In order to understand real estate financing, it is important that you understand the time value of money. Because of inf lation, a dollar today is generally worth less in the future. Thus, while real estate values may increase, an all-cash purchase may not be economically feasible, because the investor’s cash may be utilized in more effective ways. The cost of borrowing money is expressed in interest payments, usually a percent of the loan amount. Interest payments can be calculated in a variety of ways, the most common of which is simple interest. Simple interest is calculated by multiplying the loan amount by the interest rate, then dividing it up into period (12 months, 15 years, etc).
Example: A $100,000 loan at 12% simple interest is $12,000 per year, or $1,000 per month. To calculate monthly simple interest payments, take the loan amount (principal), multiply it by the interest rate, and then divide by 12. In this example, $100,000 °— .12 = $12,000 per year ÷ 12 = $1,000 per month.
Mortgage loans are generally not paid in simple interest but rather by amortization schedules (discussed in Chapter 4), calculated by amortization tables (see Appendix A). Amortization, derived from the Latin word “amorta” (death), is to pay down or “kill” a debt. Amortized payments remain the same throughout the life of the loan but are broken down into interest and principal. The payments made near the beginning of the loan are mostly interest, while the payments near the end are mostly principal. Lenders increase their return and reduce their risk by having most of the profit (interest) built into the front of the loan.
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