless the agreement said otherwise, of course.

Okay, so you are making me think about this loan stuff more and how different loans are structured. I have a Lowe's card and have purchased items where I pay no interest if I pay it off by a certain time. I love the idea of using someone else's money. The financing company gives me a nice little summary of what my interest would be/will be if I don't meet that deadline. Still, I am meeting it and can have a loan without interest; all my payments before the deadline go straight to the loan principal.

Hope this helps some.

Andrea

Ack - that compounds my question. The idea that you pay pretty much only interest for the first few years DOES make it seem like a conspiracy – can’t they just average out the interest over the course of the mortgage?

Let's say I pay $30K in mortgage payments for the first year - and that mostly goes to interest, so that at the end of one year, I have the same amount of equity in my home that I did when I first bought it (just the down payment plus any property value increases). That means that I paid 30K in rent, essentially.

Whoever I talked to about mortgages, back when I was applying for one, told me that mortgage loans had to collect the interest up front by law, and that if you were to pay less interest at the beginning, you'd end up paying more interest towards the end, and thus more interest over the long haul.

ARTICLE CONTINUES BELOW

And that's great, if you are buying your "forever" house, but since this is just a beginner home, I essentially just threw away an additional 15K this past year. Right?

Julie

When you say threw away an additional 15K, I am not sure what you mean. If that's how much more you paid to have a house than what you would have paid in rent, then you could think of it that way.

Interest is tax-deductible so if you itemize, you should get a tax benefit from the interest; that is, your cash outlay for interest over the year is less than $30K. Think of it as a government-sponsored rebate for paying interest.

Your Equity is the Value of Your House less the Loan Balance. So, if the value of your house has risen over the year, then you have gained in equity (even if you have not made much of a dent in your loan principal); this gain is based not on your payments but rising house prices. You can also gain equity by paying down the loan.

Some of the hysteria in the mortgage market is due to house prices falling so that people have less equity in their homes this year than they did in the past year.

I don't know about the "law" thing, though I think it would refer more to the math "law" rather than federal or state law.

Oh, I should have been more specific about the mortgage hysteria (if you happen to be reading about that in the news or in Philip's post about the credit squeeze). The core of the mortgage problem, from what financial newswriters are saying, is that a lot of people have these Adjustable Rate Mortgages (ARMs) rather than fixed-rate mortgages, so when the rate adjusts from say 5% to 9%, the borrower can no longer pay the monthly mortgage amount. But now the house is worth less, so when the borrower tries to sell, more is owed on the mortgage than the house is worth. Actually, the lenders shouldn't have lent money to anyone who couldn't make payments at the reset amounts (the 9% rate for example), but that's not what happened. Okay, that's more than you wanted to know but it's just amazing to me that so many people (the lenders who made the loans, the companies who bought the securitized loans or groups of loans, regulatory agencies) could have been so careless.

-----end of discussion-----

Just in case anyone is interested, I’ve created some spreadsheets that show how interest and principal are applied in the following types of mortgage loans:
30-year fixed rate (fixed interest rate of 6%)
Adjustable Rate Mortgage (initial rate of 5.6% with reset after second year to 7.6%; after fourth year, 9.6%)

And here's a discussion about the differences between a traditional mortgage loan and a simple interest loan from Jack Guttentag (professor emeritus of finance, The Wharton School of the University of Pennsylvania and founder of GHR Systems, Inc. according to his website).

Thanks to Eric for helping us to consider new ideas and different perspectives.

Disclosure: I own shares of Lowe's but I still enjoy using their money.

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Philip Brewer's picture

The amortized loan (where you make payments of fixed size, each of which pays down some of the principle) is something of a modern innovation. Until the 1930s, most loans, even home loans, were of the sort that nowadays we call "balloon payment" loans--you'd pay just interest (quarterly or semi-annually) for three or ten years, at which point the loan would come due and you'd be on the hook for the entire amount of the loan.

