It seems to me that a large number of mortgages are refinanced in the first ten years which means the bank is getting mostly interest all the time. More Profit. Also, the bank also has collected the full amount of the original loan in dollar terms by year 15 and if the customer runs into financial difficulty the bank still owns the majority of the property because principal is only half way paid off. The amortization schedule seems to benefit the bank more than the customer? Is this wrong?
You're borrowing money from someone else, and "interest" is the cost for borrowing money.
There's no Greedy, Evil Bankers conspiracy at all: it's just math that the cost is high when you owe a lot.
This should incentivize you to:
- borrow as little as possible, and
- pay extra early in the loan.
(What is a Greedy, Evil Bankers conspiracy are pre-payment penalties, but you didn't ask about that.)
I started writing this as a comment, then realized it may be better suited as a frame challenge to your question. RonJohn's answer correctly addresses the fact that interest is the cost you pay to borrow money, but there's an underlying problem with your assumptions.
You made the statement,
It seems to me that a large number of mortgages are refinanced in the first ten years which means the bank is getting mostly interest all the time. More Profit
But even if we assume you are correct that a large number of mortgages are refinanced early, that is inherently wrong. Interest is offset by risk and operating expense. More interest dollars does not directly imply more actual profit.
Unless the interest rate changes (relative to the bank's base rate, which never actually happens, even in a variable rate loan), the bank is essentially earning the same profit at any point in time during the life of the loan - if, by profit, you mean income minus expense. In other words: their risk and operating expense are spread proportionately to the interest you're paying across the life of the loan.
In fact, if you ignore the manner in which the bank spreads out their costs, and instead look at actual expense, the very opposite of your assumption is true. When customers get out of loans early, the bank typically loses money. This is because there is typically a lot of expense associated with originating the loan. For a mortgage, the expense can be significant. Not just the expense of the mortgage agent working with you, but all the back-office processing and customer interaction that typically goes along with something as major as a new mortgage. Banks cover that expense by amortizing it against the life of the loan along with other operating expenses (i.e. generating statements, answering the phone when you call with questions, etc) but that amortization schedule doesn't usually reflect the actual time distribution of costs, which is heavily weighted towards the very front of the loan's term. So, if people close their loans early in their life, the bank loses the opportunity to offset the expense they incurred at the beginning of the loan.
You’re missing the point. The reason you pay more interest in the early years is that you’re borrowing some of the money for a longer term. If you have a 30-year loan, you’re borrowing 1/360 of the total for 360 months; 1/360 of the total for 359 months; and so on. Think of it as if you had 360 tiny loans each paid off in a different month. At the end of the first month, you’ve paid off just 1 and still have 359 to go.
It’s not a bank conspiracy — it’s just how compound interest works.
It strikes me that the ability of consumers to refinance is actually very much to the advantage of the consumer. For example, I first took out a mortgage at something like 4%. If I was unable to refinance, I would still be paying that rate, but because I could refinance two years later I am paying only 2.75% which will end up saving me quite a bit. However, if the interest rate had gone up and was now 7%, I would still be paying 4%. So banks are taking some risk when they loan out money for 30 years that the money might be making well below market rate for a long time.
Also, you should consider the benefit to you of taking a mortgage. For example, you can buy a house worth more than your total net worth, and you can enjoy living in that house.
There isn't a conspiracy
a large number of mortgages are refinanced in the first ten years which means the bank is getting mostly interest all the time. More Profit.
Ignoring the part about the number of loans refinanced each year, which is irrelevant to my answer, this is a common misconception about how amortized loans work. The bank doesn't care where in your loan term you are, beginning, middle, or end. They make the same amount of money in a month on one customer who just took out a $500k loan at X% as they do with 500 customers who each have $1k left on their loans at X%. In both situations they will receive $500,000*(X/12).
