Who among us has been to a Taylor Swift concert? I have not, and I find it unlikely that I ever will. I did watch parts of her Eras Tour on Apple TV and spent a little time reading about the business side of her well oiled machine. What I learned is that her shows follow a formula that engages fans from the very first song. Everyone is singing together, and the energy shifts. A few people may be thinking about how much it costs to be there(a lot), but most are simply enjoying the atmosphere, the unity, and the shared joy of Taylor’s music. There are many songs; they follow a specific order, and the energy rises and falls throughout the night. Early in the show, the big hits take over. Later in the night, the quieter songs and deep cuts show up. A mortgage moves the same way. In the early years, the portion of interest paid is much higher than the principal. As time passes, the balance shifts, the principal takes center stage, and your equity grows. Similar to a Taylor Swift show, the real dividends are realized near the end. Swifties walk away feeling like their world has changed, and for some, it probably has. They invested a substantial amount in tickets and walked away with an experience of a lifetime, along with lasting memories, and very few have buyer’s remorse. Everyone is happy. 

Knowledge is power, always. If you’re thinking about purchasing a home, understanding how things work is key to making informed choices. When those keys slide across the closing table, you won’t have the oh so common “what did I just sign” feeling. So here we are, get comfy, and let’s break down what mortgage amortization is and how it’s the same, but also very different than an installment loan that most of us use when buying a car. After we get a general understanding of how things work, let’s talk about the 50 year mortgage I’m seeing in my social media feeds and explain why, if it ever becomes a real thing, you may want to think extra hard before you get one. Digging in, as I write this, I’m assuming you have a conceptual understanding of what a mortgage is. Most people don’t have $350k lying around to buy a house outright, so we get a loan; more specifically, a mortgage. This is a loan secured by a lien on real property. What makes a mortgage feel so much different is the term, the length of the loan, and the principal, the amount that is loaned. The amortization of a loan is nothing more than the scheduled payments and how interest and principal are paid within these payments. 

I’m going to compare and contrast a mortgage and an auto loan. Most of us have had, or currently have, an auto loan. So you understand the feel of an auto loan, how it worked for you from the car lot to the final payment. What you are going to learn is that the amortization of an auto loan and a mortgage isn’t drastically different. Which means when it’s time for you to get a mortgage, you already have a baseline understanding. According to LendingTree, the average used-car loan in America is $26,795. Experian tells us that the average rate for a used car in America is 11.87% with a term of 69 months. (This 11.87% number made my jaw drop, so I dug deeper. It is the average across all credit scores. Still jaw dropping). According to BankRate, the typical home mortgage in America is $435,300 (median) at 6.75% APR (average). The average mortgage term, per Bankrate, is 30 years. Please pay particular attention to the two terms, how wildly different they are. The term of an auto loan is just under six years, and the mortgage term is 30 years. The mortgage has a term that is 421.7% larger than the auto loan. The principles are also light years apart, with the average mortgage loan about 15.25 times larger (1,525%). These are the two primary reasons why car loans and mortgages feel so completely different. 

Let’s dig into the math of how this works, both for a car loan and a mortgage. Full disclosure! My numbers will only factor the principal and interest. Property taxes and insurance are not factored into my example. However, when you purchase a home, your mortgage payment will most likely include Principal, Interest, Taxes, and Insurance (PITI). Let’s keep our numbers nice and round to make things easier to understand. We are going to calculate our auto loan example for a $25,000 car with an interest rate of 10% and a term of 6 years. The mortgage sample will be calculated for a loan amount of $400,000, an interest rate of 6%, and a term of 30 years. Before we break this down, let me explain how each payment is calculated. Here is the algebraic equation. If you can’t make heads or tails of it, don’t worry. I’m going to explain things. 

