Mortgages are used by individuals to purchase homes, and they are generally paid over a period of 15 to 30 years. When a borrower is granted a mortgage, most of the payments made during the initial years cover the interest on the loan before any principal is paid down. This article seeks to explain why mortgages are front loaded with interest.
Amortization
The reason why mortgages are front loaded with interest is due to amortization. Amortization is the process of reducing a loan balance over time by paying off both principal and interest in regular installments. The amortization schedule shows how each payment is applied to principal and interest over the life of the loan.
During the early years of a mortgage, most of the monthly payment goes towards interest rather than principal repayment. This is because the interest is calculated based on the outstanding loan balance, which is highest at the beginning of the mortgage. For example, if the mortgage has an interest rate of 5% and the loan balance is $200,000, interest charges during the first month would be approximately $833.
Lender's Risk
Lenders prefer to receive their money back as soon as possible, and front loading the interest ensures that the lender receives more money back upfront. From a lender's perspective, this makes sense since it lowers the risk of the borrower defaulting on their loan. For a borrower, this can be seen as a disadvantage since they may not see the impact of their payments on the loan balance until later in the mortgage's life.
Moreover, lenders also charge more interest upfront to compensate for the risk they are taking. If the borrower defaults on the loan, the lender is protected because it has already collected a significant amount of interest. The amount of interest charged upfront varies according to the loan’s terms and the borrower's creditworthiness.
Interest Acceleration
Another factor that makes mortgages front loaded with interest is the concept of interest acceleration. Interest acceleration occurs when a borrower pays the minimum monthly payment on their mortgage. Since the interest is applied to the outstanding loan balance, and most of the payment goes to interest during the early years of the mortgage, the loan balance is not reduced significantly. As such, interest continues to be charged on the same high balance for a longer period, thus leading to a longer loan term and more interest paid over the life of the loan.
Conclusion
In conclusion, the front-loaded nature of mortgages with interest is primarily associated with the amortization process, which sees interest charged on the outstanding loan balance. Additionally, lenders prefer to reduce their risk by collecting more interest upfront, while borrowers may find themselves in a disadvantageous position. Borrowers can, however, pay extra amounts toward principal balance to reduce the amount of interest charged, shorten the loan term, and ultimately save money.
"