Mortgage Help
Buyers/Sellers > Mortgare Help
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Eddie Rutledge |
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How mortgages work: Understanding the key elements
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A mortgage is a long-term loan that a borrower obtains from a bank, thrift, independent mortgage broker, online lender or even the property seller. The house and the land it sits on serve as collateral for the loan. The borrower signs documents at closing time giving the lender a lien against the property. If that borrower doesn't make payments as agreed, the lender can take the home through foreclosure. Because mortgages are such large loans, consumers pay them off over long periods -- usually 15 to 30 years. Their monthly payments gradually whittle away the principal balance, slowly at first then rapidly toward the end of the loan. |
What's in a payment?
When escrow is used, a monthly mortgage payment is called a PITI payment. That's because each one covers a portion of the following four costs:
Principal -- the loan balance
Interest -- interest owed on that balance
Real estate Taxes -- taxes assessed by different government agencies to pay for school construction, fire department service, etc.
Property Insurance -- insurance coverage against theft, fire, hurricanes and other disasters
Borrowers can choose to pay their real estate taxes and insurance in lump sums when they come due, rather than in monthly installments to their escrow accounts. Depending on the kind of mortgage a borrower has, the monthly payment may also include a separate levy for private mortgage insurance (PMI) or government-backed mortgage insurance premiums. The breakdown of each payment (the amount that goes toward principal, interest, etc.) changes over time because mortgages are based on a repayment formula called amortization. That's a fancy term meaning the lender spreads the interest you owe on the mortgage over hundreds of payments so that the overall loan is as affordable as possible.
How does amortization work?
Here's how principal and interest change over the life of a loan |
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Payment number |
Principal balance |
Payment amount |
Interest paid |
Principal applied |
New balance |
1 |
$150,000 |
$1,048.82 |
$937.50 |
$111.32 |
$149,888.68 |
60 |
$142,086.93 |
$1,048.82 |
$888.04 |
$160.78 |
$141,926.15 |
120 |
$130,426.14 |
$1,048.82 |
$815.16 |
$233.66 |
$130,192.48 |
240 |
$88,851.22 |
$1,048.82 |
$555.32 |
$493.50 |
$88,357.72 |
359 |
$2,078.14 |
$1,048.82 |
$12.99 |
$1,035.83 |
$1,042.3 |
Calculator |
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On a 30-year, $150,000 mortgage with a fixed interest rate of 7.5 percent, a homeowner who keeps the loan for the full term will pay $227,575.83 in interest. The lender can't possibly expect that person to pay all that interest in just a couple of years so the interest is spread over the full 30-year term. That keeps the monthly payment at $1,048.82. But the only way to keep the payments stable is to have the majority of each month's payment go toward interest during the early years of the loan. Of the first month's payment, for instance, only $111.32 goes toward principal. The other $937.50 goes toward interest. That ratio gradually improves over time, and by the second-to-last payment, when we're all driving hovercars and have colonized the moon, $1,035.83 of the borrower's payment will apply to principal while just $12.99 will go toward interest.
How mortgages work: How much house can you afford?
Mortgage lenders are chiefly concerned with your ability to repay your mortgage. To determine if you qualify for a loan, they will consider your credit history, your monthly gross income and how much cash you'll be able to accumulate for a down payment, which generally runs anywhere from 5 percent to 20 percent of the purchase price of the home.
So how much house can you afford? You can easily calculate the answer using two standard debt-to-income ratios:
- The housing expense, or front-end ratio, shows how much of your gross (pretax) monthly income would go toward the mortgage payment. As a general guideline, your monthly mortgage payment, including principal, interest, real estate taxes and homeowners insurance, should not exceed 28 percent of your gross monthly income. To calculate your housing expense, multiply your annual salary by 0.28, then divide by 12 (months). The answer is your maximum housing expense.
- The total debt-to-income, or back-end ratio, shows how much of your gross income would go toward all of your debt obligations, including mortgage, car loans, child support and alimony, credit card bills, student loans and condominium fees. In general, your total monthly debt obligation should not exceed 36 percent of your gross income. To calculate your debt-to-income ratio, multiply your annual salary by 0.36, then divide by 12 (months). The answer is your maximum allowable debt-to-income ratio.
Example
Let's take a home buyer who makes $40,000 a year. The maximum amount available for a monthly mortgage payment at 28 percent of gross income would be $933. However, the lender says the total debt payments each month should not exceed 36 percent, which comes to $1,200. The following chart shows your maximum monthly mortgage payment and maximum allowable debt load based on your annual gross salary:
Gross income |
28% of monthly |
36% of monthly |
$20,000 |
$467 |
$600 |
$30,000 |
$700 |
$900 |
$40,000 |
$933 |
$1,200 |
$50,000 |
$1,167 |
$1,500 |
$60,000 |
$1,400 |
$1,800 |
$80,000 |
$1,867 |
$2,400 |
$100,000 |
$2,333 |
$3,000 |
$150,000 |
$3,500 |
$4,500 |
Taxes and Insurance
In addition, lenders include the cost of taxes and insurance when calculating how much house you can afford:
- Real estate taxes: Because property taxes are part of your monthly mortgage payment, it is important to get an estimate of what yours would be. Ask your real estate agent or tax office for the rates that apply in the area you want to buy.
- Homeowners insurance: You must insure your property to obtain a mortgage. You can get an estimate of insurance costs from your insurance agent or a major insurance company in the area where you are house hunting. Be sure to inquire about special requirements for hazard insurance, such as mandatory coverage for floods, earthquakes, or wind in coastal areas. If you put down less than 20 percent of your home's value, you also will have to obtain private mortgage insurance (PMI).