In plain English, P is the amount you borrow, r is the monthly interest rate (the annual rate divided by twelve), and n is the total number of payments. If we plug in the values for our car loan, $25,000 at 10% interest for six years, the monthly interest rate becomes 0.10 divided by 12, or about 0.008333. The number of payments is 72 because 6 years multiplied by 12 months is 72. Plugging these numbers into the equation gives us a monthly payment of about $463. The math works by taking the interest rate, compounding it over the full number of payments, and then dividing the result by the loan term. This creates a payment that stays the same every month, even though the amounts of interest and principal in our payment change. The same exact process is used for a mortgage. For a $400,000 home loan at 6% over 30 years, the monthly interest rate is 0.06 divided by 12, which is 0.005, and the number of payments is 360. When those numbers are put into the same equation, the monthly payment comes out to about $2,398 before taxes and insurance. This is where the difference between car loans and mortgages really becomes clear. The math is identical, but the scale is completely different. A car loan is much smaller and much shorter, so the principal is reduced quickly, and each payment makes a noticeable dent in the balance. A mortgage is much larger and stretched over 30 years, so the early payments barely reduce the principal at all. The interest portion slowly shrinks only as the principal shrinks, and because the loan is so large, that shift takes time. What feels like two completely different types of loans is really the same formula applied to two very different loan sizes and timeframes. Once we understand the equation, the behavior of both loans makes sense, and the way a mortgage amortizes becomes much less intimidating, which is the goal. 

To make things easier, I broke our examples down in a spreadsheet and exported the two graphs so we have a visual representation of the drastic difference in the amortization. This is the graph of our car loan's amortization. As you can see, our X-axis represents the number of payments, and our Y-axis represents dollars. Starting at the right, we can see that the green arch is at $25k, the original amount financed. The blue arch represents the total interest paid, starting at zero on the right. With each payment made, a little less interest is paid, and a little more of the principle is chipped away. Over the life of the loan, a little more than $7,000 in total interest has been paid, the price of borrowing the funds to purchase our car. If the term were longer, we would pay more for the loan. Now, let’s look at our mortgage graph; this is where we see the difference. 

Looking at our mortgage amortization graph, we can immediately see the blue line (interest paid) skyrockets. This is because our term is 360 months, vs our auto loan of 72 months. Our mortgage rate is 6% much lower than the auto loan rate of 10%, but the loan term significantly increases the cost. If we were to keep this mortgage to its full term, most people sell the property long before this; we would pay around $460k in interest, more than we originally borrowed. WHY?!?! Because interest is being compounded over 360 payments. A way to avoid paying so much is to make extra payments toward the principal, reducing the amount on which interest is calculated and knocking off a few payments on the back end. I’m not going to get into the weeds on how this works, maybe in a future post. Focus, CW... 

Something else our mortgage amortization visual shows is how much of our payment goes to principal and interest. This is why it’s easy to think a mortgage is calculated differently, but it isn’t. Again, the difference is in the length of the loan. Looking at the mortgage graph, we see that the green line (principal remaining) and the blue line (interest paid) are on opposite sides of the Y-axis, and as the number of payments increases, the two lines converge around the 160 mark. Again, this is because of the loan term, 30 years of payments. When we make our first payment, $2,000 will go toward interest, and only $398 goes toward the principal. That’s not much toward principle, but it does decrease our principle by $398. So, calculating payment number two, our principal is now $399,602. This means that payment number two will pay slightly less interest and a little more toward the principle because our payment amount hasn’t changed; we are just applying a little less interest because the principle decreased. Payment two applies $1,998 in interest and $400 toward principal. Payment three is $1,996 toward interest and $402 toward principal. This schedule continues for 30 years, with the interest dropping by $2 per payment and the principal increasing by the same amount. I hope we aren’t lost in the math and things are making sense to you; that’s my goal. 

Real quick, now that we understand how amortization works and knowing that the term length is a much larger factor than the interest rate, let’s look at a 50 year mortgage. You’re getting ready to see what this is a HORRIBLE idea. I'm not going to break down the math on this; let’s focus on the graph. It will get the point across. As you can see, our X-axis now shows 600 monthly payments; everything else is the same as our 30 year example. Please pay particular attention to our blue line; the amount of interest paid increases at a more dramatic rate than our 30 year. On our 30-year mortgage, we paid a total of $460k in interest over 360 payments, but on our 50 year example, we have already paid that amount around payment 210 and will pay a total of $860k in interest for a $400,000 loan at 6%! If we keep it for 50 years. And this, my friends, is why a 50 year mortgage is a HORRIBLE IDEA! 

Let’s wrap this up. If you stuck around long enough to make it to the end, thank you. I hope that we learned a few things about mortgages and how they are the same, but very different from each other. I also hope you see why a 50 year mortgage is a bad plan. 

If you have questions, ideas for future insights posts, or are looking for a knowledgeable, trustworthy Realtor®, feel free to reach out at RealEstate@cwphipps.com