I’m going to explain how mortgages work as simply as I can. For this article, I am assuming you know nothing about mortgages, so we’re going to start with the basics.
Let’s say you want to buy a house because you want to raise a family in it, but a house costs $1,000,000 and there is no way in hell you have that kind of cash right now. Maybe if you saved and invested for 30 years you could have the money, but HELL NO you’re not going to wait that long.
BUT, the bank has a shit load of money and they’re willing to give you the $1,000,000 (called a “loan”) to pay for your house, as long as you agree to pay the bank back MORE than what they lent you over the course of a set amount of time, perhaps 30 years.
How much more than $1,000,000 will you have to pay the bank? That is determined by the interest rate. For example, let’s say your interest rate is 5%, what does that mean?
Basically, a 5% interest rate means that you will have to pay 5% of how much you owe on your loan every year. So if the bank gives you $1,000,000 to buy your house at 5% interest that means that in the first year you will have to pay $50,000 in interest (which is 5% of a million). That is money in addition to what you have to pay on the principle (which is the original $1,000,000). So theoretically you could pay exactly the $50,000 interest every year and you’ll still owe the bank exactly $1,000,000, every year, forever. But there is no way in hell that will ever happen in reality.
Here is a more realistic scenario. Let’s say again the bank paid the $1,000,000 for the house and you have a 5% interest on your loan. In the first year you pay the $50,000 in interest, plus another $40,000 on the principal. After the first year then, you will owe only $960,000 on your loan. 5% of $960,000 is $48,000, so now in the second year you will only owe $48,000 in interest. Last year you paid a total of $90,000 in payments ($50,000 interest + $40,000 principal), so let’s say you can afford to pay the same amount this year. You can afford to pay $90,000 of which $48,000 will be interest and $42,000 will be principal. That $42,000 payment on the principal leaves you with only 918,000 left to pay after the 2nd year. You will repeat this process every year until you have completely paid off your loan.
Here is a chart outlining the payments every year:
| Year Number | Amount owed at beginning of year | Principle paid | Interest paid | Total payment |
| 1 | 1,000,000 | 40000 | 50000 | 90000 |
| 2 | 960,000 | 42000 | 48000 | 90000 |
| 3 | 918,000 | 44100 | 45900 | 90000 |
| 4 | 873,900 | 46305 | 43695 | 90000 |
| 5 | 827,595 | 48620.25 | 41379.75 | 90000 |
| 6 | 778,975 | 51051.26 | 38948.74 | 90000 |
| 7 | 727,923 | 53603.82 | 36396.18 | 90000 |
| 8 | 674,320 | 56284.01 | 33715.99 | 90000 |
| 9 | 618,036 | 59098.21 | 30901.79 | 90000 |
| 10 | 558,937 | 62053.12 | 27946.88 | 90000 |
| 11 | 496,884 | 65155.78 | 24844.22 | 90000 |
| 12 | 431,729 | 68413.57 | 21586.43 | 90000 |
| 13 | 363,315 | 71834.25 | 18165.75 | 90000 |
| 14 | 291,481 | 75425.96 | 14574.04 | 90000 |
| 15 | 216,055 | 79197.26 | 10802.74 | 90000 |
| 16 | 136,858 | 83157.12 | 6842.88 | 90000 |
| 17 | 53,700 | 53,700 | 0 | 53,700 |
| Totals | 1,000,000 | 493700.39 | 1493700 |
The first thing you should note about this is that you’ll be paying a whopping $493,700.39 in interest! If you happened to have the million dollars up front and didn’t need to take the loan in the first place you would have saved nearly half a million dollars over 17 years. If you weren’t aware, that is a lot of money!
Now this was just an example. A lot of factors can come into play to change the amount that you end up paying in the end. This mortgage lasted only 17 years but many mortgages these days can last for 30 years. In that case you’ll be paying even more interest in the long run, sometimes more than 100% of what the home is worth.
For example, if the house costs $1,000,000 and you can only afford to pay $66,000 every year and you get an interest rate of 5.2% (typical) it will take you 30 years to pay it off and in the process you would have not only paid $1,000,000 for the house, but also given the bank a cool $1.02 million dollars on top of that! This is one reason why banks are so filthy rich.
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- Fluctuating interest rates (variable)
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- It isn’t that easy to qualify for a mortgage because it will cost the bank a lot of money if you can’t pay your payments