People vs Banks

[Charles Brown <cbrown@xxxxxxxxxxxxxxxxx>]

Peter Hollings

What would happen if you attempted to sell the house and pay off the
mortgage before its maturity? You would have paid off more principle and
less interest, but the payoff due would come out the same as under the
conventional amortization scheme. The reason is that the interest
portion of each payment is proportional to the remaining balance at that
point in time. In other words, the interest is calculated on the balance
outstanding -- capital borrowed. While the scheme may seem to favor the
bank by lengthening the payout, it is rational when considered in terms
of the capital employed -- the amount that the lender has actually
provided and the borrower used -- which changes as the principle is paid
down. (While the relations are symmetric between borrowers and
depositors, I believe we can disregard the latter in this analysis.)

So, in the example of a $10,000 mortgage bearing 5% interest and, for
simplicity, annual payments paid in arrears (i.e., at the end of the
year), the first payment would include $500 in interest and a smaller
amount of principle, lets say $100, making a total payment of $600.

^^^^^

CB: Thanks ! I think a mistake in my approach was to not consider that the
interest is compounded yearly.


^^^^^^^



Then, at the end of the next year -- with a balance outstanding of
$9,900, the amount of the $600 payment going to interest would be $495
($9,900 X .05), and $105 to principle. And this progression continues
such that the final payment is almost all principle because the
principle, and thereby the interest portion, has been reduced to almost
zero.

What I am describing is called "simple interest" and it is enshrined in
banking laws designed to make the stated rate comport with the reality
of a calculation that is rational and fair to both borrower and lender
(unlike older, discredited amortization schemes such as the rule of
78ths).

Peter Hollings