A mortgage is a legal contract that describes the terms of the loan obtained to buy a piece of real property. Paying your mortgage will become an important goal for you; when it’s paid in full, you’ll own your property outright.
Mortgage payments are divided between principal (the amount you borrowed) and interest (the cost of borrowing the money). Each month a little bit more gets applied to the principal balance. On a traditional thirty-year mortgage, the payments for the first twenty years or so will be more interest than principal. For example, on a thirty-year $100,000 mortgage at 4 percent interest, your payments the first year would total $5,729, of which $3,968 would be for interest and only $1,761 for principal. At the end of the year you would still owe a balance of $98,239. Over the life of the thirty-year mortgage, you’d repay the $100,000 you borrowed plus $71,747 in interest, for a total of $171,747.
If it weren’t for private mortgage insurance (PMI), which protects the lender in case you’re unable to make the payments on your loan, you might not be able to buy a house for many years. Most lenders require a 20 percent down payment, so on a $100,000 loan, you’d be required to come up with approximately $20,000 for the down payment plus another $5,000 (or more) for closing costs. PMI, which ranges between 0.05 and 2.25 percent of your loan balance annually, helps you buy a house with as little as 5 to 10 percent down and is folded into your loan payments.
Under federal law, your lender is required to automatically terminate PMI when your equity reaches 22 percent of the original appraised value of your home. To calculate what percent equity you have in your home, divide your loan balance by the appraised value and deduct this number from 100. If you bought your home after 1999, your lender must terminate your PMI when you reach 20 percent equity if you request it in writing. If you have an FHA or VA loan, PMI isn’t required because the federal government has already agreed to protect the lender if you default on your loan.
You may think that all mortgages are alike, but they actually come in many shapes and sizes. There are several different terms, fixed-interest rate and variable-interest rate, balloon mortgages, government-backed mortgages, and more. To choose the best one for your personal situation, you should be familiar with at least these basic types.
Most mortgages are for fifteen, twenty, or thirty years with an interest rate that’s fixed over the life of the loan. Payments on fifteen- and twenty-year loans are somewhat higher than those on traditional thirty-year loans; you need a higher income to qualify for the shorter terms. The benefit of a shorter-term mortgage is that you build equity faster, pay off your mortgage years sooner, and save many tens of thousands of dollars.
Shorter or Longer?
If you can swing the payments comfortably, the shorter mortgage loan terms are definitely worthwhile. Not only will your house be paid off much more quickly; you’ll save tens of thousands of dollars in interest over the life of your loan.
To illustrate the difference between a thirty-year and a fifteen-year mortgage, take the example of a mortgage for $150,000 at 6 percent. The payment on a fifteen-year loan would be $1,266 per month, and the total interest paid over the life of the loan would be $77,359. The payment on a thirty-year mortgage for the same amount at the same interest rate would be $899 per month (a decrease of $367), and the total interest paid over the life of the loan would be $173,415 (an increase of $95,916). Moreover, interest rates on shorter-term mortgages are almost always lower than those on longer-term mortgages, so the difference between the total interest paid on the two loans in the example would actually be even greater.
The interest rates on adjustable-rate mortgages (ARMs) vary over time. They often start out as much as 1.5 to 2 percentage points lower than the prevailing market rates and increase (or decrease) at predetermined intervals once the introductory rate period expires. The amount of increase (or decrease) depends on the index they’re tied to. The most commonly used indexes include one-year Treasury bills, LIBOR (London Interbank Offered Rate), or the CMT (Constant Maturity Treasury). The rate is fixed for a certain period (usually between six months and five years) and then adjusted periodically, such as every six months or once a year. The amount the rate can increase at each interval is usually capped, most often at 2 percent; for example, if your rate was 3 percent, it could increase to 5 percent. In addition, most ARM loans include a lifetime rate cap, which is typically 6 percentage points. In a time of rising interest rates, it can be disturbing to know that your rate—and therefore your monthly payment—can increase every year. Before taking out an ARM, be sure that you can afford the highest payment possible under the terms of the loan. ARMs might be a good option if you know you’ll only be in the house for a few years, but if you use one because you can’t qualify for a conventional mortgage, you’re risking the possible loss of your house.
Government loans such as FHA (Federal Housing Administration) and VA (Veterans Affairs) loans make homeownership possible for people who might not otherwise qualify for a mortgage. The federal government insures the loan, which is issued by a regular lender. FHA loans allow a smaller down payment than regular mortgages (3.5 percent rather than 10 or 20 percent), allow a higher debt percentage, and allow you to borrow the down payment and closing costs from a family member, which you can’t do legally with a regular mortgage. These loans also come with mortgage insurance premiums, including an up-front fee and regular monthly payments. You’ll need a credit score of at least 580 to qualify for an FHA loan. You can learn more on the FHA website at www.hud.gov.
VA loans are for active-duty military, veterans, and honorably discharged service members. Unlike other mortgage loans, these don’t require any down payment (though that doesn’t mean you shouldn’t try to put some money down if you can). They have even less stringent requirements on the income-to-debt ratio than FHA loans. Before you can apply for a VA home loan, you’ll need to get a VA loan Certificate of Eligibility, which you can do on the VA website at www.va.gov.
Even though they’re insured by the government, FHA and VA loans are not always your best bet. If you have good credit, you should take a look at conventional loans from a bank or mortgage broker for comparison.
As you can see, there are many mortgage options, so it’s important to understand how each of the basic types would impact your payments. Don’t underestimate the impact of interest rates on your monthly payments. A $100,000 loan at 7 percent interest for thirty years would cost $665 per month. The same loan at 8 percent interest would cost $734 per month, a difference of $24,840 over the life of a thirty-year mortgage.
For most people, a standard thirty-year mortgage is a good choice. You’ll know what to expect each month, and you’re not taking any wild risks. If you really want to save on interest costs, you can go for the fifteen-year mortgage.
The federal Truth in Lending Act requires lenders to disclose the annual percentage rate (APR) and the total finance charges to borrowers in writing. The APR is the average annual finance charge. It’s more meaningful than the interest rate alone because it includes costs such as loan origination fees, private mortgage insurance premium, and points that affect the total cost of your loan.
The APR levels the playing field by allowing you to quickly and painlessly compare loans that have different rates and fees. It’s a much more accurate indicator of the cost of the loan. Be aware, however, that it can’t be used as an accurate comparison of total borrowing costs on adjustable-rate mortgages.
Points are a percentage of the loan amount that you pay up front to “buy down” the interest rate on a mortgage. One point is 1 percent of the loan and usually lowers the interest rate by 0.25 percent. One point on a $100,000 loan would be $1,000, two points would be $2,000, and so on. A 7 percent loan with one point is not necessarily better (or worse) than an 8 percent loan with no points. Remember, you have to look at the APR to compare rates and fees. Paying points in order to get a lower interest rate may be worthwhile if you’re planning to stay in the house for five years or more. The lower interest rate saves you a lot of money over the long term, but if you sell in less than five to ten years you won’t have time to recoup your costs. You can see how much money buying points might save you by plugging different scenarios into an online mortgage points calculator, which you can find at www.bankrate.com and www.nerdwallet.com.