There is nothing special about the beginning of a loan term. Your interest payments aren't shuffled around and stuck in the front of the loan as a part of some big bank conspiracy. It is true that throughout the loan term the fraction of each payment that is principle increases, and the fraction that is interest decreases. But this is simply a consequence of paying a constant amount each month while having a decreasing outstanding balance which leads to decreasing interest accrual each month as you pay down the principal.
Each month you can calculate how much interest will accrue, which is simply your outstanding balance times your APR divided by 12. Since you have a higher outstanding balance at the beginning of the loan than at the end of the loan, you accrue more interest early on and therefore more of your payment goes toward interest early on. But the important thing to realize about this, is that it is also true for any sub-term of the loan. That is, if you pick any date range within your loan, then it will still look like the interest is mostly frontloaded within the timeframe. Again, this is because you have less interest accumulation each month when your principal is lower and therefore more of your constant monthly payment can go toward principal.
You don't restart the clock when refinancing
When you refinance you don't really "restart the clock" on a loan with frontloaded interest. If you refinance your loan with the same interest rate, but a shorter payoff period, you will pay less interest to the bank by the time you finish repaying the loan. If you instead refinance your loan with a lower interest rate and the same payoff period, you will also pay less interest to the bank. Could you refinance for the same or lower interest, but a longer repayment period and end up paying more in interest to the bank? Sure, you could do that, but I would suggest avoiding that situation. But again, its not a bank conspiracy, its just borrowing the money longer and therefore needing to pay more to borrow that money.
The amortization schedule seems to benefit the bank more than the customer? Is this wrong?
Whether or not the amortization schedule benefits the customer more or the bank more is going to depend on what the customer wants. Most customers probably want a constant monthly payment since it is easiest to budget. Therefore, an amortized loan is going to be a good option. Another option could be making interest only payments with a balloon payment at the end, but I doubt many customers want that. If you wanted to pay back your loans with a constant principal payment each month, you could do that. Your monthly payments will get cheaper each month as you accrue less and less interest, but its always an option (assuming no early payment penalties).
Also, the bank also has collected the full amount of the original loan in dollar terms by year 15 and if the customer runs into financial difficulty the bank still owns the majority of the property because principal is only half way paid off.
I think you're forgetting something key here: the customer owns the asset.
Let's say someone borrows $250,000 to buy a house. They pay 5 years and then run into trouble. We'll pick being terminated from their job. They now have to move, but they still owe the bank all this principle. They can resolve this by selling the house and repaying the remaining principle. Assuming they sell it for the exact same amount they purchased it for, they still come out slightly ahead.
I ran the numbers. For a 30 year fixed mortgage for $250,000 at 5.25% interest, running into trouble in Sept 2024 for a mortgage taken out today, that shows the principle on the loan at $225,400. In other words, $24,600 of the principle has been repaid. Let's say they sell the house for $250,000. Even if we assume they take some hit in closing costs, they still walk away from that transaction with a net gain.
The danger in the past here was that it was incorrectly assumed that property values could only rise. In 2008, when the market tanked, property values tanked. One of the major drivers of that collapse was the increasing rate of foreclosures that happened. As banks would fire-sale their properties, property values around them would fall. Add in bad ideas in house lending (like interest-only mortgages, in which you never pay on the principle, making it a virtual house-leasing program) and you had a recipe for disaster. As long as you have a standard mortgage in a relatively stable market, such occurrences are thankfully rare.
The goal of Amortizing a Loan is to provide the borrower with a fixed per-month cost.
At the start of a loan, you are borrowing a bunch of money. In exchange for borrowing it, the bank charges you a certain percentage of that money.
You can also pay down the loan, and reduce the amount you owe.
At the end of the loan period, you are borrowing next to no money, as you have paid down almost all of it. So the bank isn't charging you interest.
Imagine a 30 year 300,000$ loan at 5%/year without amortization. You want to pay it off in 30 years, so you want to put 10,000$ towards the loan per year. In the first year, you'd owe 300,000$*0.5 = 15,000$ in interest.