That old style of loan is still common in the corporate and government bond market--pretty much all corporate and government bonds pay semi-annual interest until maturity, at which point you get your principal back in a lump sum.

Guest's picture
Spencer

Maybe it helps to look at it from the point of view of the lender. If you've borrowed $100K at 6% (just to make the numbers easy), then they don't have that $100K to invest elsewhere, and they want a certain level of income from it. So the first month, they want 6%/12 (0.5%) or $500 in income. Suppose you never paid any principal. They'd still be getting the 6%/year income and they would presumably be happy. Now, let's suppose you've been paying for a some years and you've reduced the principal to $50K. Now the lender has $50K to invest somewhere else, so they're happy to get less money from you (that is, 6% on $50K, or $250/month).

Without the "front loading" they wouldn't get their full income from the loan until you had finished paying it, and if you managed to pay it off early (say, by selling the house), they would end up receiving a significantly lower effective return on their money.

An easy way to significantly reduce the "front loading" effect is to double the principal payment for the first few years. Because the principal payment is relatively small, it doesn't hurt you much, but you basically pay off two years of your total term for each year you do this. On a $100K loan at 6% for 30 years, you'd start out paying about $100/month extra. After 3 years of doing this, you'll be 6 years into the "front loading" but will have paid a little less than 3 years worth of interest, saving you over $15K.

Of course, if you keep this up, in year 15, you'll be paying $1200/month instead of $600/month, but most of the benefit of this approach comes at the beginning, when you can make the "front loading" work for you instead of against you.

Guest's picture
joewatch

I think you are making things a bit confusing here.

The way I think about 30y mortgages is like this:

You have a fixed APR for the loan - let's make it 6%

You take a loan for $200,000.

In the first year, you pay the bank 6% interest on the $200,000 (about $12,000, plus some principal (about $2450)

In the second year, you pay the bank 6% interest on the remaining principal, $197,450, plus some principal (this time, about $2500).

And so on.

The amount of your payments (interest + principal) remains constant, so basically, the amount of principal you pay back is increased in response to the decrease in total interest $ you are paying each year.

So the bank isn't doing anything tricky here. The whole point is that amortization gives you the opportunity to pay the bank back over a 30 year period. You are never pre-paying your interest (or front-loading, as you say.)

If it were possible, I would like to have a fixed interest-only mortgage that I only needed to pay off when I sold the house. It think you would to, if you considered these numbers:

-Interest rate = 6% / yr, but effectively only 2.1% since it is tax deductible
-House appreciates at 4-6% per year
-By paying interest only, your monthly payments are smaller. If you invest the extra money in a broad index fund for the long term, your return is (probably) going to be 6-8%.

Ben Stein says that the main reason why 30-yr mortgages are good for families is because they turn your house into a forced savings-vehicle.

Guest's picture
Guest

That's just rich, loan officers falling back on that nebulous bogeyman "the law" says. There is no law that requires even amortization over the course of the loan. I myself have drafted all sorts of interesting and variable loans with different and uneven amortization schedules. The "reason" that the loan is "front-loaded" so called, is one of mathematics, not greed. If you insist on equal monthly payments (what is by definition an amortized amount) then you will have the first payments of any loan going only to service the interest on the loan, with very miniscule amounts going to principal. It is this very reason that the payment stays equal as the principal declines. Interest is compounded each period of the loan. Periods are normally 30 days by convention. Financial convention also dictates a 360 day year. Easy right. As the principal declines incrementally so the amount of each payment that goes to paying the interest portion of each payment declines and the amount that goes to principal increases. Not a conspiracy, unless you consider the laws of mathematics to be conspiring against you.

Nora Dunn's picture

Just a quick point in answer to Andrea's comment that she feels she might be getting ripped off with heavy-interest-bearing payments for her starter home:

Even though your first year entailed mostly interest and very little principal reduction, when you eventually get your next home you can port your mortgage to the next property. You can remain on the same amortization schedule (or if you need a bigger mortgage you can look at a blend of rates and amortization, such that you don't have to start from scratch with the lender, and pay all that additional interest.

