Guest Writer -
An “Interesting” Look
Virtually no one in this day and age is unaware of the concept of interest. Merriam-Webster defines the noun “interest” as a charge for borrowed money generally a percentage of the amount borrowed. Interest is all around us.
We pay it for our homes, cars, boats, credit cards, businesses, etc. Ironically, charging interest, although more than common today, was not always as favorably looked upon by society. In fact, many religions banned the payment of any interest for a loan.
The term used historically was “usury”. Judaism, for example, is said to forbid a Jew to lend for interest to another Jew. (See http://en.wikipedia.org/wiki/Usury)
The modern world defines usury as the charging of unreasonably high rates of interest, usually in an effort to exploit a debtor who “simply has no choice.” I suppose we can understand why loaning at interest was forbidden as it was not favorable to take advantage of another in a time of need.
However, money has evolved from those times and we now have concepts like “time value” and opportunity cost associated with the lending of money. Our modern world has evolved into a complex set of intertwined values, expectations and beliefs.
As such, there are no shortages of reasons why it is “fair” to charge “interest” for a loan. I tend to agree. Yet the power of usury survives in the modern day with the simple use of some slight of hand, as we shall see.
Interest becomes really powerful when it is compounded. That is, the interest is paid on the balance of the principal and, as the principal grows, so too does the payments.
This idea is often termed “the miracle of compound interest” and is used over and over to promote such strategies as “buy and hold” and “dollar cost average you basis”. The idea basically is to let the account grow, without withdrawals, so that interest is “earned” on the increasing principal.
This seems to make sense on the surface. Many people utilize this concept to formulate their financial plans.
However, as with most things regarding money, things are not always as they seem. So let us dissect the theory of compound interest, as it is applied to the real world.
Again, as money accumulates more and more into an account, the more interest it earns. This is not a miracle, this is common sense. Yes the account will grow if it is projected out 30 years.
What the strategy does NOT tell you is the expenses that will have to paid while the account grows. An examination of some types of these expenses follows:
Taxes – Yes, it is a dirty word, but like it or not, taxes are a major expense for every citizen. Depending on which vehicle (ie. qualified account like an IRA or unqualified account like a savings account), taxes must be paid in compliance of the tax laws.
For example, if the investor invests $100 per month for 360 months (30 years) at 10%. This equals a $225,000 account balance after 30 years. This projection strategically omits any adjustment for the payment of taxes over that period.
If the tax is paid out of the “compounding amount”, the investor will never reach $225,000 at 10%. Instead, the balance will be closer to $160,000 (about a 7 percent yield).
If the money is in a retirement qualified account, the money will actually grow exponentially if 1) the investor actually gets the rate of return projected (ie. 10%) which, by the way, is a big if. Nevertheless, the client MUST eventually take distributions on the account by law.
And when those distributions are taken, they are taxed at the highest rate possible, the earned income rate (as opposed to a capital gains rate). Of course, we do not know what that rate will be in the future. Can you envision the governments demanding less tax in the future?
Next, a complete analysis must include the lost opportunity on the taxes paid over time. That is, with the taxes paid, the investor must also lose the use of that money. That “opportunity cost” must also weigh into the equation.
Unfortunately, there is also inflation eating at the total the entire time, courtesy of our good friends at the Federal Reserve. At 3%, your total has the purchasing power of $.41 on the dollar over 30 years. Ouch, how do you like the investor’s plan now?
While compounding strategies usually do not make the investor rich, the strategy just happens to be tailor made for the financial institutions. If you were a financial institution; like a bank, or broker/dealer, or both; your main goal is deposits.
Deposits, as we all know is where the rubber meets the road, since, under the roof of fractional reserve banking, more deposits mean more money to loan.
A secondary goal would be to gain those deposits on a consistent and ongoing basis (ie. dollar cost averaging your basis). In this way, the money keeps coming in, month after month, all according to the plan.
Finally, the financial institution would like to hold on to the money as long as possible, and give back as little as possible.
The “buy/hold” fits nicely into your goals as a financial institution. That is why they promote such strategies. Yet this is but one arrow in the quiver of the financials. All of them are designed to utilize the power of compounding to THEIR advantage.
OK, enough basic investment analysis, let us talk in depth about mortgages. I choose mortgages because most people have them and there is no shortage of commentary on the subject.
