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Introduction to mortgage loans

Video transcript

what I want to do in this video is explain what a mortgage is but I think most of us have at least a general sense of it but even better than that actually go into 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 versus 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 let's say that that is the house that I would like to purchase it has a price tag of let's say that I need to pay five hundred thousand dollars to buy that house this is the seller of the house right here and they have a mustache that's the seller of the house I would like to buy it I would like to buy the house this is me right here and I've been able to save up one hundred and twenty five thousand dollars I've been able to save up one hundred twenty five thousand dollars but I would really like to live in that house so I go to a bank I go to a bank let me get a good color for a bank so that is the bank right there and I say mister 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 right this right this number right here that is 25% of five hundred thousand dollars so I asked the bank can I have a loan for the balance can I have three hundred seventy-five thousand dollar 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 three hundred and seventy five thousand dollars three hundred and seventy five thousand dollar loan then I can go and buy the house so I'm going to give the total $500,000 $500,000 to the seller of the house and I'll actually 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 this is the title of the house home 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 sellers bank because maybe they haven't paid off their mortgage it will go to the bank 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 as the security for the loan that's what a mortgage is and actually it comes from Old French more means dead dead and the gage means pledge I'm 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 the loan this pledge of the title to the bank will die 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 mortgage 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 mortgage the mortgage loan and what I want to do in the rest of this video is use a little screenshot 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 you can download the spreadsheet at Khan Academy Khan Academy dot org slash downloads downloads slash mortgage calculator mortgage are actually even better just go to the download just go to the downloads folder and on your web browser you'll see a bunch of files and it'll be the file called mortgage calculator mortgage calculator Q later dot X LS x so it's a Microsoft 2007 format so just go to this URL and then you'll see all the files there and then 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 have assumed a five point five percent interest rate I'm but I'm buying a five hundred thousand dollar home it's a twenty five percent down payment that's that's the hundred and twenty five thousand dollars that I had saved up that I talked about right over there and then the alone amount well I have one hundred twenty-five I'm gonna have to borrow three hundred seventy five it calculates it for us and then I'm going to get a pretty plain vanila loan this is going to be a thirty-year so when I say term in years this is how long the loan is for so thirty years it's going to be a 30-year fixed-rate mortgage fixed rate fixed rate which means the interest rate won't change we'll talk about that a little bit this five point five percent that I'm paying on my on the money that I borrowed will not change over the course of the thirty years we will see that the amount I've borrowed changes as I pay down some of the loan now 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 then 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 a monthly interest rate so it's literally the annual interest rate five point five percent divided by twelve 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 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 loan well a $500,000 house a $375,000 loan over 30 years at a five point five percent interest rate my mortgage payment is going to be roughly twenty one hundred dollars 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 five hundred thousand dollars we are assuming it's worth five hundred thousand dollars 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 three hundred and seventy five thousand dollar liability three hundred and seventy-five thousand loan or debt so if you are 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 could get the money then you pay it back to the bank then well actually it doesn't necessarily go into that order but I won't get too technical but if you were to unwind this transaction immediately after doing it then you would have you have a five hundred thousand dollar house you'd pay off your three hundred seventy five thousand in debt and you would get in your pocket one hundred and twenty five thousand dollars 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 I'm in this video I'm not going to assume anything about the house price where there 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 what I what I'm introducing this because as we pay down the debt this number is going to get smaller so if this number is getting smaller let's say at some point this is only three hundred thousand then my equity is going to get bigger so you can kind of view equity is 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 left over for yourself so this is really kind of your this is the real wealth in the house the owners this is what you own wealth in house or the actual what the owner has now what I've done here is 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 and there's actually 360 rows here on the actual spreadsheet and you'll see that if you go and open it up but I just want to show you what I did so on month 0 which I don't show here you've borrowed three hundred and seventy five thousand dollars now over the course of that month they're going to charge you 0.46 percent interest remember those five point five percent