Front-loaded loans: a financial conspiracy?

Julie Rains — Wed, 26 Sep 2007 20:00:55 +0000

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.

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.

This article is from Julie Rains of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

amortization schedules

Front-loaded loans: a financial conspiracy?