Understanding Your Mortgage
A FEW YEARS AGO A MAJOR TRUST company advertised during
RRSP season with a slogan that went something like this: "You do the living,
well do the math". Although this jingle is catchy, it implies that the
mathematics of life is just too complicated for the average person on the street to
comprehend. This is completely untrue and when it comes to understanding mortgages this
article will clear up some misconceptions on the subject.
Let us consider two hypothetical mortgages. The Jones family and the Smith family live
side-by-side in suburban Vancouver. On January 1, 2000 each takes out a mortgage on their
home of $100,000 bearing interest at the rate of 12% per annum. This means that, as a
minimum, they will each pay $12,000 of interest per year and any payments in excess of
that figure will be used to reduce the outstanding principal. However, there is one
difference between the neighbors. The Jones mortgage (Mortgage A) is calculated on an
annual basis, so the $12,000 interest cost is calculated as $100,000 x .12.
The Smith mortgage (Mortgage B) is calculated on a semi-annual basis so that the
interest cost for the first six months is determined by $100,000 x .06 (.12 divided in
half) for the first half of the year, and calculated in like fashion for the second half
of the year. When the two $6,000 interest calculations are added together, they result in
As you can see, if neither family pays any money toward principal, by December 31, 2000
each has paid an identical amount of interest. The difference comes in when you calculate
how much principal is owing by the families on that date.
Although the Jones and the Smiths borrowed the same amount of money and
paid the same amount of interest, the "effective interest rate" between the two
mortgages was different. Without going into the specifics of the calculations, Mortgage A
has an effective rate of 12% while Mortgage B had an effective rate of 12.36%. This is
because of the timing of when the interest payments must be made. The first interest
payment for the Jones is on December 31, while the first interest payment for the Smiths
is six months earlier, on June 30. Although the payment is one half the amount, the fact
that it is due sooner causes the effective interest rate to become higher. So, the more
often the interest is calculated, the costlier the mortgage becomes.
Whether this is a good or a bad
thing depends upon which side of the table you happen to occupy. If you are the investor,
you want the funds that you have lent out to attract interest on a semi-annual basis.
However, if you are the borrower, you would prefer annual compounding.
Of course, most mortgagors do not want to be repaid in semi-annual or
annual instalments. They want payments more frequently, usually monthly. So they take the
effective interest rate as calculated above, and translate it into monthly portions that
maintain the contracted cost of borrowing.
Besides the interest rate and its frequency of calculation
there are several additional factors that go into the mortgage document. These are (a) an
open or closed mortgage: an open mortgage allows the consumer the right to pay off the
debt at any time within the contracted period provided that he pay a penalty to the lender
at the time that it is exercised. In most cases the penalty is an increase to the interest
rate of the mortgage of one-half of one percent. A closed mortgage, on the other hand, is
a binding agreement that the debt will not be extinguished before the term of the contract
has expired; (b) term and amortization period: the term of a mortgage is the
amount of time over which the contract will extend. It is the time from the date that the
funds are advanced to the borrower until the last payment is made and the contract
completed. Today, most mortgages run for a period of between six months and five years,
and, as a rule of thumb, the shorter the term, the lower the interest rate. The
amortization period is the amount of time over which the debt will be paid off if the
contract is renewed at the same rate of interest. Historically, the period of amortization
for residential mortgages has generally been between twenty and thirty years. Today,
however, with many families having two incomes, it is not uncommon to see much shorter
amortization periods. A longer amortization period results in a lower monthly payment but
a higher total interest cost over the term of the contract (please see the accompanying
table); (c) variable rate mortgage: up to now we have assumed that the interest
rate of the mortgage had to be maintained throughout the term of the mortgage. This is not
the case. Since most mortgage payments are made up of an interest component and a
principal repayment component, when the interest rate fluctuates, the balance between them
shifts. With a variable rate mortgage, the interest varies with the current market rate.
Typically, the monthly payments remain constant for the term of the mortgage but the
amount of each payment that is applied to the principal repayment will either increase or
decrease according to a drop or rise in interest rates; and (d) optional clauses:
when negotiating a home mortgage, it is possible to include a clause that will allow the
mortgagee to significantly pay down the mortgage prior to the end of its term. One such
clause, for example, may provide for a payment, without penalty, of say ten percent of the
debts outstanding balance on each anniversary of the mortgage. Other important
clauses will allow the borrower to renegotiate the terms of the mortgage, almost always
with the payment of a penalty, should interest rates drop considerably during the term of
the mortgage as well as the right to transfer the mortgage to a third party should the
property be sold.
How much will my mortgage cost me
This table shows the monthly mortgage payment (principal & Interest) for each
$100 of mortgage debt. To calculate payments at a given interest rate, find the
corresponding amount in the amortization columns and multiply by the number of thousands
of dollars of debt. (Example: To find the monthly payment required to carry a $90,000
mortgage at 8.75% amortized over 25 years, multiply go by 8.12 to get $730.80)
Spring 1999: Prenuptial Agreements | Understanding Your Mortgage | The
Limited Liability Partnership | Automobile Expense Worksheet
Profile | Our Services | FAQ's
| Press Room | Resource
Centre | What's New | Contact
Information | Site Map | Back to Home
Copyright © 2000: Allen Futerman and
Associates. All rights reserved.
Designed and maintained: Add Value International Inc.