Lenders charge borrowers a certain percentage of the principal as interest for each year a debt is outstanding. The amount of interest due on any one payment date is calculated by computing the total yearly interest (based on the unpaid balance) and dividing that figure by the number of payments made each year.
For example, assume the current outstanding balance of a loan is $70,000. The interest rate is 7.5 percent per year, and the monthly payment is $489.30. Based on these facts, the interest and principal due on the next payment would be computed as shown:
$70,000 loan balance x .075 annual interest rate = $5,250 annual interest
$5,250 annual interest 12 months = $437.50 monthly interest
$489.30 monthly payment— $437.50 monthly interest = $51.80 monthly principal
$70,000 loan balance — $51.80 monthly principal = $69,948.20
This process is followed with each payment over the term of the loan. The same calculations are made each month, starting with the declining new balance figure from the previous month.
The most frequently used plan is the fully amortized loan, or level-payment loan. The mortgagor pays a constant amount, usually monthly. The lender credits each payment first to the interest due, then to the principal amount of the loan. As a result, while each payment remains the same, the portion applied to repayment of the principal grows and the interest due declines as the unpaid balance of the loan is reduced. If the borrower pays additional amounts that are applied directly to the principal, the loan will amortize more quickly. This benefits the borrower because she will pay less interest if the loan is paid off before the end of its term.
Level-Payment Amortized Loan
Adjustable-Rate Mortgages (ARMs)
Adjustable-rate mortgages (ARMS) generally originate at one rate of interest, then fluctuate up or down during the loan term, based on some objective economic indicator. Because the interest rate on ARMs may change, the mortgagor’s loan repayments also may change. Common components of an ARM include the following:
Balloon Payment Loan
When the periodic payments are not enough to fully amortize the loan by the time the final payment is due, the final payment is larger than the others in order to pay off the full loan. This is called a balloon payment. A balloon loan is a partially amortized loan because principal is still owed at the end of the term.
Growing Equity Mortgage (GEM)
A growing equity mortgage (GEM) is also known as a rapid-payoff mortgage. The GEM uses a fixed interest rate, but payments of principal are increased according to an index or a schedule. Thus, the total payment increases, and the loan is paid off more quickly. A GEM is most frequently used when the borrower’s income is expected to keep pace with the increasing loan payments.
Reverse Mortgage
A reverse mortgage allows people 62 or older to borrow money against the equity they have built in their home. The money may be used for any purpose, and the borrowers decide if they want to receive the money in a lump sum, fixed monthly payments, an open line of credit, or other options.
The borrower is charged a fixed rate of interest, and no payments are due until the property is sold or the borrow defaults, moves, or dies. Though reverse mortgages have been available for almost 30 years, they have become more widespread as people live longer and need more money. The FHA home equity conversion mortgage (HECM) is one of the more common reverse mortgages.
Nonrecourse Loan
A nonrecourse loan is one in which the borrower is not held personally responsible for the loan. The lender has no recourse against the borrower personally in the event of a default. Nonrecourse loans are common in those situations in which the lender is highly confident that the value of the property involved is itself sufficient security. Nonrecourse loans are more common in commercial and investment real estate transactions than in residential situations.
