Happy Monday Everyone!
In the blog's first post, we will be going over some basics of what amortization is and what different kinds of amortization schedules there are. There is also a video on how on how to create a dynamic amortization table in Excel included. The tables that are made in the video are specific to a residential mortgage. You can also download the amortization Excel file at the end of the post and use inputs from listings in your area to get an estimate of what your total interest expenses, closing costs, and monthly mortgage and MIP/PMI payments might look like.
What is Amortization?
The term Amortization can be used in two different contexts. The latter will be the focus of the post.
The first is used within accounting to gradually allocate the cost of intangible assets (including financial products) over time. The asset's value is diminished on the balance sheet and transferred to the income statement to be reflected as a cost. This allows for the asset's cost to be correlated more accurately with its useful life and cash flows it is associated with.
The second context is to repay an amount loaned (principal) in periodic payments, along with some amount (usually a percentage) of interest. The payments are structured so that each payment is comprised of mostly interest. As the amortization period goes on, the relationship will invert, and payments will shift to being made up of more and more of the principal amount loaned.
Amortization Schedules Can Be Fully, Partially, Negatively or even Non-Amortizing at all.
We will use the following scenario to help illustrate the differences between the amortization types.
Imagine you took out a $300,000 mortgage, with a 4% annual interest, amortized over 15 years. Additionally, you also plan to repair and eventually rent out the property.
Fully amortizing mortgages have a payment schedule that allows for the amount borrowed, along with interest, to be fully repaid by the end of the amortization period. The majority of residential loans utilize this schedule. In the case of fixed rate mortgages, fully amortizing schedules are structured so that each period’s payment is for the same amount.
Within our renovation scenario, our fully amortizing mortgage would have a payment of $2,219. At the end of the 15 years (180 payments), we would have no balance owed to the mortgage lender. This is a clear and easy to understand schedule type. You can stop worrying about the mortgage at the end of the amortization period and you have made all your payments.
Partially amortizing mortgages will have a periodic payment, but the sum of all the payments made during the amortization period will not be enough to pay all of the principal and interest owed. This leads to a final amount being owed at the end of the amortization period that is equal to the remaining amount that would have been paid in a fully amortizing schedule. This final payment is also known as a Balloon Payment.
Within our renovation scenario, we would have the same details, EXCEPT our payments would be calculated as if we were getting a 30-year mortgage. The payments would only be $1,432 a month. At the end of the 15 years, you would have a balance of $193,628 that needs to be paid immediately. The economic environment at that time may or may not be the best one to refinance in.
Another way to think about it would be that the amortization schedule is a 30-year, 360 payment plan and you only intend to pay 15 years, or 180 of those payments before you pay off the remaining balance with the balloon payment. The balloon payment is just the sum of the remaining 180 payments left in the schedule.
Why Would Anyone Do This?
While building or renovating a property, you can expect the revenue being generated from the property to either be zero or very low in the beginning. Having the mortgage schedule structured like this can give you time and free up cash, that would have otherwise gone toward debt payments, to be used on the property. After the property is built or renovated, it should produce higher cash flows and should allow you to refinance into a longer term, possibly fixed rate alternative.
Non-amortizing loans, balloon mortgages, interest only loans, or even non-amortizing periods within other types amortization schedules are another type of amortization structure. Well in a way, because they don't have an amortization schedule at all! The payments for the term of the loan only cover the interest owed on the principal. Interest payments are paid for a predefined amount of time in the schedule before the principal becomes due or until the fully amortizing portion of the schedule begins.
In our renovation scenario, our monthly payments would be for $1,000. At the end of the 15 years, the $300,000 we borrowed becomes due all at once.
Similar to the partially amortizing schedule, this alternative can be very useful for developers or investors who are looking for a reduced debt burden for a specific timeframe to use capital for value additions in the property that will achieve higher cash flows later.
Some common characteristics of non-amortizing debt is that it's unsecured, shorter termed and often quoted with a variable interest rate that follows an index, along with a certain amount of basis points added as a premium to fit your unique risk profile. The increased risk for the lender due to the lower payments they receive during the term and the risk of the inability to recover funds if the borrower defaults lead to higher interest rates premiums. They are also usually quoted at lower loan-to-value and loan-to-cost ratios, which means the lender will contribute a lower percentage of the appraised value of the asset or cost of the project.
Negatively amortizing mortgages do the exact opposite of what fully amortizing mortgages do. The payments in this type of structure are so small that they do not cover all of the interest owed in each period. The amount of interest that is not paid in the period is then added into the principal portion of the loan and you then have to pay interest on a larger and larger principal portion.
This type of amortization sometimes appears as the front end of tailored mortgage structures for projects that have quantifiable proof of growth, then level out to a fully amortizing or balloon payment option. This type of amortization can also occur in adjustable rate mortgages where interest rates goes up high enough to become larger than your contractual payment made every period.
