Compound Interest – Is it Your Best Friend or Your Worst Enemy?

“’Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
-Albert Einstein

Interest is simply the cost of borrowing money. If you finance your home, you are going to be paying it. It is going to be expressed as a percentage. Because of the Federal Truth in Lending Act, lenders are also required to provide you with something called an APR. It is the Annual Percentage Rate, and it is also expressed as a percentage, and it is usually higher than the loan interest rate. That is because it attempts to include other charges or fees such as mortgage insurance, closing costs, discount points, loan origination fees, etc. Most borrowers don’t understand how all of this impacts them and what they actually pay for their new home. Let’s try and remove some of the mystery from the mortgage process.

What is the difference between Compound Interest and Simple Interest?

Simple interest is a fast and easy way to calculate an interest charge on a loan. This applies to many car loans or short-term loans. The formula is Principle x Daily Interest Rate x Number of Days Between Payments = Simple Interest. When you make a payment on a simple interest loan, the payment first applies to the interest, and the rest goes towards the principal. Each month’s interest is paid in full so it never accrues.

To understand how simple interest works, let’s illustrate with a car loan example. For example, you have a car loan that has a $15,000 principal balance and it also has an annual 5% simple interest rate. If your payment is due on June 1 and you pay it precisely on the due date, the finance company calculates your interest on the 30 days in June. That makes your interest for 30 days $61.64 in this example. However, if you make the payment on June 21, the finance company will charge you interest for only 20 days in June, that reduces your interest payment to $41.09, that’s a $20 savings!

Now let’s discuss compound interest. Compound interest is the interest on a loan (or deposit) that is calculated both on the initial principal and the accumulated interest from previous periods. Compound interest is basically interest on interest and makes the balance grow at a faster rate. The formula for compound interest is a little more complicated: Total amount of Principal and Interest in future (or Future Value) less Principal amount at present (or Present Value) = Compound Interest. 

For example, take a three-year loan of $10,000 at an interest rate of 5% that compounds annually. What would be the amount of interest? In this case, it would be: $10,000 [(1 + 0.05)3 – 1] = $10,000 [1.157625 – 1] = $1,576.25. Using the above example, since compound interest also takes into consideration accumulated interest in previous periods, the interest amount is not the same for all three years, as it would be with simple interest. While the total interest payable over the three-year period of this loan is $1,576.25.

What Other Costs Get Added to My Mortgage?

Most people don’t buy a home based on total price but rather on what the monthly payment will cost them. While compound interest is your best friend if you are earning it, we just saw how it works against you when you are paying. This is especially true when dealing with large balances like you have with a home loan. We’ll illustrate that in a few case studies but first let’s discuss some other items when you’re shopping for that home mortgage that will increase the actual cost of your mortgage loan. 

APR or Annual Percentage Rate – The annual cost of a loan, expressed as a yearly rate. APR takes into account interest, discount points, lender fees and mortgage insurance, so it will be slightly higher than the interest rate on the loan.

Mortgage Insurance – Private mortgage insurance is usually known as PMI and you pay the premium as part of your mortgage payment. It is a type of mortgage insurance you may be required to pay for if you have a conventional loan. It typically kicks in if you don’t have at least 20% equity in your home. And just like other kinds of mortgage insurance, PMI is meant to protect the lender, not you. It covers the lender if you stop making payments on your loan.

RELATED: The Seven Steps of Modular Home Construction Financing

Closing Costs – These are costs or fees that are typically incurred for the origination and underwriting of a mortgage loan. They may include real estate commissions, taxes, insurance premiums, title, and record filing. Closing costs must be disclosed in advance by law and agreed upon by both the buyers and sellers. 

Discount Points – Discount points (also known as Mortgage Points) are fees paid directly to the lender at closing in exchange for reducing the interest rate. This is sometimes called the “buydown rate,” which can lower your monthly mortgage payments. One point costs 1 percent of your mortgage amount (or $1,000 for every $100,000). Basically, what you are doing is paying some interest up front in exchange for a lower interest rate over the life of your loan.

Loan Origination Fees – These are fees that the lender charges the borrower for making the mortgage loan. An origination fee can include processing the application, underwriting and funding the loan, and other administrative services.

PITI – These four components add up to your “PITI” — your total monthly payment as a homeowner: 

(P) Principal — The amount of your loan balance repaid each month

(I) Interest — The interest your mortgage lender collects on the loan 

(T) Taxes — Property taxes required by the government

(I) Insurance — Homeowners insurance and, if required, private mortgage insurance

Getting your PITI is important in evaluating a home mortgage. It gives you a realistic budget for homeownership.

Now for some “Real Life” Examples

Case Study #1 – Current Rate of 3.2%

Interest rates appear to have hit their low point several weeks ago. However, where they go is anyone’s guess. It’s 2020 and an election year. Currently, you can find interest rates for a 30 year fixed mortgage hovering around 3.2%. Here is a breakdown that shows a monthly PITI payment of $1,190 a month for a $250,000 home with a $200,000 mortgage:

Case Study #2 – Future Rate of 4.5%

Now, what happens next year if the rate goes up to 4.5%? While that is still a historically low-interest rate when it comes to a home mortgage, compound interest is working against you! With everything else being equal, your PITI payment now goes up to $1,338 a month for that very same house! With only a 1.3% increase in the interest rate, it resulted in you paying $148 more every month for the life of the loan. Over the 30 life of the loan, you will have paid $164,814 in interest on this 4.5% loan versus $111,377 for the 3.2% loan. Now that’s the power of compound interest!

What Makes a Construction Loan Different than a Mortgage?

We have been talking about 30-year mortgage loans. When you prepare to build your new modular home, you will typically get a construction loan. They work very differently than your long-term loan. The interest rate is typically 1% higher than a long-term loan but you only pay the interest accumulated on the loan each month.

A construction loan is disbursed in draws, so your balance outstanding grows during the life of the loan. You pay the interest-only each month so no interest accrues on the balance during the construction loans short life. Once your modular home is completed, your permanent loan pays off the balance and your convert to your long-term mortgage, which typically has a lower interest rate and starts you on the path to paying down your balance.

Modular Means More

If you are going to have a mortgage for your new home then the interest rate you are going to be charged is the single biggest item to impact the final cost of your home to you. Even more than the actual house price itself! It appears home mortgage rates are poised to rise in the coming months. Modular means your home will be built to provide the most comfortable living space at the best price. But it also means your home can be built more quickly, allowing you to lock in rates for your long-term loan at today’s rates. That’s just one more reason that Modular Means More!

The post Compound Interest – Is it Your Best Friend or Your Worst Enemy? appeared first on Impresa Modular.