divided by twelve point four six percent interest on three hundred seventy five thousand dollars is 1718 dollar seventy five cents so I haven't made any mortgage payments yet so I borrowed three hundred seventy five thousand 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 holding three hundred seventy five thousand at the end of the first month I owe three hundred and seventy six thousand seven hundred and eighteen dollars now I'm I'm a good guy I'm not going to default on my mortgage so I make that first mortgage payment that we calculated that we calculated right over here so after I make that payment then I'm essentially 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 what I have little asterisks here this is my equity now so remember I started with a hundred and twenty five thousand dollars of equity after paying one loan balance after after my first payment I now have a hundred and twenty five thousand four hundred and ten dollars in equity so my equity has gone up by exactly four hundred and ten dollars now you're probably saying hey gee I made a two thousand dollar payment a roughly a two thousand dollar payment and my equity only went up by four hundred ten thousand dollars shouldn't this debt have gone down by two thousand dollars and my equity have gone up by two thousand and the answer is no because you had to pay all of this interest all of this interest so that very in the beginning your payment your two thousand dollar payment is mostly interest all $410 of it is principled but as you and then your and then so 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 principle and less weighted towards interest and then to figure out the next line this interest accrued right here I took my your old your loan balance exiting the last month multiply that times 0.46% you get this new interest accrued this is your new prepayment balance I pay my mortgage again this is my new loan balance and notice already by month to two dollars more went to principal and two dollars less went to interest and over the course of 360 months you're going to see that it's actual a sizeable difference and that's what this chart shows us right here this is the interest and principal portions of our mortgage payments so this entire height right here this is let me scroll down a little bit this is by month so this entire height you notice this is the exact this is exactly our mortgage payment this two thousand one hundred and twenty nine dollars now on that very first month you saw that of my two thousand one hundred dollars only four hundred dollars of it this is the four hundred dollars only four hundred dollars 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 a better color than that there's less interest 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 can see this in the actual spreadsheet and 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 or Realtors tell you hey the benefit of buying your house is that it's it has tagged advantages and it does your interest is tax deductible your interest not your whole payment your interest is tax deductible deductible and I want to be very clear what deductible means so first let's talk about the interest means so this whole time over thirty years I am paying twenty one hundred dollars a month or twenty one hundred twenty nine dollars and twenty nine cents a month now in the beginning a lot of that is interest so on month one seventeen hundred of that was interest that seventeen hundred dollars 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 this doesn't mean let's say that let's say in one year 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 year one I pay I pay ten thousand dollars in interest ten thousand in interest remember my actual payments will be higher than that because some of my payments went to actually paying down the loan and but let's say ten thousand went to interest to say this deductible and let's say before this let's say before this I was making a hundred thousand you let's put the loan aside let's say I was making a hundred thousand dollars a year and let's say I was paying roughly thirty five percent on that hundred thousand 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 thirty five percent taxes which would be about thirty five thousand dollars in taxes for that year just this is just a rough estimate now when you say that ten thousand dollars is tax deductible the interest is tax deductible that does not mean that I can just take it from the thirty five thousand dollars that I would have normally owed and only pay twenty five thousand 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 I made $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 and this is I'm doing a gross oversimplification of how taxes actually get calculated and I pay thirty five percent of that let's get the calculator out let's get the calculator so 90 times 0.35 is equal to thirty one thousand five hundred so this will be equal to thirty one thousand and five hundred dollars and put a comma here $31,500 so off of a ten thousand deduction ten thousand a deductible interest I essentially saved thirty five hundred dollars I did not save ten thousand dollars so another way to think about is if I paid ten thousand interest I'm going to send my tax rate is 35% I'm going to save thirty five 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 you're right if there is some special thing that you can actually deduct it straight from your credit from your taxes that's a tax credit tax credit but a deduction just takes it from your income and so on this spreadsheet I just want to show you that 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 thirty five percent of that and I got the thirty five percent as one of your assumptions 35 percent of seventeen hundred dollars I will save six hundred dollars in taxes on that month so roughly over the course of the first year I'm going to save about seven thousand dollars in taxes so that's nothing 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 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 the tax savings and you can play around with the different types of fixed mortgages on this spreadsheet