Mortgages
Introduction to Mortgage Loans Introduction to mortgage loans
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- [MUSIC]
- What I want to do in this video is explain what a
- mortgage is.
- I think most of us have at least a general sense of it,
- but even better than that, actually go into to the
- numbers and understand a little bit of what you are
- actually doing when you're paying a mortgage, what it's
- made up of, and how much of it is interest verses how much of
- it is actually paying down the loan.
- So let's just start with a little example.
- Let's say that there is a house that I like that I would
- like to purchase.
- It has a price tag of-- I need to pay
- $500,000 to buy that house.
- This is the seller of the house right here, and they
- have a moustache.
- I would like to buy it.
- This is me right here, and I've been able to save up
- $125,000 but I would really like to live in that house.
- So I go to a bank, and I say, Mr. Bank, can you lend me the
- rest of the amount I need for that house, which is
- essentially $375,000?
- I'm putting 25% down, this number right here that is 25%
- of $500,000.
- So I ask the bank, can I have a loan for the balance?
- Can I have a $375,000 loan?
- And the bank says, sure, you seem like a nice guy with a
- good job who has good credit rating, I will give you the
- loan but while you're paying off the loan you can't have
- the title of that house.
- We have to have that title of the house and once you pay off
- the loan, we're going to give you the title of the house.
- So what's going to happen here is we're going to have-- the
- loan is going to go to me, so it's $375,000.
- Then I can go and by the house.
- So I'm going to give the total $500,000 to the seller of the
- house and I'll actually move into the house myself,
- assuming I'm using it for my own residence.
- But the title of the house, the document that says who
- actually owns the house-- so this is the home title-- it
- will not go to me, it will go to the bank.
- The home title will go from the seller, or maybe even the
- seller's bank, because maybe they haven't paid off their
- mortgage, to the banking that I'm borrowing from.
- And this transferring of the title to secure a loan, when I
- say secure a loan, I'm saying, look, I need to give something
- to the lender in case I don't pay back the loan
- or if I just disappear.
- So this is the security right here.
- That is technically what a mortgage is.
- This pledging of the title as the security for the loan,
- that's what a mortgage is.
- And actually it comes from Old French mort means dead and to
- gage means pledge.
- I'm 100% sure I'm mispronouncing it, but it
- comes from dead pledge because I'm pledging it now, but that
- pledge will eventually die once I pay off the loan.
- Once I pay off this loan, this pledge of the title to the
- bank will die and it'll come back to me.
- And that's why it's called a dead pledge or mortgage.
- And probably because it comes from Old French is the reason
- why we don't say more mort gage, we say mortgage.
- But anyway, this is a little bit technical, but normally
- when people refer to a mortgage, they're really
- referring to the loan itself.
- They're really referring to the mortgage loan.
- And what I want to do in the rest of this video is use a
- little screen shot from a spreadsheet I made to actually
- show you the math or actually show you what your mortgage
- payment is going to.
- And you can download this spreadsheet sheet at
- khanacademy.org/ downloads/mortgagecalculator.
- Actually, even better, just go the downloads folder and on
- your web browser you'll see a bunch of files and it'll be
- the file called mortgagecalculator.xls, so
- it's a Microsoft 2007 format.
- So just go to this URL and then you'll see all the files
- there and you can just download this file if you want
- to play with it.
- But what it does here, in this kind of dark brown color,
- these are the assumptions that you can input and you can
- change these cells in your spreadsheet without breaking
- the whole spreadsheet.
- So here I assumed the 5.5% interest rate.
- I'm buying a $500,000 home.
- It's a 25% down payment, so that's the $125,000 that I had
- saved up that I talked about right over there.
- And then the loan amount, well, I have $125,000, I'm
- going to have to borrow $375,000.
- It calculates it for us and then I'm going to get a pretty
- plain vanilla loan, this is going to be a 30-year, so when
- I say term in years this is how long the loan
- is for, so 30 years.
- It's going to be a 30-year fixed rate
- mortgage fixed rate.
- Which means the interest rate won't change.
- We'll talk about that in a little bit.
- This 5.5% that I'm paying on the money that I borrow will
- not change over the course of the 30 years.
- We will see the amount I've borrowed changes as I pay down
- some of the loan.
- And this little tax rate that I have here, this is to
- actually figure out what is the tax savings of the
- interest deduction on my loan, and we'll talk
- about that in a second.
- You can ignore it for now.
- And these other things that aren't in brown, you shouldn't
- mess with these, if you actually do open up the
- spreadsheet yourself.
- These are automatically calculated.
- And this right here is the monthly interest rate.
- So it's literally the annual interest rate,
- 5.5% divided by 12.
