Mortgage interest during life of loan

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RetiredNewbie
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Mortgage interest during life of loan

Post by RetiredNewbie » Wed Jun 06, 2018 8:07 am

I just read this on Investopedia…

Kaplan, Steven Jon / New York, NY
"If you have 7 years left of a 30-year mortgage with a 5.75% interest rate then the effective interest rate is about 1%. The fewer the number of years left on your mortgage, the more it makes sense to not prepay it since you are essentially borrowing money on your house interest-free. On the other hand, if you have 28 or 29 years left of a 30-year mortgage then you probably should pay it off because your effective interest rate is near 10% for the next few years."

This made no sense to me, so I checked my last payment. I have 4.5 years left on my 15 year mortgage, at 3%. The original loan amount was $45,700. Last month I owed Navy Federal Credit Union $15,471.17, and the interest taken from my payment was $38.68. That works out to exactly 3% divided by 12 (months) of my remaining balance. Of course the interest payment was higher in the beginning, but so was the amount I owed. And if I pay off my mortgage, I will still save the 3% interest I'm paying now. Am I missing something?
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lawrun21
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Re: Mortgage interest during life of loan

Post by lawrun21 » Wed Jun 06, 2018 8:21 am

I don't think you're missing anything. Perhaps what Mr. Kaplan is attempting to get at is the fact that more of your payment at the end of a mortgage goes to principal rather than interest, which I think is the point you are making, but that does not mean that your "effective interest rate" has changed.

Also, his argument does not take into account inflation.

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grabiner
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Re: Mortgage interest during life of loan

Post by grabiner » Wed Jun 06, 2018 8:31 am

The math you quoted is wrong, and you are correct. While it is true that the late payments on a mortgage are mostly principal, your effective interest rate is always equal to the loan rate, and your return on a mortgage prepayment is always equal to the interest rate,

Suppose you and I both have 4% loans with equal balances, and you pay $10,000 extra against your loan. Next year, your loan balance will be $10,400 lower than mine, because the payments you made covered $400 less of interest and thus $400 more of principal. The following year, your balance will be $10,816 lower than mine, and so on until your loan is paid off.

If you are late in your loan, the eliminated payments are mostly principal, which means that the same dollar payment doesn't shorten the loan as much; however, you get the benefit faster, and can get a similar long-term benefit by investing the money no longer being used for payments.
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Smorgasbord
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Re: Mortgage interest during life of loan

Post by Smorgasbord » Wed Jun 06, 2018 8:47 am

I was curious as to whether some context was left out, so here is a link to the investopedia question:
https://www.investopedia.com/advisor-ne ... alance-my/

It seems worse than what RetiredNewbie quoted as Steve Kaplan included this nugget:
If you have 7 years left of a 30-year mortgage with a 5.75% interest rate then the effective interest rate is about 1%. The fewer the number of years left on your mortgage, the more it makes sense to not prepay it since you are essentially borrowing money on your house interest-free. Even a 2% bank CD or a 6-month U.S. Treasury paying 2.1% would make more sense as an investment than prepaying a mortgage with less than 1/4 of its lifespan remaining.
I don't get Steven Kapalan's math...so I probably won't be using his investment service that charges a 20% performance fee on net profits. :?
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Nate79
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Re: Mortgage interest during life of loan

Post by Nate79 » Wed Jun 06, 2018 9:30 am

The interest on the mortgage is always the interest rate times the outstanding mortgage balance no matter if you are in the beginning or end of the mortgage. The reason that at the end that more of the payment is principle vs interest is not magic. It's simply because the principle remaining is less thus interest rate * principle remaining gets smaller and smaller as you pay it off.

This is one of the most misunderstood details in personal finance that I see over and over.

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Ketawa
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Re: Mortgage interest during life of loan

Post by Ketawa » Wed Jun 06, 2018 9:59 am

This is completely wrong. Comparing two mortgages with equal interest rates, one with 5 years remaining and the other with 29 years, it makes even more sense to pay off or accelerate payments on the shorter duration loan, since you will realize the benefit earlier. (Or refinance to a shorter duration mortgage or HEL.) Plus, it's less likely you will be itemizing deductions.

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grabiner
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Re: Mortgage interest during life of loan

Post by grabiner » Wed Jun 06, 2018 8:10 pm

Ketawa wrote:
Wed Jun 06, 2018 9:59 am
This is completely wrong. Comparing two mortgages with equal interest rates, one with 5 years remaining and the other with 29 years, it makes even more sense to pay off or accelerate payments on the shorter duration loan, since you will realize the benefit earlier. (Or refinance to a shorter duration mortgage or HEL.) Plus, it's less likely you will be itemizing deductions.
One way to see that this is correct is to consider the situation if you have two loans, one with 5 years left and one with 29 years left, both at the same rate. If you pay down the 29-year loan, you get a known benefit after 29 years. If you pay down the 5-year loan, you can use the money you would have otherwise paid on that loan to make extra payments on the other loan, and get the same benefit. However, you retain the option of doing something else with that money, such as investing it if paying down the longer loan is not worthwhile.
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