Am I paying too much in mortgage interest?

Question

Hi there all you smart people. I am looking for a hand on a mortgage I currently hold. I will give a little back story to hopefully let you see where I am coming from.

I have a summer home (the only property I own) and was unable to get a conventional mortgage on it through a bank. Basically because there is no power, a bad road and a trailer on the property not a house. That means no mortgage insurance places will insurance me for mortgage insurance. There's no getting around that so it's not to do with my question.

I ended up getting my rich boss to hold the mortgage for me. So he payed the $264,000 that I owed to the previous owners and that is what I now owe him. I really wanted to keep it simple since he is doing me a favor by letting me pay him back slowly so we worked out a deal and he's pretty casual about it. He is holding the mortgage at 6% for me. I pay interest payments in cash. Instead of doing one of those mortgage calculators and getting a whole bunch of weird numbers to pay him, I just took.

Year 1 $264,000 owing x 6% = $15,840 So for that year I owed him $15,840 in interest, as well as I could pay any large sum of money I wanted down towards the principal at the end of the year. That way I payed him 3 payments of ($15,840 / 3 = $5,280) for interest. (I did three separate interest payments so I wasn't bugging him looking for him to pay him a wad of cash every month for interest and I didn't have a years worth of interest saved up). Than I payed $34,000 in principal.

Year 2 $230,000 owing x 6% = $13,800 So I did 3 payments of (13,800 / 3 = $4600) and payed another $30,000 in principal.

Year 3 $200,000 owing x 6% = $12,000

I am currently on year 3 and trying to save an extra $30,000 but not sure if i will make it this year. Either way I have been talking with my partner and he keeps saying that I should be re-calculating the mortgage interest payment each month and not yearly. We all know paying your mortgage off bi weekly is better than monthly which is better than yearly. But I feel when I did the calculations, over the year we are only losing out on about 200$. Yes substantial in a way but I am trying to keep this simple and not have to pay the mortgage holder with bills, loonies, and twoonies etc. since I pay him cash for the interest. However my husband thinks that the $200 a year will actually compound hugely over the next 7 years till we are payed off fully on the property. I just don't feel that's right for some reason. It's not like we will put that extra $200 dollars we save a year on interest into the principal we owe since we are trying to keep the numbers round and whole. And I feel like our "term" is yearly... So the $200 a year won't compound like if somebody had a 5 year term?

Any insight is appreciated. I am finding this all a bit confusing when I use the mortgage calculators and having troubles working them to my weird situation (1 large principal payment a year and thrice yearly interest payments).

Answer 1

Yes, you are paying extra in interest, but additionally, you are decreasing your payment each year, taking 21% longer to pay off the loan, which further increases the total interest you will pay. The first year, you paid $49,840, but the second year you paid only $43,800. The third year, you're decreasing your payment to $42,000.

If you ran this like a regular mortgage, that first year you would have paid $4153.33 each month, and at that rate you could have cleared the mortgage in 7 years and 5 months. You would have paid a little under $55,000 in interest.

The way you are running this mortgage, if you keep paying $30,000 in principal (that would leave $20,000 in principal in the final [9th] year) you will pay $75,840 in interest. That's about $21,000 in extra interest so that you don't have to bother your boss with monthly payments (a pretty generous bonus just for the sake of being polite).

But hey, on the bright side, paying off your mortgage in 9 years is actually a pretty good accomplishment. It's not as good as 7 1/2 years, but it's much better than 30 years.

Answer 2

There's one problem here. You've borrowed a substantial sum, but don't seem to have any agreement with the lender. We have a principal number and interest rate, sure, but a cavalier "pay me the interest, and whatever principal you can" set of terms.

Hubby's suggestion is accurate. The way a mortgage works is when I pay principal, the interest accrues on the new balance. But the difference is probably more than the $200 you assume. Look at year 2. You paid $30K in principal. If you paid it at the end, the point is moot, no need to talk further. But if paid over the year, the boss man had the $30000 for an average of 6 months. And that's $900 you lost.

One solution is to pay interest during the year, and pay the principal down in late December, only. That will keep to the loose terms of this loan, and keep the lost interest due to that lack of accounting to a minimum.

