Components of a Financial Plan
February 12, 2025
Companies want to go public because it helps them raise cash, which can be used for further expansion. However, the promoters of these companies often do not want to go public since this would mean that their stakes would be diluted and that they would lose control over the company. A low promoter’s stake in […]
The speed at which commercial banking is being automated is astounding. The automation process is about two decades old. However, over time, many difficult processes have been automated. However, commercial banks have realized that automation can be a double-edged sword and can sometimes lead to spectacular blunders which can impact the reputation of the bank. […]
Economists all over the world are of the opinion that markets are the best system for allocating scarce resources. However, they do not seem to agree so much on what the nature of those markets should be? Countries like the United States, Japan, and France, etc. all do follow the market structure. However, there are […]
In the previous article, we have already seen how commercial banks inadvertently help anti-social elements in laundering money. We have also seen why commercial banks are preferred by anti-social elements when it comes to laundering money. We know that commercial banks have already put in place a lot of processes to stop this money laundering […]
BB&T and Sun Trust bank are both giant institutions in their own right. However, now since they have decided to merge, another “mega-bank” is likely to come into existence in America. Both these banks have been in operation for over 100 years, hence have their own heritage. Financial analysts are not clear on whether the […]
Buying a home is a huge financial decision. The effects of this decision are felt throughout the life of an average person. This is because the average investor does not have the entire cash to buy their home. Hence, they typically pay 25% to 30% of the costs as a down payment. The rest of the money is borrowed from a bank in the form of a mortgage. The typical family borrows three to five times their annual income in the form of a mortgage. This is probably the largest purchase that a person makes within their lifetime. It is also important to get this purchase right because there are significant transaction costs associated with it. Hence, if a person does not like the terms of a mortgage, replacing it can be quite expensive.
This means that they have to pay a significant portion of their income towards mortgage payments. It is therefore important for any investor to know about how mortgage loans work. In this article, we will have a closer look at the working of mortgage loans.
The most important thing to realize about mortgage loans is that they are not like savings accounts. There is a misconception amongst many people that when they pay their mortgage, they are paying themselves. Hence, they think that their mortgage is just a tool that forces them to deposit a sum of money into a savings account each year. The problem with this thinking is that it induces people to take on larger mortgages than they can afford.
The reality is that in the initial years, most of the money paid towards a mortgage goes into interest costs. Calculations show that in the first five years, almost 75% of the money paid towards a mortgage goes towards interest payments.
This is because mortgage payments are amortized over time. This means that if you have a monthly payment of $1000, the $1000 may remain constant. However, the composition of the $1000 that will be applied towards principal and interest varies over the period of the loan. In the initial years, almost $800 will go towards interest payments. This is because the principal outstanding will be large, and hence the interest payments will also be large. Over a period of time, the principal reduces. Hence, towards the end of the loan, the same $1000 will be split as $900 towards principal and $100 towards interest.
The mortgage payment is the final figure which the homeowner has to pay every month. This figure is determined by three major factors, viz. the principal amount, the tenure, and the interest rate. How each component affects the mortgage payment has been listed below:
Many people have borrowed too much money to invest in their homes. This has created a new situation called “house poor.” The details of this phenomenon have been described in another article. The bottom line is that even if banks are ready to lend more money to an individual, it would be advisable to keep the principal amount low. This is the reason why financial planners often advise individuals to make higher down payments and reduce the amount of money to be borrowed.
It needs to be understood that increasing the tenure has a disproportionate effect on the monthly payment. This means that if you double the tenure of your loan and keep the other factors constant, the payments will more than double. This is because of the fact that these loans charge compound interest. As a result, if the money is outstanding for a longer duration of time, the interest costs increase disproportionately.
Hence, a difference of even a single percentage point could make a huge difference. This is the reason that diligent home buyers tend to negotiate their interest rates hard with several banks.
The bottom line is that the impact of the mortgage decision is not limited to the mortgage itself. The decision is so huge that it impacts the overall income and savings of a person. As a result, it impacts all other financial goals, including retirement planning.
Your email address will not be published. Required fields are marked *