When choosing a mortgage, one of the most important considerations is the interest rate you'll be charged. Generally, borrowers who have large down payments and good credit pay the best rates, which means they pay less for the mortgage over the life of the loan. Regardless of the rate you're paying, the interest will almost always be front loaded if you choose a standard repayment loan. This is not a trap designed to take you for a very costly ride, but a necessary consequence of the typical mortgage structure.
Front-loading means you're paying more interest in the early years of a loan. It works due to simple math: since interest is calculated on the outstanding balance, the interest charge will be high until you pay down the principal.
How Do Mortgages Work?
Most mortgages are repayment mortgages where your payment is made up of two elements:
the amount you borrowed; and * the interest charged on the loan.
These mortgages are structured so you pay off the principal and interest monthly over 15 or 30 years, although that term could be more or less depending on the type of loan you choose. Monthly payments are fixed over the life of the loan, meaning you pay the same amount in month one as you pay in month 348. Homeowners like this structure as it helps with budgeting.
How Front-Loaded Loans Work
A repayment mortgage is, by definition, a front-loaded loan. That's because in the early years most of your payments go to paying off the interest. Only a small portion goes toward the principal. As you get deeper into the mortgage term, it switches so the interest portion decreases and you're paying off more of the principal each month.
Why? It's because the lender calculates the interest based on the current outstanding balance of the loan. This balance will start high and decrease as you gradually pay back the principal. The less principal you owe, the less interest will be charged.
Front-Loading Interest in Action
For example, imagine that you've taken out a 30-year repayment mortgage for $100,000 at a fixed interest rate of 4 percent annually. Per month, you'll pay $477 excluding insurance and taxes – that's $5,724 per year. We'll work with the annual figures to make the math easier.
In the first year, the interest charge will be $4,000 ($100,000 x 4 percent), with the remaining $1,724 ($5,724 - $4,000) going toward the principal. The outstanding mortgage balance as you enter year two is $98,276 ($100,000 - $1,724). In year two, your payments will stay the same ($5,724 per year), but now the interest charge will be approximately $3,931 ($98,276 x 4 percent) while the principal payment will be $1,793 ($5,724 - $3,931). That's $69 more per year going toward the principal portion of the loan.
Over time, the portion of the payment that's allocated toward the principal will get larger, and the portion allocated to the interest will get smaller. That's because you've paid money toward the principal amount, thus reducing it, and the interest is calculated on a smaller balance.
What Are the Alternatives?
Front-loading interest rules the mortgage world, but you can opt for an interest-only loan as an alternative way to structure the mortgage. With an interest-only product, you pay just the interest every month but you don't pay off any of the principal. This keeps your monthly payment low.
You will have to pay off the principal some day, however, and usually you'll be required to make a lump-sum payment when the interest-only period expires, usually after five to seven years. It's important to have a repayment plan in place to cover the significant balloon payment that's due at the end of the interest-free period. If you can't pay up or refinance, then you are at risk of losing the home.