This is part two of last week’s article.

The single biggest investment that most families will ever make over their lifetime is the purchase of a home. Second, by a long shot, but still almost a home-breaker is the cost of children’s education. We’ll save that topic for another day.

Yet, from many years of personal observations and anecdotal evidence, people willingly sign on the dotted lines of large legal documents knowing very little about the contract that they just committed to. And a mortgage is just that; a contract, legally and binding upon you and the bank.

Security

Mortgages require security, otherwise known in big words as the collateral, and that is your property. You (termed the mortgagor) signed the contract agreeing to performance on the loan. Your bank (the mortgagee and your creditor) is the corporate person holding the mortgaged property as security for the cash loan extended to you. In fact, you cannot take possession of your deed to your property until the mortgage is fully paid up, or satisfied. Failure to perform on the loan, your bank has the legal right (because you signed and agreed to the contract) to take, and foreclose, upon your property to satisfy the debt.

Banks get bashed on a routine basis these days regarding their treatment of customers, particularly, in the personal service areas. Some of this criticism is justly deserved, some not. I am no bank defender, but you, seeking a bank product, always need to remember that before you sign any legal transaction of any type with anyone, not just banks, you should understand exactly what you legally committed to do. Never expect any bank to monitor and vet your decision-making process. That is your responsibility. If your bank does show corporate ‘heart’, great, terrific for you.

Types of mortgage

What kind of a mortgage do you have? What type of interest rate agreement? Often the new homestead owner is not really sure. How could this be? Mortgages require math. Most of us are completely intimidated by mathematical reasoning, standing in awe of those math geniuses who solve complex math equations for fun. Your lowly writer here has math fear — still. A very big reason I have been motivated for so many years to write and explain finance stuff to everyone in basic language, not legalese.

Mortgages, in general, are offered in two types. Straight term — otherwise known as interest only — and fully amortised mortgages. The straight-term method of payments assessed interest charges only for the life of the mortgage, with the entire principal due at the very end of the term. This method was a partial cause of the Great Depression in the US and a much more recent sub-prime recession where the borrowers (the mortgagees) could not begin the pay the entire principal demanded at the end of the contract (interest-only mortgage).

Fully amortised mortgages are the most commonly used to secure financing, as a piece of both interest and principal due is paid each month of the mortgage term.

Fixed versus variable interest rates

Competitive interest rates applicable to mortgages are extremely important. The difference in one-quarter of one percent interest is huge when based on a 30 year mortgage term. A fixed interest rate, which is the more conservative choice, locks in the interest rate offered at the date of mortgage contract closing for the entire term of the mortgage. This means a lower interest rate than the mortgage market when interest rates skyrocket, but it also becomes a disadvantage when rates drop lower than your locked-in rate. In the end, does it all even out? Possibly, but who can predict the future?

Variable interest rates are simply that. The rate will change in concert with the increase or decrease in the overall capital/mortgage markets. In a declining interest rate market, this is terrific as more of your monthly payment is applied to principal. The reverse happens when interest rates climb.

Fixed monthly payments.

Generally, monthly payment amounts are usually the same amount each and every month. The amortisation calculation adjusts the amount of interest and principal to be applied within the payment itself.

Calculating a mortgage

Here, we calculate an amortised mortgage. This is basic math — you can do this by hand, with a calculator or a spreadsheet.

And we review the components of the mortgage — taken from our illustrative example of last week.

$400,000 principal to be borrowed.

6.50% annual interest rate, fixed rate mortgage

20 year repayment term

$2,982.29 total monthly payment of interest and principal.

Ok. Here is the figuring part. Get out your calculator or you can do this by long hand.

Month one — start date of new mortgage: July 1. Ending July 31, 2034

One. Multiply 400,000 by the interest rate of 6.5% per year.

Convert that percentage to decimal.

$400,000 * .065 = $26,000 total amount of interest per year.

Two. Calculate the interest amount charged per month.

$26,000 divided by 12 months = equals cost of one month’s interest on the principal.

$26,000/12 = $2,166.67

Three. Subtract the monthly interest cost of $2,166.67 from the total monthly payment.

$2,982.29 minus interest of $2,166.67 = $815.62

$815.62 is the amount to be applied to your mortgage principal reduction.

$400,000 minus $815.62 = $399,184.38 This is your new principal balance for Month 2.

Month two — Repeat. August

But use the new principal balance above to calculate your interest and remaining principal balance. Follow the steps and let me know if you are successful.

But the question is, what happens if the numbers don’t match your bank mortgage statement. Ah, they may be calculating based upon daily interest rates, so stay tuned. Or, a mistake was made.....

Start now to educate yourself and your family on how your mortgage payments are applied and how your mortgage calculations work. So, take a deep breath, forget your math fear, and dig in. Be prepared to independently track and monitor your mortgage payment every single month against the mortgage statements provided to you by your bank.

Your priority. Manage your own money to your benefit.

Next week. Learn how to calculate the daily interest rate. What happens when you apply the extra principal payments. Organise to watch those payment statements carefully. The extra money you remit to the bank — MUST — be applied to your principal only. And, find where can you find extra cash-out-of-pocket.

Keep sending me your comments and questions. I will be writing an entire article to answer them all. Thank you to those who wrote me last week!

Sources and references

Part 1 of Managing and Tracking Your Bermuda Mortgage was featured on July 12, 2014 and is linked here. http://www.royalgazette.com/article/20140712/COLUMN07/140719909

www.amortization-calc.com

Martha Harris Myron CPA CFP JSM: Masters of Law: International Tax and Financial Services

Appointed to the Professional Tax Advisory Council, American Citizens Abroad, Geneva, Switzerland

President: The Pondstraddler* Life™ Consultancy providing international financial planning for the challenging lifestyles of multinational individuals and their families residing, working, crossing borders, and straddling ponds in the North Atlantic Quadrangle. Specific focus for residents of Bermuda, the premier international finance centre. www.marthamyron.com Contact: martha@pondstraddler.com

* Pondstraddler. A person with one foot on each shore whose heart resides in both countries*