How Mortgage Loans Work
Excluding property taxes and insurance, a traditional fixed-rate mortgage payment consist of two parts: (1) interest on the loan and (2) payment towards the principal or unpaid balance of the loan.
Many people are surprised to learn, however, that the amount you pay towards interest and principal varies dramatically over time. This is because mortgage loans work in such a way that the early payments are primarily in interest, and the later payments are primarily towards the principal.
In the beginning… you pay interest
To help calculate monthly payments for loans based on different interest rates, lenders long ago developed what are known as “amortization tables.” These tables also make it fairly easy to calculate how much money of each payment is interest, and how much goes towards the principal balance.
For example, let’s calculate the principle and interest for the very first monthly payment of a 30-year, $100,000 mortgage loan at 7.5 percent interest. According to the amortization tables, the monthly payment on this loan is fixed at $699.21.
The first step is to calculate the annual interest by multiplying $100,000 x .075 (7.5 %). This equals $7,500, which we then divide by 12 (for the number of months in a year), which equals $625.
If you subtract $625 from the monthly payment of $699.21, we see that:
$625 of the first payment is interest
$74.21 of the first payment goes towards the principal
Next, if we subtract $74.21 (the first principal payment) from the $100,000 of the loan, we come up with a new unpaid principal balance of $99,925.79. To determine the next month’s principal and interest payments, we just repeat the steps already described.
Thus, we now multiply the new principal balance (99,925.79) times the interest rate (7.5%) to get an annual interest payment of $7,494.43. Divided by 12, this equals $624.54. So during the second month’s payment:
$624.54 is interest
$74.67 goes towards the principal.
Note: In Canada, payments are compounded semi-annually instead of monthly.
Equity
As you can see from the above example, even though you pay a lot of interest upfront, you’re also slowly paying down the overall debt. This is known as building equity. Thus, even if you sell a house before the loan is paid in full, you only have to pay off the unpaid principal balance–the difference between the sales price and the unpaid principle is your equity.
In order to build equity faster–as well as save money on interest payments–some homeowners choose loans with faster repayment schedules (such as a 15-year loan).
Time vs savings
To help illustrate how this works, consider our previous example of a $100,000 loan at 7.5 percent interest. The monthly payment is around $700, which over 30 years adds up to $252,000. In other words, over the life of the loan, you would pay $152,000 just in interest.
With the aggressive repayment schedule of a 15-year loan, however, the monthly payment jumps to $927-for a total of $166,860 over the life of the loan. Obviously, the monthly payments are more than they would be for a 30-year mortgage, but over the life of the loan, you would save more than $85,000 in interest.
Bear in mind that shorter-term loans are not the right answer for everyone, so make sure to ask your lender or real estate agent about what loan makes the best sense for your individual situation.
The Length Of A Mortgage
15-Year, 30-Year, or a Biweekly Mortgage?
In the past, the 30-year, fixed-rate mortgage was the standard choice for most homebuyers. Today, however, lenders offer a wide array of loan types of varying lengths–including 15, 20, 30, and even 40-year mortgages.
Deciding what length is best for you should be based on several factors including your purchasing power, your anticipated future income, and how disciplined you want to be about paying off the mortgage.
What are the benefits of a shorter loan term?
Some homeowners choose fixed-rate loans that are less than 30 years in order to save money by paying less interest over the life of the loan. For example, a $100,000 loan at 8 percent interest comes with a monthly payment of around $734 (excluding taxes and homeowner’s insurance). Over 30 years, this adds up to $264,240. In other words, over the life of the loan, you would pay a whopping $164,240 just in interest.
With a 15-year loan, however, the monthly payments on the same loan would be approximately $956–for a total of $172,080. The monthly payments are more than $200 more than they would be for a 30-year mortgage, but over the life of the loan, you would save more than $92,000.
What are the advantages to a 30-year loan?
Despite the interest savings of a 15-year loan, they’re not for everyone. For one thing, the higher monthly payment might not allow some homeowners to qualify for a house they could otherwise afford with the lower payments of a 30-year mortgage. The lower monthly payment can also provide a greater sense of security in the event your future earning power might decrease.
Furthermore, with a little bit of financial discipline, there are a variety of methods that can help you pay off a 30-year loan faster with only a moderately higher monthly payment. One such choice is the biweekly mortgage payment plan, which is now offered by many lenders for both new and existing loans.
