A Home mortgage is typically the largest debt that you will take on at one time. It can be a bit scary to take on hundreds of thousands of dollars in debt. Especially with an expected timeframe of 30 years to pay that debt off. That is no small commitment. Let’s make Cents Of It and break down the mortgage concepts!
Over the last 15 years, I’ve bought and sold 6 houses in a few different states, plus done a few re-finances and HELOCs (Home Equity Line of Credit). I made money on some, lost money on others. The market goes up and down in each area and you can’t always get in or out at the best possible times. Often, the reason for moving brought enough benefits to justify the financial hit.
It’s a cliché, but if I knew then what I know now, I would have made out much better financially than I did.
Introduction to Mortgage Concepts
Let’s break down the common terminology associated with a mortgage and explain what it really means to you. When you understand everything the mortgage broker is talking about, it’s easier to make sure you can focus on the aspects most important to how you want to manage your mortgage payoff.
Interest Rate vs Annual Percentage Rate (APR)
The interest rate is the rate that you will pay on the main loan itself. The interest rate is applied to the remaining balance each month. This determine the portion of the payment that will go to interest versus the principal.
The APR is the primary interest rate plus the other fees that are involved. This can include points, which we will talk about in a minute, broker fees, lender fees, and others. The idea is that these fees are not paid up front but are spread over the course of the loan.
If two mortgages have the same interest rate, compare the APRs and ask the lender what fees are included in each APR to decide if they are directly comparable. If one APR contains the appraisal fee, but the other doesn’t, then they are not directly comparable. They can however give you an idea of the fees that are associated with each loan.
Fixed Rate, Adjustable Rate, and Interest Only Mortgages
The Fixed Rate Mortgage (FRM) is the most common type of home loan. There is a single interest rate that is used over the course of the entire mortgage. This also means that your monthly payment on the mortgage itself will stay constant over the course of the loan. These mortgages are usually 30-year, 15-year, and 10-year. However, I have seen 8-year offerings.
It is common to receive a lower interest rate when you use a mortgage with a shorter duration because the lender is receiving their money back sooner to re-invest elsewhere and the risk is lower for them. The shorter duration mortgage will have a higher monthly payment but can save you very large amounts of interest over the course of the loan.
Adjustable Rate Mortgages (ARMs) are typically offered in the 5-year and 10-year variety. These mortgages usually offering a lower initial interest rate than a fixed mortgage, but after either 5 or 10 years, the rate becomes adjustable and will fluctuate periodically based on the current mortgage rates. Make sure you ask the lender the terms and conditions that affect the rate fluctuations. If you are planning to aggressively pay off your mortgage, an ARM may be a good solution, but keep in mind that if your plans change you could find yourself with a much higher interest rate and payment than you were expect. Unlike the fixed rate mortgage, your payment can change based on fluctuations in the interest rate.
Interest Only Mortgages do not involve any repayment of the principal. This is equivalent to paying rent in that you are not really building any additional equity if you just make the monthly payment. There are a couple major differences of note. The first is that if you are itemizing your tax deductions, the interest payments are tax deductible just like on a standard mortgage. The second is that you stand to either gain or lose based on fluctuations in the real estate market, because you do technically own the home.
In most cases, I would suggest avoiding Interest Only Mortgages unless you have a specific investment plan that benefits from using one and you have the discipline to follow it. Using an Interest Only Mortgage because you want more home then you can afford is a bad idea, you are incurring risk with the expectation that in the future your situation will have changed such that you can accommodate it.
This is not an all-inclusive list, but covers the most common. The other one that may apply is a Jumbo Loan, that is where the amount exceeds the federal guidelines put in place by Freddie Mac and Fannie Mae. Bridge Loans can be used when building a new home prior to the sale of your existing residence.
Buying Mortgage Points
The concept of buying points is that you are able to pay a fee up front, usually 1% of the total loan to receive a reduction in the interest rate, usually .125%. This will slightly reduce the monthly payment for the loan, but it will take a while to earn back the money spent on the points. As a quick example, if you take out a $200,000 loan on a 30-year fixed rate mortgage at 4.5% your monthly mortgage payment (principal + interest) will be $1,013. If you buy 1 point, you will pay $2,000 and your payment will drop to $999. That means you spent $2,000 to save $14/mo. It will take 143 months’ worth of payments ($2000 / $14) to break even, or almost 12 years.