- And most mortgage loans are compounded on a monthly basis.
- So at the end of every month, they see how much money you
- owe and then they will charge you this much interest on that
- for the month.
- Now given all these assumptions, there's a little
- bit of behind-the-scenes math, and in a future video I might
- actually show you how to calculate what the actual
- mortgage payment is.
- It's actually a pretty interesting problem.
- But for a $500,000 house, a $375,000 loan, over 30 years
- at a 5.5% interest rate, my mortgage payment is going to
- be roughly $2,100.
- Now, right when I bought the house-- I want to introduce a
- little bit of vocabulary, and we've talked about this in
- some of the other videos.
- There's an asset in question right here,
- it's called a house.
- And we're assuming that it's worth $500,000.
- We're assuming it's worth $500,000, that is an asset.
- It's an asset because it gives you future benefit, the future
- benefit of being able to live in it.
- Now there's a liability against that asset, that's the
- mortgage loan.
- That's a $375,000 liability.
- A $375,000 loan or debt.
- So if this was your balance sheet, if this was all of your
- assets and this is all of your debt, and if you were
- essentially to sell the assets and pay off the debt-- if you
- sell the house you get the title, you can get the money
- then you pay it back to the bank.
- Well, actually it doesn't necessarily go into that
- order, but I won't get to technical.
- But if you were to unwind this transaction immediately after
- doing it, then you would have a $500,000 house, you'd pay
- off your $375,000 in debt, and you would get in your pocket
- $125,000, which is exactly what your original down
- payment was.
- But this is your equity, and the reason why I'm pointing it
- out now is-- in this video, I'm not going to assume
- anything about the house price whether it goes up or down.
- We're assuming it's constant.
- But you could not assume it's constant and play with the
- spreadsheet a little bit.
- But I'm introducing this because, as we pay down the
- debt, this number is going to get smaller.
- So this number is getting smaller.
- Let's say at some point this is only $300,000.
- Then my equity is going to get bigger.
- So you can kind view equity as how much value do you have
- after you pay off the debt for your house.
- If you were to sell the house, pay off the debt, what do you
- have leftover for yourself?
- So this is the real wealth in the house.
- This is what do you own, wealth in house or the actual
- what the owner has.
- Now, what I've done here is-- well, actually before I get to
- the chart, let me actually show you how I
- calculate the chart.
- And I do this over the course of 30 years and it goes by
- month, so you can imagine that there's actually 360 rows here
- on the actual spreadsheet, you'll see that if you go in
- and open it up.
- But I just want to show you what I did.
- So on month zero, which I don't show here,
- you borrowed $375,000.
- Now, over the course of that month, they're going to charge
- you 0.46% interest. Remember, that was 5.5% divided by 12.
- 0.46% interest on $375,000 is $1,718.75.
- So I haven't made any mortgage payments yet.
- So I borrowed $375,000, this much interest essentially got
- built up on top of that, it got accrued.
- So now before I pay any of my payments, instead of owing
- $375,000 at the end of the first month, I owe $376,718.
- Now, I'm a good guy, I'm not going to default on my
- mortgage, so I make that first mortgage payment that we
- calculated right over here.
- So after I make that payment, then what's my loan balance
- after making that payment?
- Well, this was before making the payment, so you subtract
- the payment from it, this is my loan
- balance after the payment.
- Now this right here with a little asterisk here, this is
- my equity now.
- So remember, I started with a $125,000 of equity.
- After paying one loan balance, after my first payment, I now
- have a $125,410 in equity.
- So my equity has gone up by exactly $410.
- Now you're probably saying, hey, gee, I made a $2,000
- payment and my equity only went up by $410.
- Shouldn't this debt have gone down by $2,000 and my equity
- have gone up by $2,000?
- And the answer is no, because you have to pay all of this
- interest. So in the beginning, your payment, your $2,000
- payment is mostly interest. Only $410 of it is principal.
- But as your loan balance goes down, you're going to pay less
- interest here, and so each of your payments are going to be
- more weighted towards principal and less weighted
- towards interest. And then to figure out the next line, this
- interest accrued right here, I took my loan balance exiting
- the last month, multiply that times 0.46%, you get this new
- interest accued.
- This is your new pre-payment balance.
- I pay my mortgage again, this is my new loan balance.
- And notice, already by month two, $2 more went to
- principal, and $2 dollars less went to interest. And over the
- course of 360 months, you're going to see that it's an
- actual sizable difference.
- And that's what this chart shows us right here.
- This is the interest and principal portions of our
- mortgage payment.
- So this entire height right here-- let me scroll down a
- little bit-- this is by month, so this entire height, you
- notice, this is exactly our mortgage payment, this $2,129.