However, I have yet to find the following mortgage analysis anywhere on the web. If you take the time to look at the fine print, you will be astounded at what you see. And guess what, it is all about tapping into the power of compound interest.
Under Discussed Mortgage Concepts
I have closed a fair amount of residential real estate loans since I first began practicing law over 12 years ago. In fact, when you first “hang a shingle”, real estate closings are an easier way to gain new clients and generate a little income.
In the last 12 years, I often field questions regarding the interest rate, pre-payment penalties, adjustable rates, etc. I have never, EVER, heard anyone ask about how the interest is calculated, on what amount, and how it is amortized.
Yet these questions get to the heart of the matter and reveal another misdirection play as perpetrated by the banks on the unsuspecting public.
Let us take, for example, your standard Note signed in connection with a real estate transaction. Most of these notes have a provision entitled “Borrower’s Right to Prepay”. The language usually resembles the following:
“I may make a full prepayment or partial prepayments without paying a Prepayment charge. The Note Holder will use my Prepayments to reduce the amount of Principal that I owe under this Note.
However, the Note Holder may apply my Prepayment to the accrued and unpaid interest on the Prepayment amount, before applying my Prepayment to reduce the Principal amount of the Note.” (emphasis added).
Notice what this says. First, your payment will be applied to the principle. Then, the language gives you one of those, “it depends” answers. What does it depend on? Well, that is left unclear. This question piqued my curious side. So I decided to call over to my friendly mortgage company to find out what would happen to my pre-payment.
One would think that once a mortgagor paid additional money to the lender, the loan would be “re-amortized” to reflect a new principal amount. At least that’s what I thought when I first began investigating this issue.
After all, it seems fair that less principal would reduce the monthly payment from that point forward. However, fairness when it comes to banking is about as common as a Quaker in a strip club, as we will see.
When I finally reached someone on the phone, she informed me that it “depended” on the loan but “typically” the loan would not be re-amortized and the amount of the prepayment would be applied to the “total amount due on the loan”.
It turned out, the definition of “total amount due on the loan” was NOT the principal amount, but the amount of interest and principal due as amortized over the life of the loan.
In other words, the effect of the pre-payment would only be to shorten the time it takes to pay off the loan. The amount of interest to be paid on the loan remains the same!
This reminds me of my first car loan, where the interest was quoted at 6.09% (a pretty good rate at the time). The catch was that the interest was based upon the original loan throughout the entire term of the loan.
The amount of interest never decreased as the principal decreased. Anyway, all of this to say that the mortgage document is more oppressive than a quick glance would reveal.
Of course, it could be worse. And, it is. It is worse because of two facts: 1) the mortgage is front-loaded. That is, in the first few years, virtually none of the principal is repaid. 2) The vast majority of home loans are paid in full within 5 years, usually because of a sale or a re-finance.
Let us break down this problem further, and discover why this is great for the banking institutions and not so great for the borrowers.
Below you can see an amortized mortgage payment schedule at 6.5% for 30 years at a fixed rate. (I included only the first 5 years and 8 months).
This loan is amortized out for 30 years. However, the most likely scenario is that the loan will be paid off in less than five years. I included the amortization for the first 68 months (5 years, 8 months) just to be safe.
Notice the totals for the years in bold. If the loan was closed today, April 8, 2006, then by the end of the year, the Mortgagor would have paid $21,156.56 back to the lender. Of that $21,156.56, $18,072.66 is interest payment. Only $3,083.90 is paid toward the principal. If you do the calculations, the percentage going toward the principal in the first few months is only 14.58%!
By the end of 5 years, and 8 months, the percentage going toward payment of principal has only increased to 19.94%. This is still under 1/5 of your payment going toward principal. Put another way, more than 80 cents of every dollar you pay goes toward interest.
Adding up the totals after our example, the Mortgagor has paid a total of $179,830.76. Of that amount, $148,834.86 was interest payments. The remaining $31,025.60 was paid toward the principal. The percentage of principal to interest averages over this time period only 17.25%.
Further, the borrower paid $148,834.86 interest on a $418,400.00 loan in just under 6 years. According to my TValue program, that’s closer to a 26% APR, if the borrower pays off and/or re-fi’s his next purchase.
So you might be thinking, “so what?” The Borrower gets the money and the house and the bank gets their money.
What’s the big deal?
First, it may not be a big deal IF property values keep increasing. Increasing property values offset the massive interest payments over time. However, this is a big “if”. Just because property values have been increasing across the board for over a decade does not mean they will continue to do so indefinitely. What happens if you decide to sell your property during a market adjustment?
