A mortgage is money rented from the bank
Updated: Oct 4, 2020
Albert Einstein is often quoted as saying that “compound interest is the 8th wonder of the world' and that 'he who understands it, earns it; he who doesn't pays it.'
Whether the quote is accurate or not we can't say for sure, but it is certainly true. And nowhere is this more true than for mortgages.
Banks understand compound interest and earn it, while many of us do not so end up paying it.
Now, while some people do prefer renting, a popular reason for buying your home is to avoid ‘wasting money on rent’ or some variation of this.
What’s often missed in this analysis is that once you have a mortgage you are still renting. But instead of a property, you are renting money from the bank.
When you buy your house with a mortgage you agree to pay back the loan with monthly repayments. Each repayment is split into two different costs. One cost is the principal and the other cost is the interest on the principal.
The principal refers to the initial size of the loan but it can also mean the amount still owed on a loan. So if you take out a £500,000 mortgage, for example, the principal would be £500,000. If you pay off £300,000, the principal balance is now the remaining £200,000.
As well as paying the principal each month you also pay the interest on the principal. As the principal goes down monthly so does the amount of interest you pay.
Check out the diagram below. It shows how the split between the principal and the interest changes over time. At the start of your mortgage, each monthly repayment is mostly interest. But over time, as you repay back more and more of the principal, the interest you pay each month goes down.
So you can get a good look at the numbers, look at the table below. It shows the monthly repayments for a £500,000 house, including how each monthly repayment is split between the principal and the interest. On top of this, it shows how your equity (how much of your property you actually own) changes over time.
In this example, the mortgage deposit (the amount you put down upfront) is £30,000, so the amount borrowed (the principal) is £470,000. The interest rate in this example is fixed at 5% and the length of the mortgage (the time you have to repay the loan) is 30 years.
As you can see each monthly repayment is £2,523. But in the first month, where the principal is at its largest (£470,000), again the repayment is mostly interest. Take a look at the first row. In month 1, of the £2,523 paid back to the bank, £1,958 is interest and only £565 goes to repaying the principal.
Now, the interest does go down gradually each month as more of the principal is repaid. For example, in month 1 the interest is £1,958 and in month 3 it is £1,954. Still, of the £2,523 being paid each month most of the money goes on interest i.e. the cost of ‘renting’ the money from the bank.
By month 3 with £5,046 spent, only £1,701 has been spent repaying the principal.
In fact, for the first 20 years of a mortgage, you will pay mostly interest. In year 20 of this mortgage, you’ll have paid a total of £373,412 in interest and only repaid £89,000 of the principal.
It’s not until the 195th month, 16 years into this mortgage, that the principal repaid each month even becomes higher than the amount paid in interest. This is shown in the last row of the table above, where the monthly interest (£1257.84) is finally less than the monthly principal repayment (£1265.22).
Once this mortgage is complete the interest alone would have come to £438,302. That’s £31,698 less than the £470,000 you originally borrowed. So with an interest rate as low as 5% you effectively pay for your home twice, spending £938,302 on a mortgage for a £500,000 property.
Of course, this is a simple example. Interest rates will vary over a 30 year period and as explained in our last blog post house prices rise as banks create more and more money. So while you only make a dent in the principal in the first 20 years, after a few years your home is often worth more than you bought it for.
What's crucial though is that this house price growth is paid for by more buyers coming into the market and asking banks to create money for their mortgages too. In this way, the housing market has all the hallmarks of a pyramid scheme; growth is paid for by new people joining the enterprise. See the quote below from American economist Michael Hudson, Professor of Economics at the University of Missouri–Kansas City:
The more banks lend, the higher prices rise for the real estate being bought on credit. And the more prices rise, the more banks are willing to lend - as long as more people keep joining what looks like a perpetual motion wealth-creating machine...But bubbles always burst, because they are financed with debt, which expands like a chain letter for the economy as a whole
For reference, a chain letter is a pyramid scheme that asks recipients to funnel money up the chain while requesting the letter be distributed to multiple new recipients.
Now there is a benefit to having the mortgage described above. Put simply after 30 years of paying it, you would own your home. Whereas after 30 years of renting and not saving, you might still have nothing.
Alternatively though, by renting and investing your additional savings wisely, you could also grow your money by enough to buy your dream home outright.
This isn't as outlandish as you might think either. For example, today first-time buyers in the UK are putting down 33k for their mortgage deposit, with those in London stumping up £110k. What's impressive is that many are managing to do this while renting too. So rather than save only for their deposit why not save enough to cut out the banks and the mortgage interest entirely? If we're only going to repay 89k after 20 years of the mortgage above, but pay over 370k in interest, then building your savings while renting doesn't sound like such a bad option.
Whether you’re renting a property or renting money (interest), there is always a cost of renting. While the cost of renting a property comes with the flexibility to move, at PropBloc we find it hard to see the upside of renting money from the banks.
While you and I have to work for money and pay the banks back interest, banks simply create money and watch the interest work for them. This really gives them little incentive to create a better system. In fact, since their lending helps push up prices, they're encouraged to keep the 'game' going.
Luckily new blockchain technology means we can solve these problems for them.
That's why we are launching a cryptocurrency designed to help you buy your home without a mortgage or large deposit.
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