Mortgage's Handout

# Mortgage's Handout - 1. Basics of mortgages and...

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Principles of Finance, August 2010, Mortgages Page 1 1. Basics of mortgages and amortization schedules. Before we start building a spreadsheet, it’s useful to get some background. Learning about mortgages is probably the most useful thing you will learn in FIN 3403. Almost all of us envision owning a house some day, not to mention that some of us may already. And, unless you are filthy rich, you will need a mortgage. The first thing to understand about a mortgage is the amortization schedule. As you probably know, a mortgage requires a monthly payment that does not change (for a standard fixed-rate mortgage, that is). We calculate this payment using our financial calculators. This payment is used to pay the interest we owe each month, along with paying off part of the mortgage. It is designed so that the balance on the mortgage will be zero when we have made our final payment. Let’s see an example and how the calculations are done, using the following example. The Jordan family recently purchased their first home. The house has a 15-year (180-month), \$165,000 mortgage. The mortgage has a nominal interest rate of 7.75%. All mortgage payments are made at the end of the month. What is the monthly payment on the mortgage? To calculate the monthly payment on the mortgage using a financial calculator, the following steps will accomplish the task: P/Y = 1 PV = 165,000 N = 180 I = 7.75 / 12 FV = 0 CPT PMT = 1,553.10 So, we know we need to send our lender \$1,553.10 each month, but what does this cover? That is what an amortization schedule is for. An amortization schedule is setup as follows: Month Beginning Balance Payment Interest Principal Ending Balance 1 \$165,000.00 \$1,553.10 For each month, we want to know what portion of the \$1,553.10 goes toward interest. What’s left goes toward principal – that is, repayment of the loan. To calculate the interest portion, we multiply the monthly interest rate by the beginning balance. That is:

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Principles of Finance, August 2010, Mortgages Page 2 Interest = Beginning Balance x Monthly Interest Rate \$1,065.63 = \$165,000 x 7.75% / 12 Once we know this, the remainder of the \$1,553.10 goes toward the loan (principal). So, Principal = Payment – Interest \$487.47 = \$1,553.10 – \$1,065.63 Finally, the balance on the loan at the end of the month is just the difference between the beginning balance and the portion of the payment that went toward principal. Remember, don’t include the interest. You owe that on the money you borrowed – it is gone. Ending Balance = Beginning Balance – Principal \$164,512.53 = \$165,000 – \$487.47 In net, here’s what the 1 st month looks like: Month Beginning Balance Payment Interest Principal Ending Balance 1 \$165,000.00 \$1,553.10 \$1,065.63 \$487.48 \$164,512.53 Now we are ready to start month 2. First, the Beginning Balance for the second month is the Ending Balance from the previous month. Beginning Balance
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## This note was uploaded on 02/08/2011 for the course FIN 3403 taught by Professor Tapley during the Spring '06 term at University of Florida.

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Mortgage's Handout - 1. Basics of mortgages and...

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