Michael Sack Elmaleh , CPA, CVA

One of the most common uses of time value formulas
is the calculation of constant payments on a loan that has a fixed initial
balance, fixed interest rate and fixed time of repayment. The fixed payment
over time has a principal component and an interest component. The ** principal
**component of the payment is that portion that reduces the loan balance.
As payments are made the principal component increases and the interest
component decreases.

The need for the specific fixed payment formula arises in figuring out mortgage and car loan payments. These loans have the needed elements to apply the formula: a fixed loan balance, a fixed interest rate and a fixed repayment period. Here is the payment formula:

One point to emphasize is that most installment
loans compute ** interest in arrears**. The above formula assumes
this. What does this mean? If you borrow a lump sum and you are going to make
interest and principal payments monthly, you do not make the first payment
until after you have used to the funds for the first month.

Example. You close on a
house purchase on the 1^{st} of October and take out a mortgage loan.
Your first monthly payment will be on November 1^{st}. This makes sense
because only after having use of the funds for the month should you owe
interest on those funds.

There is something else interesting going on with this formula. The “n” in most cases will be one month. But we all know that not all months in a year do not have the same number of days. Also, not all years have the same number of days. You might then expect that you would pay more interest expense in months that have more days than in months that have fewer days. Likewise, in leap years you would expect to pay one more day’s interest than in non-leap years. But these differences are not reflected in the formula which assumes that all months and years are of the same duration.

This problem has not escaped the attention of commercial lenders. Using the calendar days in the month as a guide fully seven of the months have 31 days, leading to what could be considered an under collection of interest using the standard fixed payment formula, four are neutral with 30 days, and only one with 28 or 29 days could lead to an over collection of interest. To create an equalization of interest payments that adjusts for the idiosyncrasies of the calendar, commercial lenders will adjust nominal annual interest rates by multiplying this rate by the ratio of 365/360 and applying this adjusted rate in its computation of payments using the standard formula. This overt adjustment is generally made only for commercial loans, not for home mortgages.

Now the idea of an amortizable loan, one in which the same fixed predictable payment is due every month, with a payment that brings the loan balance to zero over the fixed life of the loan is one of the most unsung economically revolutionary ideas ever developed. I do not believe it is an exaggeration to claim that without the introduction of amortizable home mortgages the United States would not have developed a large relatively comfortable middle class. Interestingly, the 30-year fixed interest mortgage was first introduced on a widespread basis as part of the New Deal programs in the 1930s.

This introduction of
the 30-year fixed interest mortgage loan combined with the use of mortgage
insurance has greatly increased the percentage of households that own their own
home. Think of it. How would it be possible for ordinary wage earners to buy
and own a home if they had to pay cash for it? Only the
wealthiest could afford to buy homes under these circumstances. And without
amortization of the principal of these loans the middle-class largest asset,
its ** equity** in their homes, could not have been accrued.

In today’s mortgage markets borrowers have a wide variety of choices. They can choose 15- or 30-year fixed interest rate mortgages, which means that the balance is paid off in 15 or 30 years at a fixed interest rate. The short term and long-term impacts of each mortgage option are significant. Look at this example:

Example: Assume you are looking to purchase a $300,000 home and you can put 20% down, $60,000. This means that you will need a $240,000 mortgage. Assume you can obtain a 2.5% fixed interest, 30-year amortization mortgage or a 2.1% fixed interest 15-year amortization mortgage. Let’s compare first the amount of the monthly payments.

As you can see there is a significant difference in the total monthly payments, the 30-year loan calls for over $600 less monthly payment than the 15-year loan. But what you save in monthly payments costs you quite a bit more in the long run. If you keep your home for thirty years, you will pay a total of $341,348 in principal and interest under the 30-year mortgage option versus $279,989 in total payments under the 15-year mortgage option. This means that you would pay $101,384 in interest under the 30-year option and only $39,989 in interest under the 15-year option.

Because there are no pre-payment penalties you could pay a little bit extra in principal every month under the 30-year option and see a pretty sizable impact on the total payments made and the interest expense incurred. The table above shows the impact of paying an extra $100 principal every month. As you can see the extra payment reduces the total payments, total interest expense and payback period.

In the above example it was assumed that the borrower was going to stay in the home for another thirty years. This is an unlikely prospect. Most U.S. homeowners will keep their homes for a far shorter period. The overall median ownership period in the U.S. is 13 years. But this length of ownership varies considerably by region. Rust belt and rural homeownership lengths tend to be much longer than sunbelt or urban and suburban ownership lengths.

In addition to fixed interest mortgage rates lenders also offer adjustable-rate mortgages. These offer a fixed interest rate for the first term of the loan and the then variable interest adjustments after the first fixed term. The first fixed terms tend to be offered in increments of 3,5 or 7 years. Usually, the default amortization period is 30 years. Because there is less interest rate risk to lenders the initial term interest rates offered usually are less than fixed interest rate 15 or 30-year mortgages. The difference in interest rates between these adjustable interest loans and fixed interest loans has become less dramatic in recent years due to the overall steep decline in all forms of mortgage interest rates.

You may assume that if you have a choice between paying cash for a home or getting a mortgage that it is always a better idea to use cash. Similarly, you might think it is always a better idea to pay down your mortgage as soon as soon as possible to reduce the amount of interest expense you will incur. Certainly, from a psychological point of view it would seem to be better to have less debt than more debt. But will it always make economic sense to prefer less mortgage to more mortgage?

Perhaps surprisingly the answer is no. If the cash you would use as an alternative to having a mortgage or paying it down more quickly yields a higher rate of return on your investments, then it makes sense to have and keep the mortgage.

Example. Suppose you
have a 3% interest rate mortgage. Suppose further that you have enough income
and assets to increase the amount of principal payment you make each month on
the mortgage. Does it make economic sense to increase your payment? The answer
is no if the rate of return on the cash you plan to use to make the extra
principal payments is greater than 3%. Suppose that your surplus cash yields a
return of say 6%. Then not only does it not make sense to retire the 3%
mortgage loan early, but it would also make sense to increase the 3% loan as
much as possible as long as you could generate the 6% return on the new
borrowings. Utilizing the spread between the cost of borrowing
and the investment return from the use of the borrowed funds is called ** arbitrage**.