Why would anyone want to buy points if it takes 12 years for payback? If you intend to hold that mortgage for the full 30 years, over the life of the loan you will only pay $159,485 interest instead of $164,813, saving $5,328 in interest, for a net return of $3,328.
It is worth considering that if you invest the $2,000 with a 7% annual compounding return over the same 30-year period, you would end up with $15,224.51. For a better understanding of why check out my previous post on compounding interest. The benefit from buying the points is guaranteed, the returns from an investment are not.
Let’s look at one more scenario regarding the benefits of buying points. In our example above, the mortgage payment dropped by $14/mo. If you use that extra $14/mo to pay down on principal, essentially making the same payment as you would have without buying points, you will only pay $154,303 over the course of the loan, saving $10,510 (Net $8,510) and paying off the loan 10 months early.
I do not consider buying points to be a worthwhile investment if the sole purpose is to reduce the monthly mortgage payment. If you need a lower payment, save up more down payment, or buy less house. In fact, if you take the $2,000 that you pay for buying points and use it as a single lump pre-payment at the start of your mortgage, you will knock 7 months off the mortgage and will only pay $159,240 in interest. You gain $240 over buying the point, have a $14/mo higher payment, but are done with your loan 7 months early.
Private Mortgage Insurance
If you don’t have 20% to put down on a house, lenders will often force you to buy Private Mortgage Insurance (PMI). They want to ensure that if you go into default, they can sell the house quickly and get their money back on the loan. Typically, this is 1% of the total amount of the loan per year. If you have a $200,000 mortgage, you will pay $2,000/year or $167/mo in PMI. This is not like insurance where there is some benefit, because it’s not really insurance for you. It is insurance for the bank against the risk you default on the loan. It may remain in place for a very long time.
If you put down 10% and the value of the home stays flat, it could take approximately 74 months until you reach 20% equity. At this point, you may be able to have the PMI removed, IF your loan agreement allows the removal of PMI. It is also very common that banks will require you to keep the PMI in place for at least a year, so even if you pre-pay large sums to get to 20% equity quickly, you may have to continue paying PMI for a while.
A common alternative is to use an 80/10/10 loan. Essentially it means you take out a conventional loan for 80% of the home, you take out a piggyback loan for 10%, and you put down a 10% down payment. On a $250,000 home, you would have a $200,000 conventional mortgage, a $25,000 piggyback loan, and a $25,000 down payment. The second piggyback loan is typically at a higher rate, because it carries higher risk to the bank, and has a shorter duration between 7-10 years. If you go the route of an 80/10/10 loan, make sure the piggyback loan does not have any pre-payment penalties.
Why is my house payment so large?
A monthly house payment consists of more than just the mortgage payment, there are two other components. These are homeowner’s insurance and property tax. It is common for banks to include these in your monthly payment and hold the money in escrow. When these come due, the bank takes care of paying them for you.
Lenders require homeowner’s insurance to protect the home in case of damage or loss. This is the underlying asset that the bank is expecting to use to repay the loan if you default. It is not uncommon for this to run several hundred dollars per year or more. It depends on where you live, what is covered, and what deductible you choose.
Well, if there is one thing you can’t escape, it is taxes. This can be a very significant sum. In the area where I live, I typically pay 2.75%-3% of the value of the home in annual taxes. This is typically deductible on your taxes, at least up to a certain point. This can vary widely based on where you live. I had one home that I’d bought for $350,000 with 20% down and moved to a different state. The new home cost me $600,000 with 20% down. The monthly payment on these two houses were within $20/mo of each other, it was all property tax. They each cost about $2,600/mo.
What is the monthly payment on that $250,000 house with 20% down, so a $200,000 30-year mortgage at 4.5%?
Mortgage Payment – $1,013/mo
Homeowner’s Insurance – $67/mo ($800/yr)
Property Tax (3%) – $625/mo
Total Payment – $1,705/mo
It is very common to see a lot of personal finance calculations leave out the homeowner’s insurance and property taxes. Keep in mind the upkeep costs on the home in addition to the potential for home owner’s association (HOA) dues.
In this part, we dug into the main mortgage concepts. In the next part, we will dive into the amortization table and really understand how your mortgage payment works. It’s not as simple and straight forward as you would think.
Disclaimer: I am not a tax accountant, financial advisor, or lawyer. The information provided is based on how I analyze these investments and my own personal experience. I make no guarantees or predictions about the future performance of the markets, economy or interest rates.