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Do You Understand Real Estate Loan Formulas?

What does the real estate loan formula really consist of?

All loans are based on a mathematical formula which determines how much you will pay. There are five crucial loan variables including: term, interest rate, principal, terminal value and payment. These are also the five most important terms you need to know before applying for a loan.

All of them are interconnected and changing one is likely to change the others, although often not quite the way you think. There are a few ground rules about this, but best not to rely on them too much. Before you even start thinking about a specific home loan, you should spend some time learning the variables with a financial calculator.

Term: this is the period used to calculate the repayment of the loan, often the same as the maturity, ie. the time the last installment is due. Keep in mind, however, that in some cases the loan term is much shorter than the loan term (eg balloon mortgages). The standard duration of a home mortgage is 30 years, but in the case of amortized loans, you can choose a period of 10 to 40 years. Generally, the longer the term, the lower the monthly payment, although the change is much smaller than expected.

Interest rate: is the amount of money charged by the loan creditor for lending you money. It is usually a percentage of the amount you are borrowing. The rate is charged at each payment term, but is usually quoted on an annual basis. An interest rate of 6% is usually 12 multiplied by 0.5% (in the case of monthly payments). The lower the interest rate, the less you have to pay. The effect is greater in the case of long-term loans.

Director: this term can mean either (1) the part of the payment that is used to reduce the balance, or (2) the total amount of money funded. Generally, the principal (1) must be higher than the interest rate, otherwise you will experience negative amortization (your debt will increase even if you pay the deposit). The higher the principal (1), the lower the final value.

Final value: this is the total amount you pay for the loan (all installments plus any additional fees). The terminal value at the end of the mortgage should generally be zero, which means that the debt has been fully paid off. Keep in mind that the lower the final value you want to obtain, the higher the installments you will have to pay.

Payment: your monthly (rarely quarterly) amount due. This important variable determines whether you can ultimately afford a loan or not.

A word of warning: while it’s relatively easy to run the formula on a financial calculator, it’s very difficult to do on paper, even if you were good at math in college. An online financial calculator is much faster and does not make mistakes.

Remember that when choosing a home loan for yourself, you need to know the five variables – only then can you determine what you can actually buy. Often, it’s actually better to go for a higher monthly payment if it means a lower final value. On the other hand, you might want to stretch your loan (longer term and higher end value) to get more money for a low down payment… The number of possibilities is huge, but you need to know what ‘they really are if you’re going to profit from them.

Good luck with your real estate projects.

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