I have been in the Real Estate business for the past 25 years and currently hold a Brokers License in the State of Illinois. The topic which I am about to speak on, is one that I have had much experience
in and one that I am definitely qualified in. The two biggest questions I have found which all my buying clients have always had are one: what is the lowest price that I can pay for this property and two: what is the best interest rate that I can get? Of course I am talking about clients that do not pay cash and need to obtain a mortgage, which has been for me, just about all of them. Let’s talk about mortgage interest rates and what they really are in the reality of what one actually pays for that property and the percentage of interest out of all mortgage payments made.
This morning I went online and checked with one of our nations largest lenders to see what was the best mortgage interest rate they were offering. Obviously the best rates are reserved for only those with the the highest and most impeccable credit. Lenders always wish to limit the risk to themselves. They will reward the best clients with the best rates. I am not going to go through all the other factors that lenders use to qualify applicants. Let’s just assume that one is qualified in the example which I am about to give for a loan of $200,000 dollars. One has the required down payment and falls within the proper debt to income ratio.
I found being offered today a rate of 3.75% fixed for 30 years. Fixed means the rate and monthly payment never changes and is spread over 30 years or 360 months. That is 360 payments. The next best rate I found was 3.25% fixed for 15 years. Same way but for 180 months or 180 payments which is 15 years. These rates are very low and sound very attractive. They sound great. Most people would jump at either of these mortgage rate plans. Home buyers might even pay a fee or what are called points so that they can have one of these rate plans! However, they are really not what they seem to be! Let me break down both of these excellent, by historical standards, mortgage interest rate plans in order to show truthfully what they really represent.
Let’s talk about a loan of $200,000 dollars at 3.25% fixed for 30 years. I ran what is called an amortization schedule. This is what the banking and mortgage industry uses in order to calculate what the monthly payment is and give a break down of how much of ones money applies to interest and how much applies to principal, that which one originally borrowed. Here is the breakdown. The monthly payment on this loan will be $926.23. Now I am not including any other additions to this payment such as property taxes, or insurance.
I am only going to show what the actual interest and principal breakdown is. Notice that I say Interest and principal and not the reverse. The first monthly payment breaks down like this: $625 dollars is applied to interest and $301.23 is applied towards principal or loan reduction. Now hear is the simple math equation that one can use to figure the percentage of interest that is paid in that 1st monthly payment. Simply take the interest portion of $625 dollars and divide that number by the actual dollar amount that came out of ones checking account, or pocket I like to say, and hear is what one will find. $625 divided by $926.23 is equal to.674 or 67%. Yes 67 percent interest!
Now lets look at the totals after the first year. Twelve payments of $926.23 is equal to a total of $11,115
dollars paid out. The total interest paid out of that is $7,437.21. Divide interest by total paid to determine the percentage and that figure is.67 or 67% interest! Wow where did the 3.25% go? Now let’s look at some totals down the years. After five years one will have paid out a total of $55,574 dollars in mortgage payments. Out of that figure $35,635 is applied towards interest. Divide $35,635 by $55,571 and the number is.64 or 64%. Yes 64 percent is the actual average interest rate paid on that $200,000 dollar loan at that excellent, illusionary rate of 3.25%. If one looks at the ten year totals one will find the true interest rate paid out to be 61%. The rate does decrease gradually over the years.
If one were to pay consistently over 30 years, the average interest rate will come out to be 40% and not anywhere near that most excellent rate, reserved for only the best customers, of 3.25%.
This is what I call the banking magic effect of the compounding numbers. The truth is that the only time that one would actually pay 3.75% or less is if that original loan of $200,000 was paid back at the end of the first year or sooner and not with another mortgage loan. Few to none ever do this.
Now lets look at that same loan of $200,000 dollars at a most excellent rate of 3.25% fixed for 15 years. The first months payment comes out to be $1,405.35. That is principal and interest only. Notice this time I said the reverse of what I said on the 30 year rate. Out of this figure $541.67 is applied towards interest and the greater portion of the payment is actually applied towards principal. Now let’s take a look at the true interest rate. Interest of $541.67 divided by payment of $1,405.35 is equal to.385 or 38.5% interest. Much better than the 30 year program.But once again nowhere near that illusionary rate 3.25%. After five years total payments amount to $84,321 and total interest paid out of those payments will be $28,135. Divide interest paid by total paid out to come up with the true interest rate of.33 or 33%. After ten years the total interest paid comes out to 27.5%. Continue with this plan for the total of fifteen years and the actual interest rate paid is 21%. A far better rate than the thirty year plan. But still nowhere close to that illusionary rate of 3.25%. More banking magic, in there favor of course.
So in summary while payments of $926 dollars or $1,405 dollars on a $200,000 mortgage loan can be quite affordable to many, the truth is that the interest rate, or the interest rate carrot so to speak, is never really what one has been led to believe! It is true however that the lower the carrot rate or deception rate, the lower the actual true interest rate will be. I ran this example at a rate of 5.5% and came up with a true interest rate of 80% after year one on a 30 year program! If one has the ability to pay cash for a property than it might be easy to see by my examples here how that cash can actually give one a return on ones money of anywhere from 21% to 67.% verses the mortgage interest rate program, using reverse reasoning!