The Power of Compound Interest, Down Payments & Loan Periods

December 21, 2017

Since a house is something that most people make payments on for a large majority of their life, I want to stress the importance of understanding compound interest.  So let’s run through an example of the different types of mortgage loans at different interest rates so you can get a better understanding of how much you are really paying for the house over the set loan period.

Lets say you want to buy a 2bd/2bth condo in Clarendon and got a deal for $500,000.  We will show four different mortgage loans and compare them to see how much different interest rates, down payments and loan periods affect the long term cost of the loan.  The four different mortgage loans are Base Mortgage, Higher Interest Mortgage, Minimum Down Payment Mortgage and Shorter Loan Period Mortgage. See the comparison table below.
 

*PMI is usually 0.5-1.0% of the mortgage loan.  A borrower has to pay PMI until they obtain at least 20% equity.  In this example, the borrower will obtain 20% at roughly the 8 year mark.


The "Base Mortgage" is a typical 30 year fixed conventional mortgage with a 20% down payment.  Your monthly payment would be $1,796.18 and the $500,000 house will end up costing $746,624.35.

The "Higher Interest" mortgage is also a typical 30 year fixed conventional mortgage with a 20% down payment and an interest rate of 4.5%; 1% higher than the "Base Mortgage."  Your monthly payment would be $2,026.74 and the $500,000 house will end up costing $829,626.85.  It is a good example of how just 1% can result in an extra $83,002.50 spent in interest over 30 years!

The "Minimum Down Payment" mortgage is a 30 year fixed FHA mortgage but you only put 3.5% down.  Your monthly loan payment would be $2,166.64 + $275 for the PMI = $2441.64!  It will be this much for roughly 8 years until you pay off 20% of the mortgage, then it will reduce to $2,166.64.   So since you did not put down 20%, the PMI will cost an extra $26,400 over those 8 years. The $500,000 house will end up costing $823,890.62!  It is a good example of how a low down payment can result in an extra $77,266.27 spent in interest over 30 years compared to the "Base Mortgage"!

The "Shorter Loan Period" mortgage is a 15 year fixed conventional mortgage with a 20% down payment.  Your monthly payment would be $2,859.53 and the $500,000 house will end up costing $614,715.43.  It is a good example of how 15 less years of payments can result in a savings of $131,908.92 in interest compared to the "Base Mortgage"!  Also, shorter term mortgages have lower interest rates which could save you even more money.

These examples were not meant to scare you, however, just teach you how powerful compound interest can be.  You might be thinking, I’ll never be able to afford a home.  Well here is some advice: never try to live above your means.  It is always easier to upgrade than downgrade.  It is also important to note that your house will appreciate over the course of your life.  On average, houses have appreciated around 2-3% per year over the past century.  Therefore, purchasing a house is a long term investment.

These examples are also meant to teach you to shop around when obtaining a loan.  A few percentage points or a couple of extra thousand dollars spent on the down payment can have a huge effect over the course of 30 years.

Also note, the above examples do not include Real Estate taxes or homeowners insurance so the monthly payment would be even higher.  It is important to know that your monthly mortgage payment will include your real estate taxes (~1% of your home's assessed value in Virginia) and your home owners insurance (usually less than $100 per month).

 

To learn more about mortgages, visit our Mortgage 101 page.

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