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Mortgage Math: We've Got The Breakdown

By: Old Point National Bank / 05 Jan 2017
Mortgage Math: We've Got The Breakdown

Mortgages aren't complicated financial instruments, but if you didn't go to business school or are otherwise unfamiliar with how a loan or investment works, they can seem more complex than they actually are. Mortgages really are simple instruments and can certainly be used to your advantage as a soon-to-be homeowner, but understanding them starts with some simple finance. Fortunately, we've got you covered. Here's a breakdown on mortgage math.

Compounding Interest

Compounding interest is a powerful tool. As an investor using an IRA to increase your personal retirement savings, compounding interest is your best friend; however, for a borrower looking to get equity in a purchase or pay down a loan, it's your worst enemy. Regardless of the situation you're in, compounding interest is unavoidable.

In essence, compounding interest can be broken down simply. At the end of each financial period (monthly, quarterly, biannually, annually, etc.) the interest accrued on a loan is added to the principle. This addition of interest, from a borrower's perspective anyway, means that a greater portion of your monthly payments are going towards interest compounded over the previous month and less is going towards the principle.

Understanding the Rule of 72

One of the single most powerful tools anyone can use to understand the cumulative effect of compounding interest is what's known as the Rule of 72. Essentially, by dividing the number 72 by the interest rate of a loan or investment (as a whole number) you can roughly calculate the amount of time it will take for the loan to double in value.

This is especially useful if you're shopping for interest rates and want to know what the effect of fractional interest percentages can be on your loan. Let's use a simple example:

You purchase a home for $100,000 at a 10% interest rate. By using the rule of 72 (72 divided by 10), your loan value will double in 7.2 years. Let's say on the other hand that you take out the same principle for half the interest rate ($100,000 at 5% interest), using the Rule of 72 would tell us that it would take 14.4 years for that same investment to double.

If you're like many Americans working through a few minor debt obligations, you can use this tool to prioritize your loans, and chip away at the obligations with the largest interest rates. In essence, though, the Rule of 72 helps us understand how compounding interest affects our overall debt obligations, loans, and investments.

Interest vs. Time

Finally, let's look at the function of the overall math problem we're trying to solve. When deciding whether or not to purchase a home, you're likely faced with a lot of numbers. How long your mortgage term is and how much interest you pay along the journey are key among them. What's important to remember is that lower interest is your friend, and that often only comes with a shorter mortgage term.

Of course, in the end, it comes down to what you can afford month-to-month at the outset. If you can't make the monthly payments of a 15-year mortgage, but a 30-year mortgage is easily attainable, go with the safe payment. You can always put more money towards your mortgage each month, but in the event of an emergency, you aren't stuck with an exorbitant monthly payment.

The formula of interest vs. time will also factor strongly into your decision for a home mortgage. Perhaps you value not paying as much interest over the life of your loan or maybe you have other obligations to settle before you can really tackle your mortgage. Either way, there is a time and interest correlation that will work for you.

Get Started with Your Home Loan

Hopefully, we've cleared up the overall math involved with purchasing a home and signing your first mortgage, but there are probably still some lingering questions that only a professional can answer.

Give Old Point Mortgage a call today. The loan professionals at Old Point can help you get started with your first home purchase and get you prequalified today! Additionally, they can answer any of the burning questions you may have and clarify the sometimes muddy mortgage market. The first step, though, is to get prequalified and start shopping for the home of your dreams.

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