Biweekly mortgages
As the name implies, biweekly mortgage payments are made every two weeks instead of once a month–which over a year works out to the equivalent of making one extra monthly payment (compared to a traditional payment plan). One extra payment a year may not sound like much, but it can really add up over time. In fact, switching from a traditional payment plan to a biweekly mortgage can actually shorten the term of a 30-year loan by several years and save you thousands in interest.
If you’re interested in a biweekly payment plan, make sure to check with your lender. In many cases, lenders also offer direct payment services that automatically withdraw funds from your bank account, saving you the trouble of having to write and mail a check every two weeks.
Making extra payments yourself–do it early!
Another way to pay off your loan more quickly is to simply include extra funds with your monthly payment. Most lenders will allow you to make extra payments towards the principal balance of your loan without penalty. This is especially attractive to homebuyers who are concerned about their future earning power but still want to be aggressive about paying off their loan.
For example, if you had a 30-year loan, you might decide to send the equivalent of one or two extra payments a year (which could shorten the overall length of the loan by many years). But if your financial situation suddenly took a turn for the worse, you could always fall back on the regular monthly payment.
One important note, though, is that if you do decide to send extra funds, make sure to do it EARLY in the life of the loan. This is because most home loans are calculated in such a way that the first few years of payments almost entirely interest, while the last few years are mostly applied towards the principal balance. Thus, you can get the most bang for your buck by making the extra payments early in the life of the loan.
Mortgage PrePayment
What about splitting my mortgage in two and paying bi-weekly?
Some people set on paying off their home loan early and reducing interest charges opt for a biweekly mortgage. Monthly payments are divided in half, payable every two weeks.
Because there are 52 weeks in a year, the program results in 26 half-payments or the equivalent of 13 monthly payments per year instead of 12. Using the biweekly payment system, a homeowner with a $70,000, 30-year biweekly mortgage at 10 percent interest could save $60,000 in interest and pay off the balance in less than 21 years.
What are the benefits of pre-paying the mortgage?
By making additional payments that go toward the principal balance, you can save thousands of dollars and shave years off the length of your loan.
Principal payments over and above the minimum monthly amount required by the terms of the mortgage constitute partial prepayment of a mortgage. Each mortgage will have terms describing how and when prepayment may occur. Refer to the note to see if there is any penalty incurred for prepayment.
The total savings potential also depends on how long you want to stay in the house. Borrowers who plan to move in the near future should not expect to realize as significant a savings as people who pay ahead of schedule until they own the home free and clear.
Check with your lender, who should be able to provide specific answers as to how such a prepayment plan will shorten the life of the loan and what kind of interest savings can be expected.
Mortgage Lock-ins
How do you lock in an interest rate?
Locking in a mortgage rate with a lender is one way to ensure that the same rate still will be available when you need it
Lock-ins make sense when borrowers expect rates to rise during the next 30 to 60 days, which is the usual length of time lock-ins are available.
A lock-in given at the time of application is useful because it may take the lender several weeks or longer to prepare a loan application (though automated loan practices are cutting this time dramatically).
However, some lenders require borrowers to pay lock-in fees to assure particular rates and terms. Be sure to check that the rates and points are guaranteed and that your lock-in period is long enough. If your lock-in expires, most lenders will offer the loan based on the prevailing interest rate and points.
Lenders may have preprinted forms that set out the exact terms of the lock-in agreement. Others may only make an oral lock-in promise on the telephone or at the time of application.
Resources:
* “A Consumer’s Guide to Mortgage Lock-Ins,” published by the Federal Reserve Board and Office of Thrift Supervision, Washington, D.C.
Do you advise a lock-in on a home loan?
Locking in a mortgage rate with a lender is one way to ensure that the same rate still will be available when you need it
Lock-ins make sense when borrowers expect rates to rise during the next 30 to 60 days, which is the usual length of time lock-ins are available.
A lock-in given at the time of application is useful because it may take the lender several weeks or longer to prepare a loan application (though automated loan practices are cutting this time dramatically).
However, some lenders require borrowers to pay lock-in fees to assure particular rates and terms. Be sure to check that the rates and points are guaranteed and that your lock-in period is long enough. If your lock-in expires, most lenders will offer the loan based on the prevailing interest rate and points.