Answer 3

How much do you trust your boss? How much does he trust you? What happens if you (or he) are fired or find a better job? If all of the interest payments are in cash, how can he prove how much principal or you paid? How can you prove how much interest you've paid so you can deduct it? Is there a term for the loan or do you just keep paying until it's paid off? There are many things that could go wrong with this arrangement.

I would immediately set a time to meet with your boss and get a more formal agreement in writing. It's not just for your protection, but for his as well. You could stop paying the mortgage altogether and he could have a tough time proving that you owe him anything. He also needs an actual mortgage to ensure that the house is properly collateralizing the loan.

You can have a loan that compounds annually, so that's not a problem. You can even make the principal payments flexible rather than being on a fixed amortization schedule. If you both agree to that, then your calculations are correct. Pay a year's worth of interest over the year, pay some extra amount in principal, and recalculate the next year's interest based on the principal remaining. The more you pay in principal the aster you pay the loan off. Yes, you would save a little bit by paying monthly and recalculating interest, but it may be worth it for the convenience and simplicity that you have.

It may be awkward having an actual signed contract between you, but it's in BOTH of your best interests to do so. If he is not comfortable doing so, then go to a bank and get a traditional mortgage. If he's as rich as you say he is, then he should be smart and/or experienced enough to know the value of a contract, even between friends, and know that it doesn't mean a lack of trust.

Finally, if mortgage insurance is the deal-breaker then just make sure you don't borrow more then 80% of the value of the home. Most banks will not require mortgage insurance if you have a Loan-to-Value (LTV) ratio of 80% or lower. If you need to borrow some money from your boss to cover the 20% then that might be viable, but I would pay that off as quickly as possible.

Answer 4

In short, unless your contract specifies otherwise, you should be recalculating the interest and principal with each payment.

It sounds as if you are doing quarterly payments, with a larger payment at the end of the year.

So as you described the payments for year one, starting with a balance of $264,000, you paid $5,280 at the end of the first quarter, but only $3,960 worth of interest had accrued at that point. Meaning the extra $1,320 should have applied to principal at this point. Principal balance = $262,680

With that reduction in principal, the interest accrued at the end of the second quarter would be down to $3,940.20, meaning that $1,339.80 of your $5,280 for the second quarter should have gone to principal. Principal balance = $261,340.20

For the third quarter your accrued interest would have been $3,920.10, giving another $1,359.90 to principal for the third quarter payment. Principal balance = $259,980.30

Then in the forth quarter you paid $34,000. The accrued interest at this point would have been $3,899.70, leaving $30,100.30 to apply to principal. Principal balance = $229,880

As compared to the $230,000 balance you calculated. So calculating things this way would have reduced your principal an extra $120 in the first year using the same payment pattern. However if you had spread things out and made 4 equal payments of $12,460 each quarter, your principal would have been down to $229,227.30, or $772.70 ahead of the way you did it.

While these "savings" numbers don't seem too significant in terms of the overall picture. They do add up to a decent amount over the full course of a loan. In general, your goal with paying off any loan should be to reduce the principal as soon, and as often, as you can.

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EDIT

Just for grins I ran a few more numbers and thought I would share them with you. I rounded a bit from your actual numbers so they are not an exact match, but they are still useful for illustrating the point.

Lets start with your $264,000 loan, and say you made total of $41,000 combined principal & interest payments per year with a 6% APR. After 4 years you will have paid $164,000 into your loan. The question is, what will the principal be at that time? And how much of your $164,000 went to interest?

Making a single $41,000 payment per year, which is essentially what you have been doing. Your balance at the end of 4 years is $153,934.66, with $53,934.66 having gone to interest.

Making four payments of $10,250 evenly spaced in the year. Your balance at the end of 4 years is $151,205.38, with $51,205.38 having gone to interest. An improvement of $2,729.28 over the single payment/year.

Making twelve monthly payments of $3,416.67. Your balance at the end of 4 years is $150,574.91, with $50,574.91 having gone to interest. An improvement of $3,359.75 over the single payment/year, or $630.47 over the quarterly plan.