- Now, on that very first month you saw that of my $2,100,
- only $400 of it went to actually pay down the
- principal, the actual loan amount.
- The rest of it went to pay down interest, the interest
- for that month.
- Most of it went for the interest of the month.
- But as I start paying down the loan, as the loan balance gets
- smaller and smaller, each of my payments, there's less
- interest to pay-- let me do it the better color than that.
- Let's say we go out here, this is month 198.
- Over there, that last month, there was less interest. So
- more of my $2,100 actually goes to pay off the loan until
- we get all the way to month 360, and you could see this in
- the actual spreadhseet, at month 360 my final payment is
- all going to pay off the principal.
- Very little, if anything, of that is interest.
- Now, the last thing I want to talk about in this video,
- without making it too long, is this idea of a
- interest tax deduction.
- So a lot of times, you'll hear financial planners and
- Realtors tell you, hey, the benefit of buying your house
- is that it has tax advantages, and it does.
- Your interest is tax-deductible.
- Your interest, not your whole payment.
- And I want to be very clear what deductible means.
- So first let's talk about what interest means.
- So this whole time over 30 years, I am paying $2,100 a
- month or $2,129.29.
- Now in the beginning, a lot of that is interest. So on month
- one, $1,700 of that was interest. That $1,700 is
- tax-deductible.
- Now, as we go further and further each month, I get a
- smaller and smaller tax-deductible portion of my
- actual mortgage payment.
- Out here, the tax deduction is actually very small as I'm
- getting ready to pay off my entire mortgage and get the
- title of my house.
- Now I want to be very clear on this notion of what
- tax-deductible even means, because I think it is
- misunderstood very often.
- Let's say in one year, I paid, I don't know-- I'm going to
- make up a number, I didn't calculate it on the
- spreadsheet.
- Let's say in year one, I pay $10,000 in interest. Remember,
- my actual payments will be higher than that, because some
- of my payments went to actually paying down the loan,
- but let's say $10,000 went to interest. And let's say before
- this, I was making a $100,000 a year-- and let's put the
- loan aside-- let's say I was making $100,000 a year and
- let's say I was paying roughly 35% on that $100,000.
- I won't go into the whole tax structure and the different
- brackets and all of that.
- Let's say, you know, if I didn't have this mortgage, I
- would pay 35% taxes, which would be about $35,000 in
- taxes for that year.
- This is just a rough estimate.
- Now, when you say that $10,000 is tax-deductible, the
- interest is tax-deductible, that does not mean that I can
- just take it from the $35,000 that I would have normally
- owed and only pay $25,000.
- What it means is I can deduct this amount from my income.
- So when I tell the IRS how much did I make this year,
- instead of saying $100,000, I say that I made $90,000
- because I was able to deduct this, not directly from my
- taxes, I was able to deduct it from my income.
- So now if I only made $90,000 and-- I'm doing a gross
- over-simplification of how taxes actually get
- calculated-- and I pay 35% of that, let's get
- the calculator out.
- So 90 times 0.35 is equal to 31,500.
- So this will be equal to $31,500.
- So off of a $10,000 deduction, a deductible interest, I
- essentially saved $3,500.
- I did not save $10,000.
- So another way to think about it is, I pay $10,000 interest
- and my tax rate is 35%, I'm going to save 35% percent of
- this in actual taxes.
- This is what people mean when they say deductible, you're
- deducting it from the income that you report to the IRS.
- If there's something that you actually could take straight
- from your taxes, that's called a tax credit.
- So if there was some special thing that you could actually
- deduct it straight from your taxes, that's a tax credit.
- But a deduction just takes it from your income.
- And so on this spreadsheet, I just want to show you that I
- actually calculated in that month how much of a tax
- deduction do you get.
- So, for example, just off of the first month, you paid
- $1,700 in interest of your $2,100 mortgage payment.
- So 35% of that, and I got the 35% as one of your
- assumptions, 35% of $1,700, I will save $600 in taxes on
- that month.
- So roughly over the course of the first year, I'm going to
- save about $7,000 in taxes.
- So that's nothing to sneeze at.
- Anyway, hopefully you found this helpful, and I encourage
- you to go to that spreadsheet and play with the assumptions,
- only the assumptions in this brown color unless you really
- know what you're doing with the spreadsheet, and you can
- see how this actually changes based on different interest
- rates, different loan amounts, different down payments,
- different terms, different tax rates.
- That'll actually change the tax savings and you can play
- around with the different types of fixed mortgages on
- this spreadsheet.
- [MUSIC]
Be specific, and indicate a time in the video:
At 5:31, how is the moon large enough to block the sun? Isn't the sun way larger?
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