General financing concepts: interest, amortization, points, and loan-to-value

Four numbers, four jobs

Principal is the unpaid loan balance. Interest is the charge for using borrowed money. With simple interest, interest equals principal times annual rate times time in years. On an unchanged $240,000 balance at 6% for one month, using one-twelfth of a year, interest is $240,000 × 0.06 ÷ 12 = $1,200. The note rate measures interest; the annual percentage rate, or APR, also reflects certain finance charges and their timing, so it is not interchangeable with the note rate.

How repayment changes the balance

Amortization is repayment of principal over time. For a fully amortizing fixed-rate loan with level principal-and-interest payments, each payment covers the period's interest and reduces principal. As the balance falls, interest falls and the principal portion grows. If the first payment in the example is $1,500, $1,200 pays interest and $300 reduces principal to $239,700. The next month's interest is $239,700 × 0.06 ÷ 12 = $1,198.50; the principal portion is $301.50.

An interest-only payment leaves principal unchanged. A partially amortizing loan leaves a balance due at maturity, commonly a balloon payment. Negative amortization occurs when unpaid interest is added to principal because the payment does not cover accrued interest. A fixed interest rate does not freeze tax and insurance expenses included in an overall housing payment.

Points and borrowing relative to value

One point is 1% of the loan amount, not the sale price or down payment. Two points on $240,000 cost $240,000 × 0.02 = $4,800. Discount points are an upfront charge used to obtain a lower interest rate; an origination charge compensates for making the loan. A point does not specify a fixed amount of rate reduction. For a simple break-even comparison, divide the extra upfront cost by monthly payment savings. If $4,800 saves $100 monthly, $4,800 ÷ $100 = 48 months, ignoring time value, taxes, and differences in remaining balances.

Loan-to-value, or LTV, equals loan amount divided by the property value used by the lender, times 100. A $240,000 loan against $300,000 of value has 80% LTV: $240,000 ÷ $300,000 × 100 = 80%. The remaining $60,000 represents 20% equity before transaction costs, assuming no other liens. Combined LTV includes additional secured loans. For a purchase, lenders commonly use the lower of purchase price or appraised value. Use the valuation basis stated in an exam problem.

California connection

California Civil Code section 2954.8 requires covered institutions holding advance property-tax, insurance, or related funds on California one-to-four-family residential security to pay at least 2% simple annual interest, credited annually or at account termination, whichever is earlier. This is interest credited on held funds, not the borrower's mortgage rate. The rule has statutory exceptions, including specified regulator-required non-interest-bearing trust arrangements.