July 14, 2013

The standard mortgage contract in the US today calls for full repayment of the balance over the term with equal monthly payments of principal and interest. For example, a $100,000 loan at 6% for 30 years has a monthly payment of $599.56. That payment, if made every month, will pay off the loan in 30 years. I will save space by calling a fully amortizing mortgage with equal monthly payments a FAM.

Under-Appreciation

The great virtue of the FAM is budgetary convenience for the borrower, plus the prospect of full payoff at the end of the term. It is underappreciated by those who have not considered the alternatives.

One alternative, which was very common during the 1920s, was for borrowers to pay interest only until the end of the term, at which point they had to pay the entire balance. If they could not refinance, which was frequently the case during the depression of the 1930s, the alternative was foreclosure -- until the creation of the Home Owners Loan Corporation (HOLC), which bailed out many distressed borrowers.

Another way to pay off the balance by the end of the term is to pay interest plus equal monthly principal payments.  For a long time, this was the method used in New Zealand. In my example, this would require a principal payment of $100,000/360, or $277.78 a month. In the first month, interest would be $500, making the total payment $777.78, as compared to $599.56 on the FAM. While the payment using this approach would decline over time, the borrower’s ability to afford a given-priced house would be reduced, which is why New Zealand ultimately replaced it with the FAM.

The FAM was developed and used by our early building societies, which were mutual institutions that later evolved into savings and loan associations. In 1934, the newly-created FHA declared that all FHA-insured mortgages had to be FAMs. Within a few years, the FAM had become the standard for the industry.

Misunderstandings: The Conspiracy Theorists

The feature  of a FAM that generates misunderstanding is that the composition of the monthly payment between interest and principal changes over time. In the early years, the payment is mostly interest while in the later years it is mostly principal. This has given rise to the allegation that the way lenders charge interest is both unfair and self-serving – possibly even sinister. The following statement is typical.  

“All mortgages are front end loaded, meaning you're paying off the interest first. So during all of those first years, you aren't paying down the principle. Instead, you're buying the banker a new Mercedes…Your 6% mortgage is really costing you upwards of 60% or more!”  [See Is Interest on Home Mortgages Front-End Loaded?]

This is nonsense, but it is widely believed nonsense. Interest payments in the early years are larger because the loan balances on which the interest is calculated are larger. On the 6% $100,000 loan, the interest payment in month 1 is $500 because the borrower owes $100,000, in month 253 the interest payment is $250 because at that point the borrower is owed only $50,000. The lender is earning the same annual rate of 6% in month 1 and month 253.

If large interest payments in the early years really generated additional profits for lenders, they would prefer 30-year to 15-year mortgages, because interest payments on the 30 are higher in the early years and don’t decline as rapidly. They should therefore charge higher rates on 15s. In fact, they charge lower rates on 15s.

Mortgage lenders have enough to answer for without saddling them with a charge that is wholly bogus.

Misunderstandings: Borrowers With Multiple Mortgages 

Borrowers with more than one mortgage who are deciding how they should allocate their extra payments, sometimes go astray for the same reason. 

“I am coming into a large sum of money that I intend to use to pay down my mortgage balances.  I have a first mortgage at 4.5% and a second mortgage at 6%, but the second is more recent and a smaller part of the payment goes to principal. Am I thinking correctly that I will save more interest by paying down the first mortgage?” 

This is a perfect illustration of the old adage that a little bit of knowledge can be a dangerous thing. Borrowers who don’t understand how FAMs work assume correctly that you pay down the highest rate loan first. It is only borrowers who are aware of how the mortgage payment is divided between interest and principal who mistakenly believe that they will do better directing their extra payment toward the mortgage on which the principal payment is the highest. The mistake is in not realizing that 100% of extra payments are always allocated to principal. For further discussion of this point, see Mortgage Prepayment When You Have Two Mortgages.