Wednesday, April 28, 2010

amortization

During the 1930s, homeowners purchased homes with much shorter mortgages (three to five years) than today’s 20-30 year loans. Down payments for these short mortgages ranged from 50% to 80% of the purchase price and ended with a large balloon payment. That may explain why more than half of the population rented and most of the rest were in danger of losing their homes during the Great Depression. In 1934, the Federal Housing Authority stepped in with a new system of government-backed mortgages, which required a much lower down payment, and spread repayment of the loan amount (the principle) and the cost of the loan (the interest) over a longer period, using a system called amortization. Using an amortized payment plan, the borrower—for example, in a mortgage or car loan—gradually pays less interest (and more principal) as the payment plan progresses.

EXAMPLE: Jake borrows $100,000 to purchase a condo at 8% interest and plans to pay it back over ten years. Although each of his120 monthly payments will be for the same amount ($1213), less than half of his first payment will go toward paying off the principal; the rest will pay the interest on the loan. As the principal is paid off, the interest owed decreases and the amount of each payment that goes toward the principal increases over the life of the loan, until only $8 of his final payment goes toward interest.



[i] Service Employees International Union Local 503 v. State of Oregon (Ct. App. 2002).

[ii] Ibid.

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