Here's a look at typical debt ratio requirements by loan type:
- Conventional loans
Housing costs: 26-28 percent of monthly gross income
Housing + debt costs: 33-36 percent of monthly gross income
- FHA loans
Housing costs: 29 percent of monthly gross income
Housing + debt costs: 41 percent of monthly gross income
How mortgages work: Types of mortgages -- fixed rate
Lenders offer several types of mortgages, but the most common are fixed-rate mortgages. These loans feature fixed rates and monthly payments, generally for 15-year and 30-year periods. They're popular because:
- Consumers balk at the thought of their house payment rising and falling with interest rates.
- Whenever rates are low, fixed-rate mortgages are very affordable.
Fixed-rate loan borrowers face one major choice: 15 year or 30? For some, a 30-year loan makes more sense. For others, a 15-year one does. Here are some pros and cons of each.
Advantages of a 30-year fixed rate
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Offers borrowers the chance to borrow money on a long-term basis without having to worry about the interest rates or payments changing.
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Monthly payments are lower than those on 15-year loans because the interest is amortized over a longer period.
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Lower monthly payments free up money that borrowers can pour into investments that yield more than their homes.
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Higher interest bill increases the amount consumers can deduct at tax time, potentially reducing or eliminating their federal income tax liability.
Disadvantages of a 30-year fixed rate
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Borrowers build equity at a very slow pace because payments during the first several years go largely toward interest rather than principal.
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The overall interest bill is much higher because of the long amortization term.
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The interest rates are higher than on 15-year loans.
Advantages of a 15-year fixed rate
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Borrowers build equity much more quickly due to shorter amortization schedules.
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Overall interest bills are dramatically lower than those on longer-term loans.
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The interest rates are lower than 30-year loans.
Disadvantages of a 15-year fixed rate
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Monthly payments can be significantly higher than those on 30-year loans.
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Restricts home buyers to smaller house than they might be able to afford with longer-term loans.
Example
Let's say you have a $150,000 mortgage. Let's compare how much money you would pay out in interest over 30 years vs. 15 years. The following chart shows the numbers. The monthly loan payments are principal and interest only. As you can see, with a 15-year loan, you would save $117,001 in interest.
Loan term |
Rate |
Monthly payment |
Total interest |
30 years |
6.64% |
$961 |
$196,304 |
15 years |
6.10% |
$1,274 |
$ 79,304 |
Interest savings: $ 117,001 |
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Other factors to consider
Take the example above: With the 15-year loan, the monthly mortgage payment is $313 more than the 30-year mortgage. You may want to put that money toward another investment. For instance, in a bull-market economy, you can make more money investing that $313 monthly in mutual funds or other investment securities.
Keep in mind that there are ways to prepay your mortgage and whittle away at the principal each month, so that the loan is paid off sooner than 30 years. Also, it depends on how long you plan to own the home you are purchasing. If it's less than five years, you may be better off with an adjustable-rate mortgage, or ARM.
How adjustable rate mortgages work:
Adjustable-rate mortgages, or ARMs, differ from fixed-rate mortgages in that the interest rate and monthly payment move up and down as market interest rates fluctuate. Most have an initial fixed-rate period during which the borrower's rate doesn't change, followed by a much longer period during which the rate changes at preset intervals.
Adjustable rates start low
The rates charged during the initial periods are generally lower than the rates found on comparable fixed-rate mortgages. After all, lenders have to offer borrowers something to make it worth their while to assume the risk of higher rates in the future. The initial fixed-rate period can be as short as a month or as long as 10 years. One-year ARMs are the most common, though so-called hybrid ARMs have become more popular in recent years. These hybrid ARMs -- sometimes referred to as 3/1, 5/1, 7/1 or 10/1 loans -- have fixed rates for the first three, five, seven or 10 years, followed by rates that adjust annually thereafter.
After the fixed-rate honeymoon, an ARM's rate fluctuates at the same rate as an index spelled out in closing documents. The lender finds out what the index value is, adds a margin to that figure, then recalculates what the borrower's new rate and payment will be. The process repeats each time an adjustment date rolls around.
Most ARM rates are tied to the performance of one of three major indexes:
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The weekly constant maturity yield on the one-year Treasury Bill
The yield debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board -
The 11th District Cost of Funds Index (COFI)
The interest financial institutions in the western U.S. are paying on deposits they hold -
The London Interbank Offer Rate (LIBOR)
The rate most international banks are charging each other on large loans
Sky's not the limit
Borrowers have some protection from extreme changes because ARMs come with caps. These caps limit the amount by which ARM rates and payments can adjust. Caps come in a couple of different forms. The most common are:
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Periodic rate cap
Limits how much the rate can change at any one time. These are usually annual caps, or caps that prevent the rate from rising more than a certain number of percentage points in any given year. -
Lifetime cap
Limits how much the interest rate can rise over the life of the loan. -
Payment cap
Offered on some ARMs. It limits the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.
Variety of flavors
Some ARMs come with a conversion feature that allows borrowers to convert their loans to fixed-rate mortgages for a fee. Others allow borrowers to make interest-only payments for a portion of their loan terms to keep their payments low. But no matter the exact terms, most ARMs are more difficult to understand than fixed-rate loans. To keep your financial options open, make sure to ask the mortgage lender if the ARM is convertible to a fixed-rate mortgage. Also, ask if the ARM is assumable, which means when you sell your home the buyer may qualify to assume your existing mortgage. That could be desirable if mortgage interest rates are high.