Great article Julie! 

Guest's picture
Andrew

I was just discussing this topic with a friend of mine and we were trying to figure out a way to get around this "front-loaded" loan concept. It's a true point that amortization is a simple mathematical principle and if the borrower wants to make equal payments (as a previous commenter noted), the loan will end up front-loaded.

I don't think it's a financial conspiracy though. It's simply a tool to enable people to more easily afford homes. It wouldn't be financially viable (or mathematically sound) for a bank to take a traditional 360 payment loan, figure out the total interest+principal and then divide it by 360 and have each payment equally go to principal and interest.

If the borrower re-financed after 2 years, the bank would not have actually received its due "interest" for the loan because of the pro-rating. The only way to get around this would be to have a pre-payment penalty equal to the amount of "unpaid" interest. It's easy to forget that banks have to make money in order to have money to lend to people who want mortgages. If banks kept losing money on mortgages, there wouldn't be anymore mortgages.

Julie Rains's picture

Nora, I hadn't heard of porting a loan, which seems to mean transferring your loan to another property. Is this something done in Canada?

I found this article about portable mortgages offered by Etrade in the Real Estate Journal (2003) and it looks like the company still offers such a loan.

Guest's picture
JimmyDaGeek

As a number of posters already pointed out, the monthly payment on a mortgage loan, or any other similar loan, like a modern car loan, is merely calculated to let the borrower pay the same amount of money each month until the loan is payed off. The calculation assumes that you pay all the interest you owe on the previous month's balance, plus enough principal to even out the monthly payment. This is the fairest way to calculate a payback as you are only charged interest for the money you use.

Other interest calculation methods assume you pay back the principal in even installments, but make you pay most of the interest near the start of loan, and rebate this interest to you if you pay off the loan early. This is truly a "front-loaded" loan.

Even worse, a negative-amortization loan lets you make a smaller monthly payment by deferring the payment of the interest you owe and tacking it onto the outstanding balance instead. You end up owing interest on the interest. This is how many sub-prime loans work that are causing problems now.

The modern mortgage is truly consumer-friendly. Many states make it illegal to assess prepayment penalties, so you can pay your loans off early without owing any extra interest. Also, banks can't "call the loan", that is, to force you to pay it all back immediately. One reason for the Great Depression was that when the stock market crashed and people couldn't pay back their broker loans, the banks looked for cash by calling in their loans. This meant mortgages, too. Many, many people lost their homes and farms this way.

The only conspiracy is people's willful ignorance of math and how money works.

Guest's picture
Guest B-RAD

Not only were the banks in bad shape in the great depression President Franklin Delano Rossevelt pledged the Americans of the United Stated Birth Certificates to open up accounts in the federal Reserve in your name so every time u sign a contract in the
United States with any lender the name that u sign on that contract such as(mortgage)Is sent to the federal reserve for collection by the lender being the creditor and u the debtor they've already been paid for that mortgage within a short period of time.that money that they get for your house that u signed for is YOUR MONEY TO BEGIN WITH the government has and the people that play a part in it have been fooling us for a long time STOP BEING FOOLED YOUR PAYING BACK YOUR OWN MONEY

Julie Rains's picture

Thinking about loan structures is inituitive for some, but not for everyone. For me, it is helpful to see the practical implications of a loan using a spreadsheet. 

It's useful to consider underlying assumptions and to see if these assumptions still hold true and how they are applicable to your particular situation: Will the housing market continue to rise?; will I sell my home within a few years? Loans are often structured and sold with unspoken, underlying assumptions. And even what seems risky as a structure may not be all bad. For example, if you can lock in a low initial interest rate on an ARM and you pay extra each month, then you could really pay down your principal quickly and when the rate reset, your monthly payment may still be fairly manageable.

