Introduction to mortgage loans

- [Voiceover] 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 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. 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 $500,000 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 $125,000 dollars. 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. I go to a bank, let me get a good color for a bank. That is the bank right there. 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 $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." What's gonna happen here is the loan is gonna go to me, so it's $375,000. $375,000 loan. Then I can go and buy the house. I'm gonna give the total $500,000, $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. This is the home title. This is the title of the house. 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. It will go to the bank that I'm borrowing from. This transferring of the title to secure a loan. When I say "secure a loan," I'm saying I need to give something to the lender in case I don't pay back the loan or if I just disappear. 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. It actually comes from old French. Mort means dead, and the 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 the loan this pledge of the title to the bank will die and it will come back to me. That's why it's called a dead pledge, or a mortgage. And probably because it comes from old French is the reason we don't say 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. What I want to do in the rest of this video is use a screenshot from a spreadsheet I made to actually show you the math, or actually show you what your mortgage payment is going to. You can download this spreadsheet at khanacademy, khanacademy.org/downloads/mortgagecalculator Or actually, even better, just go to the downloads folder and on your web browser you'll see a bunch of files, and it will be the file called MortgageCalculator, MortgageCalculator.xlsx. It's a Microsoft 2007 format. Just go to this URL, then you'll see all the files there and you can just download this file if you want to play with it. What it does here, in this kind of dark brown color, these are the assumptions that you can input and then you can change these cells in your spreadsheet without breaking the whole spreadsheet. Here I've assumed a 5.5% interest rate. I'm buying a $500,000 home. It's a 25% down payment, 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, I'm gonna have to borrow 375, it calculates it for us. And then I'm gonna get a pretty plain vanilla loan. This is gonna be a 30 year. When I say term in years, this is how long the loan is for. So 30 years. It's gonna be a 30 year fixed-rate mortgage. Fixed rate, which means the interest rate won't change. We'll talk about that a little bit. This 5.5% that I'm paying on the money that I borrowed will not change over the course of the 30 years. We will see that the amount I've borrowed changes as I pay down some of the loan. 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. We'll talk about that in a second, you can ignore it for now. 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. This right here is a 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 they will charge you this much interest on that for the month. Now given all of 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 loan-- Well, 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. 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 a asset in question right here, it's called a house. And we're assuming 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. $375,000 loan or debt. If this was your balance sheet, if this was all of your assets and this is all of your debt, and 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 too 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. The reason why I'm pointing it out now is, in this video I'm not gonna 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's 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 could do equity is how much value 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. This is the real wealth in the house, this is what you own. Wealth in house, or the actual what the owner has. What I've done here is-- Actually before I get to the chart let me actually show you how I calculate the chart. 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 in 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. On month 0, which I don't show here, you borrow $375,000. Now, over the course of that month they're going to charge you .46% interest. Remember, that was 5.5% divided by 12. .46% interest on $375,000 is $1,718.75. So I haven't made any mortgage payments yet. I've borrowed 375,000. This much interest essentially got built up on top of that, it got accrued. So now before I've paid 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 gonna default on my mortgage so I make that first mortgage payment that we calculated right over here. 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, the little asterisk here, this is my equity now. So remember, I started with $125,000 of equity. After paying one loan balance, after my first payment, I now have $125,410 in equity, so my equity has gone up by exactly $410. Now you're probably saying, "Gee. I made a $2,000 payment, "roughly 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 had to pay all of this interest. So at the very beginning, your payment, your $2,000 payment, is mostly interest. Only $410 of it is principal. So as your loan balance goes down you're going to pay less interest here, 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 your loan balance exiting the last month, multiplied that times .46%. You get this new interest accrued. 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 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, this is-- 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, this is the $400. 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 a better color than that. There's less interest. 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. You can see this in the actual spreadsheet. 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. A lot of times you'll hear financial planners or realtors tell you the benefit of buying your house is it has tax advantages, and it does. Your interest is tax deductible. Your interest, not your whole payment. Your interest is tax deductible. I want to be very clear what deductible means. First let's talk about what the interest means. This whole time over 30 years I am paying $2,100 a month, or $2129.21 a month. Now the beginning, a lot of that is interest. So on month one, 1,700 of that was interest. That $1,700 is tax deductible. As we go further and further, each month I get 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. 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 gonna make up a number, I didn't calculate it on the spreadsheet. Let's say in year one I pay $10,000 in interest. 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, let's say before this I was making 100,000, 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 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. 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. 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 this is, I'm doing a gross oversimplification of how taxes actually get calculated -- and I pay 35% of that, let's get the calculator out. Let's get the calculator. So 90 times .35 is equal to 31,500. So this will be equal to $31,500. $31,500. Off of a 10,000 deduction, $10,000 of deductible interest, I essentially saved $3,500. I did not save $10,000. Another way to think about it, if I paid 10,000 interest and my tax rate is 35%, I'm gonna save 35% 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 could take straight from your taxes, that's called a tax credit. 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. 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 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 gonna 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 a 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 will actually change the tax savings, and you can play around with the different types of fixed mortgages on this spreadsheet.