Secondly, if you should happen to sell at a profit, it is highly unlikely that the “profit” realized is enough to offset the oppressive nature of debt servicing. Do not forget, there are other costs eating away at your bottom line.
For example, there most likely will be broker compensation for the sale. Next, there is tax on the gain that just might have to be paid. (Of course, there are exceptions). Finally, there is inflation eating away at the purchasing power of your money. And this is only a short list of line items that could affect your bottom line on a sale.
But what is most troubling is the fact that when a borrower re-fi’s his home or pays off the existing mortgage and buys a new house with a new mortgage, he is essentially starting the process all over again. That is, paying mostly interest and virtually none of the principal on the loan. This means that the average American’s payment of interest continues throughout his life.
His proportional share of interest for items such as cars, boats, homes, etc. usually stays right around 20%-25% his WHOLE life! Let this sink in for a second and realize that because every dollar is financed, (you either earn or forego those earnings), you are literally at the mercy of the banking system.
In other words, the concept of compounding interest is engineered in reverse against the borrower. The interest is front loaded so that when a debtor re-fi’s or moves, he gets to make the same interest laden payments anew. Moreover, that rate is usually more in line with the usury rates defined by local jurisdictions. With this minor tweaking of the amortization schedule, coupled with the general public’s lack of financial literacy, means that the average Joe citizen is doomed to pay debt service his entire life.
Just because a borrower plays Scarlett O’Hara and denies the whole thing is happening, does not mean that it is not happening.
Think about the above scenario the next time you are barraged by mortgage brokers trying to “save” you money on your monthly payment by turning your dwelling into an ATM machine. Sure your payment will be lower, but your true costs will soar!
To combat this situation, you can reduce your debt or you can visit http://www.moneyandthemiddleman.com/ and set up your own banking system. Click here for more information.
Thanks.
Paul Paulson
www.moneykeg.com
www.moneyandthemiddleman.com
www.life-insurance-strategies.com
DISCLAIMER: This writing is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever.
Trading and investing involves high levels of risk. The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The authors may or may not have positions in the financial instruments discussed in this newsletter.
Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future performance.
An “Interesting” Look
Virtually no one in this day and age is unaware of the concept of interest. Merriam-Webster defines the noun “interest” as a charge for borrowed money generally a percentage of the amount borrowed. Interest is all around us.
We pay it for our homes, cars, boats, credit cards, businesses, etc. Ironically, charging interest, although more than common today, was not always as favorably looked upon by society. In fact, many religions banned the payment of any interest for a loan.
The term used historically was “usury”. Judaism, for example, is said to forbid a Jew to lend for interest to another Jew. (See http://en.wikipedia.org/wiki/Usury)
The modern world defines usury as the charging of unreasonably high rates of interest, usually in an effort to exploit a debtor who “simply has no choice.” I suppose we can understand why loaning at interest was forbidden as it was not favorable to take advantage of another in a time of need.
However, money has evolved from those times and we now have concepts like “time value” and opportunity cost associated with the lending of money. Our modern world has evolved into a complex set of intertwined values, expectations and beliefs.
As such, there are no shortages of reasons why it is “fair” to charge “interest” for a loan. I tend to agree. Yet the power of usury survives in the modern day with the simple use of some slight of hand, as we shall see.
Interest becomes really powerful when it is compounded. That is, the interest is paid on the balance of the principal and, as the principal grows, so too does the payments.
This idea is often termed “the miracle of compound interest” and is used over and over to promote such strategies as “buy and hold” and “dollar cost average you basis”. The idea basically is to let the account grow, without withdrawals, so that interest is “earned” on the increasing principal.
This seems to make sense on the surface. Many people utilize this concept to formulate their financial plans.
However, as with most things regarding money, things are not always as they seem. So let us dissect the theory of compound interest, as it is applied to the real world.
Again, as money accumulates more and more into an account, the more interest it earns. This is not a miracle, this is common sense. Yes the account will grow if it is projected out 30 years.
What the strategy does NOT tell you is the expenses that will have to paid while the account grows. An examination of some types of these expenses follows:
Taxes – Yes, it is a dirty word, but like it or not, taxes are a major expense for every citizen. Depending on which vehicle (ie. qualified account like an IRA or unqualified account like a savings account), taxes must be paid in compliance of the tax laws.