Also, what seems like a imperfect decision at a given point of time may turn out to be a great decision later. Andrea lives in an urban market and though housing prices may be slowing in growth right now, prices are likely increase. Warren Buffett didn't look particularly savvy when he didn't buy tech stocks but after the dot.com bubble burst, he returned to genius status.

 

Guest's picture

As others have said, it's pretty straightforward. You have a higher loan balance at the beginning, so the interest is higher at the beginning. If you have a $500K loan and you pay 6% then you need to pay $30,000 a year or $2500 a month in interest at the beginning. Typically people want to get as much house as they can afford and so they get a loan where their monthly payment is equal to the interest payment at the beginning (and then as the interest payment decreases the principle payments can increase.)

"There's nothing that I ever learned in math that can explain why I should put the first few years of house payments towards interest, which doesn’t increase the equity in my house at all."

Well, no one's stopping you from paying extra. But that's not going to decrease the $2500 a month you owe them in interest.

"The idea that you pay pretty much only interest for the first few years DOES make it seem like a conspiracy – can’t they just average out the interest over the course of the mortgage?"

It wouldn't be any better off if they did. You are still going to owe them around $30,000 in interest for those first few years-- because you agreed to a $500K mortgage at 6% APR and that's what it costs. If you paid less than your share of interest in the first few years (saying "I'll pay it later, at the end") and then sold your house, you'd better believe the bank would charge you the difference.

Basically, it's not that the banks are ripping you off. It's that all the "renting is throwing your money away, buying is investing in yourself" stuff we hear non-stop only works if a) you stay in the house at least 5-7 years or b) home values go up significantly. This is why I'm waiting to buy until I'm damn sure it's a place I want to stay for the medium-term.

Guest's picture
FlatGreg

I think the mathematical reason for front loading becomes evident if you start by thinking of an interest only loan. Every payment you make is for interest, and it's the exact same amount every month.

Now what if you pay a little more than just the interest? Well that would reduce your principal, so next month you'd have a smaller loan and owe less interest. If you make the same payment as the previous month, more can go to principal since you owe less interest. A 30 year amortization is what you'd have to stick to to pay off the entire principal in 30 years using this interest + principal method.

Guest's picture
Roddy

A mortgage is a loan. If a lender loans you $200,000 to buy a house and you pay off a small part of it in one year, he charges interest on the unpaid balance. If that doesn't seem fair, try to convince an individual or bank to lend you money interest-free. Another alternative would be to save up $200,000 and buy the house cash.

Julie Rains's picture

You make an excellent point Penny Nickel. There are many factors in deciding whether it's time to buy (also discussed by Philip in "Renting is Cheaper", Jessica Harp in Are You Ready for Homeownership? and their commenters) including market conditions in your market and rental prices in your market.

But even though most loans are structured (reasonably so) so that you pay more interest at the beginning as the principal is higher, I think it's useful to consider that there could be a different way to structure a loan as Andrea wondered - that's how new products are invented. For example, if a builder developed a community and then did the financing, the builder could offer a loan that allowed the principal to be reduced early on (similar to how car manufacturers may offer 0% financing b/c they are making money from the sale of products and not just the interest), or as Nora suggested having a portable loan.

Guest's picture
Guest

I read another artical from a PHd and essentially the very simple way to look at a 30 year fixed loan is actaully 360 individual loans where you pay X worth of interest on the remaining amount of the amount borrowed and it is completely up to the borrower to prepay the pricipal. This artical was very helpful and all the comments as well.

G

Guest's picture
Guest

I hate to be blunt but many of you posting on here are crazy. Front loaded amortization was concocted by the banks to get their money first (the interest). I've owned my home for the last 8 years. I have great credit and work in the financial/real estate industry so I understand the math and the reasoning. My home cost $170K when I bought it and over the last 8 years I've paid $90K in interest and have only paid down my principle by $25K to $155K . Selling it, assuming I'll be able to sell it for the same $170K I purchased it for, I will only receive a cash out for $25K ($170K-$155K). But the bank has received $90K over the same 8 years.

