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Tuesday, November 22, 2011

Amortization

The word amortization comes from the Latin word admortire, which means, “to kill.”  Given the state of the housing and debt markets these days the derivation couldn’t be more fitting.   Regardless of the origin, understanding how an amortization schedule is calculated and the influence of such a calculation on things like the housing market could not be timelier. 

I’m not going to go through the entire amortization formula as it would take most of this piece.  But know that the interest rate, the number of payment periods and the principal balance are the variables that calculate the monthly payment.  (Visit our mortgage calculator at http://warcap.com/services/harmonyloans).  Those variables also dictate the amount of interest vs. principal allocated within each payment: the amortization schedule.  As you might deduce, the larger the number of payments (there are 360 monthly payments in a 30-year loan) the less principal allocated at the start of the loan.  The nature of this formula and the fact that very few homeowners or mortgage brokers understand the formula is a primary reason for the current state of the housing market in this country. 

Take a 30-year fixed loan for $500,000 initiated in November 2009 at 6%.  The monthly principal and interest payment would be $2,997.  While that is an important number, often mortgage brokers fail to properly explain that such a mortgage obligates the borrower to pay $579,190 in interest over the 30 years of that loan for a total repayment of $1,079,190.  Today a qualified borrower could get a 30-year fixed mortgage for about 4.3%.  While this is a significant rate difference, there is a dirty little secret hidden inside the option to refinance and most in the industry don’t want you to recognize it.

Two years of payments at $2,997 equals $71,928.  But because of the magic of the bank’s amortization formula, the principal balance of this loan after two years is $482,922.  Only $17,078 of $71,928 has gone to paying down the $500,000 borrowed.  Moreover, refinancing into a new 30-year fixed mortgage immediately subjugates the borrower to another 360 monthly payments and a new amortization schedule.  Under this scenario, after four years of payments totaling $129,480, the borrower would have a principal balance of $466,427.  When you add back the $22,000 of closing costs the borrower would have to pay for both loans the total reduction of debt is de minimis.  Here at Warren Capital, we believe this type of scenario should be avoided and we give our clients a much better solution.

Through our alliance with Mortgage Harmony Corp., we are able to offer our clients a unique type of loan that allows the borrower to reset their interest rate after they finance by simply clicking a button on their lender’s Web site.  If interest rates change after the loan closes, which they always do, you now have the ability to take advantage of that new rate without refinancing.  No credit check, no appraisal, no title work, no income or job verification and no new 30 year amortization schedule. 

Our job at Warren Capital is to build and protect our clients’ wealth.  Both asset and liability management are necessary to accomplish our job.  There will be times when asset growth will be limited because of economic circumstances.  During such times, you can be assured that we will use that opportunity to improve the other side of our clients’ ledgers and to make sure they don’t succumb to hidden financial pitfalls.  While this is a unique approach for advisors in our industry, we know it’s the right way to help our clients build their net worth. 

As always, I appreciate the continued trust and confidence.