So in year 1, you pay 25,000$ in total payments.
By year 16, the loan is down to 150,000$. The interest rate remains 5%, so you owe 7,500$ in interest. You are paying 10,000$ towards principle, so you owe 17500$ in total payments.
On the 30th year, you owe 10,000$. That generates 500$ worth of interest. Plus 10,000$ against principle, for 10500$ in total payments.
You'll see that the amount you pay drops from 25,000$ down to 17500$ down to 10500$ over the period of the loan.
If you amortized that loan, you'd pay about 20000$ per year every year for 30 years. In the first year, you'd only pay 5000$ off the principle, and in the last year you'd pay off 20000$.
This means you are paying more in total, but your initial payments are lower. So you can afford a bigger house, or you are less financially squeezed from the new house.
In many mortgages, you can emulate this. They have the option to put additional payments against principle; simply put 5000$ extra the first year (25% on top of your usual payments), a little bit less the next year, etc. By around year 10 you'll be down to paying the same as the theoretical "unamortized" loan; at that point, either refinance (to lower payments) or stop topping off and watch your mortgage evaporate even faster.
I suggest reading Adam Smith's "The Wealth of Nations", or any decent (that is, non-Marxist*) economics text. In any economic exchange, both sides must perceive a benefit. Here, the bank collects interest (and possibly fees/points for refinancing), while the borrower presumably gets lower payments and/or cash out from accumulated equity. So both see themselves as benefitting from the refinance, otherwise they wouldn't do it.
(Added in response to comments) *My point is that Marxist economics starts with the presumption that banks (like capitalists in general) are oppressors of the working class, which naturally presupposes that they're doing whatever they do with evil intentions, instead of from a reasonable desire to make profits. This is likely to lead to wrong answers, on the GIGO principle.
I see this in the question's statement that the bank owns the majority of the property. But the bank (or other mortgage lender) has no real interest in owning the property. It wants to keep collecting payments in a timely fashion, as it benefits by being able to lend that money to someone else. If it forces the borrower into foreclosure, it can (according to my understanding of US law) only collect the outstanding balance, plus the foreclosure expenses. If the property sold for more than that, the borrower gets the excess. If it's underwater, or nearly so, the bank probably winds up taking a significant loss. So it's generally to the lender's advantage to allow refinancing, as that means the borrower is more likely to be able to keep paying on the loan.
In most transactions, both the bank and the customer benefit in their respective ways. The transaction MUST 'benefit the bank more than the customer', if that means the same thing as the bank earning a reasonable amount of profit on the deal. Otherwise, the bank could not exist. Eventually it would not have any money to lend to the next guy.
To add on to what @ChrisJohnson said, there is another point about the interest the bank is earning.
As you and other borrowers pay down their loans each month, the bank is going to be doing their best to originate new loans so that the total amount of their outstanding loans is close to the same. So assuming they do a good job of that, they are going to be earning about the same amount of interest every month regardless of where you or any other borrower actually is in their repayment schedule. This is as it should be. If you had a large amount of money in the bank, would you want all of it earning interest every month, or just some of it?
You are seeing the power of what Einstein referred to as the eighth wonder of the world: compound interest.
For a really long loan, it's indeed mostly interest and very little principal.
Interest on top of interest can get pretty expensive pretty quickly. To avoid this problem, you need to: (1) borrow what you actually need, (2) pay back as quickly as you can, as the upvoted answer already noted. It's also recommended to shop for the lowest interest rate: the problem is far more severe with high interest rates.
Note the compound interest works both ways. Once you have paid your loan, you can start investing in stocks (or well, you can start earlier if you are willing to take the risk). At 8% yield, yield on top of yield will make you very rich if you have the long time horizon and save a lot of your income.
protected by GS - Apologise to Monica♦ Sep 16 at 18:21
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