For example, if the investor invests $100 per month for 360 months (30 years) at 10%. This equals a $225,000 account balance after 30 years. This projection strategically omits any adjustment for the payment of taxes over that period.
If the tax is paid out of the “compounding amount”, the investor will never reach $225,000 at 10%. Instead, the balance will be closer to $160,000 (about a 7 percent yield).
If the money is in a retirement qualified account, the money will actually grow exponentially if 1) the investor actually gets the rate of return projected (ie. 10%) which, by the way, is a big if. Nevertheless, the client MUST eventually take distributions on the account by law.
And when those distributions are taken, they are taxed at the highest rate possible, the earned income rate (as opposed to a capital gains rate). Of course, we do not know what that rate will be in the future. Can you envision the governments demanding less tax in the future?
Next, a complete analysis must include the lost opportunity on the taxes paid over time. That is, with the taxes paid, the investor must also lose the use of that money. That “opportunity cost” must also weigh into the equation.
Unfortunately, there is also inflation eating at the total the entire time, courtesy of our good friends at the Federal Reserve. At 3%, your total has the purchasing power of $.41 on the dollar over 30 years. Ouch, how do you like the investor’s plan now?
While compounding strategies usually do not make the investor rich, the strategy just happens to be tailor made for the financial institutions. If you were a financial institution; like a bank, or broker/dealer, or both; your main goal is deposits.
Deposits, as we all know is where the rubber meets the road, since, under the roof of fractional reserve banking, more deposits mean more money to loan.
A secondary goal would be to gain those deposits on a consistent and ongoing basis (ie. dollar cost averaging your basis). In this way, the money keeps coming in, month after month, all according to the plan.
Finally, the financial institution would like to hold on to the money as long as possible, and give back as little as possible.
The “buy/hold” fits nicely into your goals as a financial institution. That is why they promote such strategies. Yet this is but one arrow in the quiver of the financials. All of them are designed to utilize the power of compounding to THEIR advantage.
OK, enough basic investment analysis, let us talk in depth about mortgages. I choose mortgages because most people have them and there is no shortage of commentary on the subject.
However, I have yet to find the following mortgage analysis anywhere on the web. If you take the time to look at the fine print, you will be astounded at what you see. And guess what, it is all about tapping into the power of compound interest.
Under Discussed Mortgage Concepts
I have closed a fair amount of residential real estate loans since I first began practicing law over 12 years ago. In fact, when you first “hang a shingle”, real estate closings are an easier way to gain new clients and generate a little income.
In the last 12 years, I often field questions regarding the interest rate, pre-payment penalties, adjustable rates, etc. I have never, EVER, heard anyone ask about how the interest is calculated, on what amount, and how it is amortized.
Yet these questions get to the heart of the matter and reveal another misdirection play as perpetrated by the banks on the unsuspecting public.
Let us take, for example, your standard Note signed in connection with a real estate transaction. Most of these notes have a provision entitled “Borrower’s Right to Prepay”. The language usually resembles the following:
“I may make a full prepayment or partial prepayments without paying a Prepayment charge. The Note Holder will use my Prepayments to reduce the amount of Principal that I owe under this Note.
However, the Note Holder may apply my Prepayment to the accrued and unpaid interest on the Prepayment amount, before applying my Prepayment to reduce the Principal amount of the Note.” (emphasis added).
Notice what this says. First, your payment will be applied to the principle. Then, the language gives you one of those, “it depends” answers. What does it depend on? Well, that is left unclear. This question piqued my curious side. So I decided to call over to my friendly mortgage company to find out what would happen to my pre-payment.
One would think that once a mortgagor paid additional money to the lender, the loan would be “re-amortized” to reflect a new principal amount. At least that’s what I thought when I first began investigating this issue.
After all, it seems fair that less principal would reduce the monthly payment from that point forward. However, fairness when it comes to banking is about as common as a Quaker in a strip club, as we will see.
When I finally reached someone on the phone, she informed me that it “depended” on the loan but “typically” the loan would not be re-amortized and the amount of the prepayment would be applied to the “total amount due on the loan”.
It turned out, the definition of “total amount due on the loan” was NOT the principal amount, but the amount of interest and principal due as amortized over the life of the loan.
In other words, the effect of the pre-payment would only be to shorten the time it takes to pay off the loan. The amount of interest to be paid on the loan remains the same!
