Compound Interest and how does it work with Mortgage loans.

Compound Interest

One of the Wonders of the World

Many of us know all about compound interest and how it works. You may now ask what does compounding have to do with home ownership and mortgage financing. Good questions and below, we’ll provide not just the answers but why you want to know them.

Simple vs. Compound Interest –As you can see in the chart above, “simple interest” accumulates far less quickly than compounding interest. What’s important to realize as it relates to financing a home is that the typical mortgage loan is paid based on simple interest – that’s good as it means that you pay less. The interest owed each month is based on the remaining balance and since with most loans, you’re paying at least a little bit of principal with each payment, the finance cost goes down as the balance declines.

Compound Principal? – OK, we’ve never really heard of this one but in realty, that’s what’s happening on a regular fixed rate amortizing loan. The amount of interest you pay declines with the balance, yet, because you’re making a fixed payment every month, the amount of principal paid is ever increasing. This works just like the growth curve on the chart above for compound interest.

Appreciation – There has always been cyclicality in real estate values meaning that the rates of increase or even decreases in value are never static. The actual rates are always changing from year to year based on many factors and they are even different from house to house. Still, if your home’s value is up by 3% every year, the actual dollar value of that increase is more from one period to the next and is another form of compounding.

Ex. Year 1 $100,000 x 3% - $3,000, Year 2 $103,000 x 3.0% = $3,900, Year 3 $106090

Adding it all up – If we assemble the factors above we can see why owning a home over time has been the most valuable contributor to building wealth. A progressively less expensive cost of interest, a progressively decreasing loan balance equaling rising equity and when measured over long enough periods of time, this is all usually backed by a progressively increasing home value which builds even more equity for you.

One More Thing – Strategy – We know or we’ve learned that compound interest is more valuable to the recipient than simple interest. Hence, when investing or saving our money, we will always pursue the choice that offers a compounding return. What takes a little more thought is what happens when we elect a shorter term loan over a longer one. Though the interest rate is usually lower on a shorter loan, the payments are much higher. So, whenever considering a shorter term, a smart analysis should include what might happen if the difference in the payments were invested with a compounding return vs. the simple interest rate being saved. It all depends on things such as tax bracket, rate of return, amount of time, etc., yet in the end, it is possible for the compounded return to equal more than the simple savings. Being smart or even just open minded about your options is always the best place to start and that’s what we’re always here to help. Reach out whenever you like and we’ll be happy to assist whenever you need us.