The Inner Workings of a Mortgage- What you weren’t Taught at School

The schooling system in New Zealand is great, but the one thing it doesn’t tech (at least when I attended) is personal finance. When I finished I knew more about ancient Greece than I did about mortgages and how they work.

Sure, I get why learning history is important, but wouldn’t it be better if the schooling system taught more about money and personal finance? Or just other useful day to day topics. I think the song don’t stay in school by boyinaband sums it up quite nicely.

“I wasn’t taught how to get a job, but I can remember dissecting a frog.

I wasn’t taught how to pay tax, but I know loads about Shakespeare’s classics.

I was never taught how to vote, they devoted that time to defining isotopes.

I wasn’t taught how to look after my health, but mitochondria is the powerhouse of the cell

I was never taught what laws there are. I was never taught what laws there are. Let me repeat I was not taught the laws for the country I live in, but I know how Henry the eighth’s killed his women; divorced, beheaded, died, divorced, beheaded, survived. Now that’s in my head instead of financial advice.

I was shown the wavelengths of different hues of light but I was never taught my human rights. Apparently there’s 30, do you know them I don’t. Why the hell can’t we both recite them by rote.

I know igneous, metamorphic and sedimentary rocks, yet I don’t know squat about trading stocks. How money works at all. Where does it come from? How does the thing that motivates the world function. Not taught to budget and disperse my earnings”

It’s a great song, but I would still recommend staying in school. I can relate to many of the examples given. For example the quadratic equation is burnt into my memory, but there have been very few time in my day to day life that I actually use it. Similarly, Pythagoras’s theorem, although that one is useful.

Now for today’s lesson.


How do mortgages work?

I was never taught about mortgages and how they work. Everything I know about them I had to learn myself. To make it easier for you to learn everything about mortgages here’s a run down.

Definitions

First of, here are the definitions of some words used when discussing mortgages

Interest: The profit earned by the lender, usually described as a yearly interest rate on the balance (principle) of money loaned.

Principle: The amount of money that you have borrowed from a lender, on which you pay an ongoing fee (interest) for the privilege, until you have paid it back in full.

Term: The period of time it will take to pay back the sum of money (principle) borrowed which is agreed between the lender and borrower

Payment: The amount of money you are obliged to pay at the end of each period

Mortgage Formula

A mortgage is a loan used for the purchase of a property. You borrow the money from a bank or financial institution, and agree to pay it back over a period of time with interest.

To work out the amount you are obliged to pay back you can use the mortgage payment formula below.

Where M is the payment you make on each term, P is the principal amount that you have borrowed,  r is the interest rate charged, and n is the length of the term.

So the four factors of a mortgage are: Principle, Interest, Term, and Payment. And by looking at the formula above, you can see that they are all interconnected.

By the way, you don’t need to calculate this on paper. There are many mortgage calculators online. I usually use the one on Interest.co.nz as it can show me two scenarios at the same time. It’s great for making comparisons.

Interest and Principle

Each mortgage payment you make will have both a component of interest and a component of principle. The interest is paid to the lender, and the principle goes towards paying off you home.

How do mortgages work


To work out the total interest you will paid on your mortgage, you will need to work out the total you will pay over the entire term

Payment amount x the No. of Terms = Total amount paid.

Then you can subtract the amount borrowed from this to work out the interest paid.

Total amount paid – Mortgage Amount = Total Interest Paid

Again, a good mortgage calculator can work this out for you.

Control your mortgage

Now that you know that there are four components to a mortgage (Principle, Interest, Term, and Payment) you can start to control your mortgage.

For me, The goal is to minimise the total interest paid. This will change depending on the principal amount, payment amount, the interest rate and the terms. We are going look into each component and see how they affect the goal to minimise our total interest paid. Let’s look at the following example.

  • Principle: $500,000
  • Term: 30 years
  • Interest rate: 5%
  • Monthly Payment:

To keep it simple, I assume interest rate will stay the same during the whole period. For the example about the total amount of interest paid will be $466,240. That is nearly the same as the amount of money borrowed. Now, lets see how each of the four components can affect the interest paid.

Size of Principle

The mortgage principal is the main factor in a mortgage. The amount you borrowed is in direct proportion to your monthly payment and total interest paid. The more you borrow, the more you pay on interest. However, the relative amount of total interest paid compared to the relative amount of principle reminds the same. In the above example, no matter the size of the principal borrowed, you will still pay an extra 93% on just interest.

See the example below. One is for a loan amount of 500k, and one is for 1 million. In both situations, the interest paid is 93% of the loan. Therefore, you will pay 1.93 times as much as the house is worth over the lifetime of the loan.

How do mortgages work

Generally, you want to borrow as little as possible.

Size of payment (and term)

The size of the payments you make is directly related to the lenght of the term of you mortgage. The term is how long the mortgage is supposed to last and payment is how much you will pay each time.

If you increase the mortgage terms, the payment amount will be lower but you will pay more on interest over the lifetime of the mortgage. On the other hand, if you increase the payment amount, you will shorten the mortgage terms.

In the example below, you can see if you shorten the mortgage from 30 years in option 1 to 15 years in option two your monthly payments increase from $2684 to $3954. But by increase your payment amount, you will be paying a lot less on interest. Compare $466,240 in interest for a 30 year term to $211,720 interest for a 15 year term.

How do mortgages work

Interest Rate

The interest rate charged by a lender will determine the amount of interest paid over the lifetime of the loan. Interest rate change from time to time due to multiple factors, including the official cash rate change by Reserve Bank of NZ.

Increasing the interest rate for a mortgage will affect mortgage payment and total interest paid. Right now, mortgage rates are at a historic low of around 5%. If you took a 5% interest rate and increased that by 0.5% to 5.5%, the mortgage payment will increase by 5.8% but the total interest paid to mortgage ratio jump from 93% to 104%. So you want to try an negotiate a low as possible interest rate with your lender.

What you can change

In reality, the factor that you have the most power over is the payment rate/term. The borrowing amount will be determined by the real estate market at the time of purchase. And the interest rate will be determined by the economy. But the amount you pay can be governed by you.

Increasing your payment amount, which decreases your mortgage term, is a great way to get to financial independence over the long term.

Now that you understand how a mortgage works, you know what you need to do. You need to get the smallest mortgage you can with the best interest rate possible and pay it off with the largest payment you can afford. If you want any other tips on mortgages check out one of my previous posts.

What did you learn in school

Now, what did you learn in school that you haven’t used in you everyday life?


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