I understand the banks need to make money but they have been making huge sums and have destroyed the American dream of owning your home because it's now a money looser, not a money maker. More Americans move about every five years than ever before. They spend their time improving their homes by buying from retail stores and paying for upkeep on the house (Mowing, repairs, fertilizer, etc) Essentially fixing it up in the hopes of getting some more money out of it when they sell it. So they get a little return on their investment if the value goes up.

Finally the next buyer comes along and buys your improved house for an even greater price and the front loaded interest payments start all over again on an even higher price meaning the bank makes even more money over the next five years until it time to do it again for the next sucker.

The math has been done. It's cheaper to rent than it is to own, even when you consider the interest deduction on taxes. It didn't used to be this why back in the 40's-60's, but it is now.

Finally, this nonsense about being able to afford a home that's 2x's, 3x's, 4x's, or 5x's your gross household income is pure crap promoted by guess who-- the banks.

Cash is king people. If you can't pay cash, which I understand most can't then only pay the least house possible or rent. I moved to CA for a $150K job and I live in a trailer that cost's $90K. Very cheap here and less than 1x's my annual income. What do I do with the rest? Invest and enjoy life with my family so I'm not paying some bankster to get rich off my hard work. I would much rather see my family enjoy it.

WAKE UP PEOPLE!!!!

Guest's picture
Pat

Well I suppose if all prospective home buyers only purchased what they could truly afford upfront, homes would not cost nearly what they do today. The creative lending strategies over the past decade have allowed many individuals to acquire the 'American Dream' in spite of whether they can afford that dream or not. I guess the only equivalent I can draw is if you opened a $200K line of credit at a bank and immediately maxed that credit line out. If you amortized that loan out over 30 years...in fact, you would realize that you are paying a lot of interest up front too.

It is a tough pill to swallow, believe me. Especially being one of those conscientious home owners that put down at least 20% during the bubble peak and watched the value of my home erode under my feet while making my interest-loaded payments as agreed.

Sometimes you just have to realize when you called on a hand when you probably should have folded pre-flop (sorry for the obscure poker metaphor for many of you).

Guest's picture
DJ

I know it's been many years since this discussion was started, but I too struggled with the idea that Mortgages are front-loaded and only recently figured out why that is.

It's true that you pay more interest in the beginning because you owe more money.

What no one talks about is that basically, to make homes affordable, the payments are set too low at the minimum. The monthly payment remains the same each month although the interest payment is always proportional to the outstanding balance. And that is why it takes forever to pay off a mortgage and why you end up paying ridiculous amounts of interest for it over the amortization period.

Basically, they structure the mortgage to be affordable to home owners and easy to pay with regular, predictable monthly payments. The side effect is that because you're not paying a proportional amount of principal, you end up giving the lender many, many years of your payments as mostly interest...

If you want to avoid this you basically need to either 1) Not get a mortgage and if you can, get an equity line of credit. The interest-only loan allows you to pay back as much principal as you like, anytime that you like with no penalties. But you need to be good with money or you'll keep borrowing your equity and never paying your loan off.

or 2) Make sure that you get a mortgage that allows for either doubling up of payments - some mortgages let you make two payments a month and the second payment will be all principal. Other mortgages also allow of 'lump sums' which give you once-a-year or more often chances to put extra money down against your principal, which will ultimately reduce the total amount of interest you pay.

or 3) when you refinance, you can ask to set your payments higher.

If you can somehow do a bit of all three - higher monthly payments, putting down lump sums and double payments when you can afford it, you'll pay off the house a lot quicker and pay much less interest.

Of course, there is the argument that Mortgages are so low interest in the first place, you'd be better off making minimum payments and using your extra money to do other things with it - like buying a rental property or investing in something more lucrative than a slumped real estate market...