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Mortgage Misconceptions – Simple Vs. Compound

Somehow my eyeballs landed on a few disturbing pages on the Internet and I started to wonder if this is the caliber of education being passed around by “do-it-yourselfers”. There is nothing wrong with trying to educate yourself and accomplishing your own financial goals…on your own.

However, if you decide to do this, just make sure that you are properly educated. Here is what I’m talking about:

The reason that the interest rate is so important is that you’re paying compound interest, not simple interest.

The heading of this article was titled:

“Compound Interest on Mortgage Loans”

This statement, and many other false and/or misleading statements were made on a site which has not – apparently – removed the incorrect material (it used to be located here: michaelbluejay. com/house/compoundinterest.html). The site also receives a fair amount of visitors, so my guess is that my eyeballs aren’t the only ones viewing the material.

It might be worth a read, but I can tell you the gist of the article right now. Basically, the premise is that you should get a 15 year mortgage or make extra payments on your mortgage to save yourself a lot of interest…and the reason that you normally pay so much interest to the bank is because mortgages are calculated on a compounded basis.

Now, let’s take a look at what this article is really saying. First, I must address the issue of compound interest. Mortgages are not computed on the basis of compound interest. For example, the author of this particular article states that: Let’s say you borrowed $100,000 to buy a house at 9% interest. You might think that you’d pay 9% of $100,000 in interest, or $9,000. But actually, over the 30-year term, you’d pay nearly $200,000 in interest! How can this be?

How can this be? Well, it’s simple really. $200,000 divided by 30 years is  a little less than $7,000 per year in interest. But, the author told us that at 9%, that’s $9,000 interest, and it’s compound interest. How can that be?

It works like this: A 30 year mortgage loan is calculated on simple interest, but it is calculated over 30 years with the assumption that part of the payment represents repayment of principal. So, the amount of interest gets less every year. So, in the first year, on $100,000, 9% is $9,000. But some of payment you make is principal. So the interest you pay in the second year is a little bit less. You keep hacking away at that loan and pretty soon you end up paying almost no interest until the mortgage is finally paid off.

The implication the author makes about paying $9,000 in interest at 9% is valid…if the term of the loan were only 1 year. But it’s not, it’s 30 years. That’s why they call it an APR, or Annual Percentage Rate, not a total percentage rate. It works the same way with a car and everything else you buy.

Think about it in reverse. If you were an investor, and you lent someone money (i.e. you bought a bond, either corporate or Government), would you be willing to accept $9,000 over the course of 30 years on a $100,000 loan/investment? By the way, $9,000 over 30 years is a paltry $300 per year, or .3% annually. That’s what you earn in a savings account at your local bank. If you’re lending money to someone, you’d probably want 9% every single year. And, so does the bank.

Conversely, if you were earning compound interest on your $100,000 loan, you would accumulate $1,326,767.85 in 30 years. That’s a good investment wouldn’t you say? …but let me ask you…do you know anyone that has paid anything close to that on their $100,000 mortgage? I didn’t think so. But that’s something the author would have to (logically) convince you of.

This entry was posted on December 25th, 2011 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Budgeting & Money Management, Investing

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