This reminds me of my first car loan, where the interest was quoted at 6.09% (a pretty good rate at the time). The catch was that the interest was based upon the original loan throughout the entire term of the loan.
The amount of interest never decreased as the principal decreased. Anyway, all of this to say that the mortgage document is more oppressive than a quick glance would reveal.
Of course, it could be worse. And, it is. It is worse because of two facts: 1) the mortgage is front-loaded. That is, in the first few years, virtually none of the principal is repaid. 2) The vast majority of home loans are paid in full within 5 years, usually because of a sale or a re-finance.
Let us break down this problem further, and discover why this is great for the banking institutions and not so great for the borrowers.
Below you can see an amortized mortgage payment schedule at 6.5% for 30 years at a fixed rate. (I included only the first 5 years and 8 months).
This loan is amortized out for 30 years. However, the most likely scenario is that the loan will be paid off in less than five years. I included the amortization for the first 68 months (5 years, 8 months) just to be safe.
Notice the totals for the years in bold. If the loan was closed today, April 8, 2006, then by the end of the year, the Mortgagor would have paid $21,156.56 back to the lender. Of that $21,156.56, $18,072.66 is interest payment. Only $3,083.90 is paid toward the principal. If you do the calculations, the percentage going toward the principal in the first few months is only 14.58%!
By the end of 5 years, and 8 months, the percentage going toward payment of principal has only increased to 19.94%. This is still under 1/5 of your payment going toward principal. Put another way, more than 80 cents of every dollar you pay goes toward interest.
Adding up the totals after our example, the Mortgagor has paid a total of $179,830.76. Of that amount, $148,834.86 was interest payments. The remaining $31,025.60 was paid toward the principal. The percentage of principal to interest averages over this time period only 17.25%.
Further, the borrower paid $148,834.86 interest on a $418,400.00 loan in just under 6 years. According to my TValue program, that’s closer to a 26% APR, if the borrower pays off and/or re-fi’s his next purchase.
So you might be thinking, “so what?” The Borrower gets the money and the house and the bank gets their money.
What’s the big deal?
First, it may not be a big deal IF property values keep increasing. Increasing property values offset the massive interest payments over time. However, this is a big “if”. Just because property values have been increasing across the board for over a decade does not mean they will continue to do so indefinitely. What happens if you decide to sell your property during a market adjustment?
Secondly, if you should happen to sell at a profit, it is highly unlikely that the “profit” realized is enough to offset the oppressive nature of debt servicing. Do not forget, there are other costs eating away at your bottom line.
For example, there most likely will be broker compensation for the sale. Next, there is tax on the gain that just might have to be paid. (Of course, there are exceptions). Finally, there is inflation eating away at the purchasing power of your money. And this is only a short list of line items that could affect your bottom line on a sale.
But what is most troubling is the fact that when a borrower re-fi’s his home or pays off the existing mortgage and buys a new house with a new mortgage, he is essentially starting the process all over again. That is, paying mostly interest and virtually none of the principal on the loan. This means that the average American’s payment of interest continues throughout his life.
His proportional share of interest for items such as cars, boats, homes, etc. usually stays right around 20%-25% his WHOLE life! Let this sink in for a second and realize that because every dollar is financed, (you either earn or forego those earnings), you are literally at the mercy of the banking system.
In other words, the concept of compounding interest is engineered in reverse against the borrower. The interest is front loaded so that when a debtor re-fi’s or moves, he gets to make the same interest laden payments anew. Moreover, that rate is usually more in line with the usury rates defined by local jurisdictions. With this minor tweaking of the amortization schedule, coupled with the general public’s lack of financial literacy, means that the average Joe citizen is doomed to pay debt service his entire life.
Just because a borrower plays Scarlett O’Hara and denies the whole thing is happening, does not mean that it is not happening.
Think about the above scenario the next time you are barraged by mortgage brokers trying to “save” you money on your monthly payment by turning your dwelling into an ATM machine. Sure your payment will be lower, but your true costs will soar!
To combat this situation, you can reduce your debt or you can visit http://www.moneyandthemiddleman.com/ and set up your own banking system. Click here for more information.
Thanks.
Paul Paulson
www.moneykeg.com
www.moneyandthemiddleman.com
www.life-insurance-strategies.com
DISCLAIMER: This writing is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever.
Trading and investing involves high levels of risk. The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The authors may or may not have positions in the financial instruments discussed in this newsletter.
Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future performance.