PMI Vs. MIP
What is Mortgage Insurance?
Mortgage insurance is insurance that protects the lender in the event you die or default and are unable to make your mortgage payments. Within mortgage lending, most lenders will only contribute up to 80% of the property's purchase price. The remaining 20% that needs to be paid by the borrower can be an unattainably large requirement for many people while buying a home. As a solution, lenders can contribute a higher percentage of the funds but will require the borrower to obtain mortgage insurance to offset the increased risk. Mortgage insurance can be paid annually, monthly, as an upfront/one-time premium at closing, or some combination.
What Is the Difference?
Private mortgage insurance (PMI) is insurance that is required on conventional mortgages when the borrower contributes less than 20% of the purchase price. While exact terms will vary from lender to lender, this insurance can usually be canceled at the request of the borrower once the loan balance reaches 80% of the original home value and you are up to date on your mortgage payments.
Mortgage Insurance Premium (MIP) is insurance for FHA mortgages when the borrower contributes less than 20% of the purchase price. The borrower is only able to cancel monthly MIP payments after 11 years, if the mortgage was loaned at an LTV less than 90%. Otherwise, the MIP payments are for the duration of the mortgage. This monthly premium can accumulate to a significant amount over the life of the mortgage.
FHA mortgages can provide a pathway toward property ownership for people with lower credit or who don't have large capital reserves (most people.) FHA mortgages have significant fees associated with them and should only be considered if they fit your current financial needs.
Amortization Schedule in Excel
Now that we have an idea of how customizable amortization schedules can be, let’s take some time to focus on the most common type in residential lending. The fully amortizing schedule.
The amortization schedule Excel model has a focus on mortgage insurance. The video walkthrough and mortgage charts within the model help show how the characteristics of your mortgage can impact how expensive your mortgage insurance is.
We have divided the excel file into 6 sections that we go into further detail about below. The sections are listed in the order they are created in the walkthrough video.
Section 1 on the upper left side is an area for inputs related to most home loans. (Purchase Price, LTV, Down Payment, Interest Rate, Amortization Length, etc.)
Section 2 is the amortization schedule. Within the schedule, there are columns for the Year, Month, beginning balance, total debt payment, principal, interest, ending balance and the amount of equity you have in the property during any given period.
Section 3 comprises two tables that provide information on MIP (mortgage insurance premiums) and PMI (private mortgage insurance.) These tables are in black text and are not intended to be adjusted or altered. The insurance premiums included in the charts are quoted as a percent of the base loan amount. The MIP information is sourced from the most recent FHA handbook. The information for PMI is from NerdWallet and Wells Fargo’s Mortgage calculator. Insurance premiums for conventional mortgages can vary based on factors like the state you are in, credit worthiness, LTV, loan term, and insurance company.
There is a positive correlation between the amortization length and the premium paid on the mortgage insurance. The risk for (the borrower to) default increases the longer the (lender's) money is exposed to default risk (borrower's property.)
There is a negative correlation between the down payment percent and the premium. The larger your down payment is, the lower your premium will be. The premium will approach zero the closer your initial equity contribution is to 20% of the property's purchase price. This is because the riskiness of the mortgage decreases as the bank is exposed to less and less of the deal. The bank has a lot more to lose (and possibly gain) in a mortgage where they fund 90% of the deal as opposed to 80%.
Section 4 includes a sensitivity matrix that helps you see the data “surrounding” your inputs. The matrix illustrates how sensitive your mortgage payment is to your interest rate and the amount you put down at closing.
When buying a property, things like how high current mortgage interest rates are and how much money you have saved up to put down at closing can impact your timeline. The mortgage loan matrix can help you see what different interest rate scenarios might look like and if you put more or less cash down at closing.
Section 5 includes 3 key outputs. The 3 outputs are interest over the life of the loan, total MIP/PMI payments and total possible closing costs.
Section 6 is a table that includes many of the common costs associated with purchasing a property. The Closing Costs table provides an area to accumulate quotes or estimates of relevant expenses that you can expect to pay before you close on the purchase of your next property. Within the labels of many expense line items in the Closing Costs table, further detail of some expenses is included. These can be seen by hovering over the expense labels that have a red marker on the upper right side of the cell.
Check out websites like WalletHub, BankRate and NerdWallet to compare and estimate what kind of mortgage you may qualify for, without having to sign up or give up all of your personal information.
Excel File
Resources
4000.1: FHA Single Family Housing Policy Handbook
Archive 4000.1 - 2015
Archive 4000.1 Published on 4/30/2015
APPENDIX 1.0 – MORTGAGE INSURANCE PREMIUMS (09/14/15)
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