Lenders may have preprinted forms that set out the exact terms of the lock-in agreement. Others may only make an oral lock-in promise on the telephone or at the time of application.
Resources:
* “A Consumer’s Guide to Mortgage Lock-Ins,” published by the Federal Reserve Board and Office of Thrift Supervision, Washington, D.C.
Where do I get information on lock-ins?
For information on lock-in mortgage rates, check out this brochure:
* “Consumer’s Guide to Mortgage Lock-Ins” from the Federal Reserve Bank of San Francisco, Public Information Department, P.O. Box 7702, San Francisco, CA 94120; or call (415) 974-2163 to order.
What is the value of a mortgage lock-in?
Locking in a mortgage rate with a lender is one way to ensure that the same rate still will be available when you need it
Lock-ins make sense when borrowers expect rates to rise during the next 30 to 60 days, which is the usual length of time lock-ins are available.
A lock-in given at the time of application is useful because it may take the lender several weeks or longer to prepare a loan application (though automated loan practices are cutting this time dramatically).
However, some lenders require borrowers to pay lock-in fees to assure particular rates and terms. Be sure to check that the rates and points are guaranteed and that your lock-in period is long enough. If your lock-in expires, most lenders will offer the loan based on the prevailing interest rate and points.
Lenders may have preprinted forms that set out the exact terms of the lock-in agreement. Others may only make an oral lock-in promise on the telephone or at the time of application.
Resources:
* “A Consumer’s Guide to Mortgage Lock-Ins,” published by the Federal Reserve Board and Office of Thrift Supervision, Washington, D.C.
Adjustable-Rate Mortgages
Adjustable-rate mortgages (ARMs) differ from fixed-rate mortgages in that the interest rate and monthly payment can change over the life of the loan. ARMs also generally have lower introductory interest rates vs. fixed-rate mortgages. Before deciding on an ARM, key factors to consider include how long you plan to own the property, and how frequently your monthly payment may change.
Why choose an adjustable-rate mortgage?
The low initial interest rates offered by ARMs make them attractive during periods when interest rates are high, or when homeowners only plan to stay in their home for a relatively short period. Similarly, homebuyers may find it easier to qualify for an ARM than a traditional loan. However, ARMs are not for everyone. If you plan to stay in your home long-term or are hesitant about having loan payments that shift from year-to-year, then you may prefer the stability of a fixed-rate mortagage.
Components of adjustable-rate mortgages
Adjustable-rate mortgages have three primary components: an index, margin, and calculated interest rate.
Index
The interest rate for an ARM is based on an index that measures the lender’s ability to borrow money. While the specific index used may vary depending on the lender, some common indexes include U.S. Treasury Bills and the Federal Housing Finance Board’s Contract Mortgage Rate. One thing all indexes have in common, however, is that they cannot be controlled by the lender.
Margin
The margin (also called the “spread”) is a percentage added to the index in order to cover the lender’s administrative costs and profit. Though the index may rise and fall over time, the margin usually remains constant over the life of the loan.
Calculated interest rate
By adding the index and margin together, you arrive at the calculated interest rate, which is the rate the homeowner pays. It is also the rate to which any future rate adjustments will apply (rather than the “teaser rate,” explained below).
Adjustment periods and teaser rates
Because the interest rate for an ARM may change due to economic conditions, a key feature to ask your lender about is the adjustment period–or how often your interest rate may change. Many ARMS have one-year adjustment periods, which means the interest rate and monthly payment is recalculated (based on the index) every year. Depending on the lender, longer adjustment periods are also available.
An ARM can also have an initial adjustment period based on a “teaser rate,” which is an artificially low introductory interest rate offered by a lender to attract homebuyers. Usually, teaser rates are good for 6 months or a year, at which point the loan reverts back to the calculated interest rate. Remember, too, that most lender will not use the teaser rate to qualify you for the loan, but instead use a 7.5% interest rate (or calculated interest rate if it is lower).
Rate caps
To protect homebuyers from dramatic rises in the interest rate, most ARMs have “caps” that govern how much the interest rate may rise between adjustment periods, as well as how much the rate may rise (or fall) over the life of the loan. For example, an ARM may be said to have a 2% periodic cap, and a 6% lifetime cap. This means that the rate can rise no more than 2% during an adjustment period, and no more than 6% over the life of the loan. The lifetime cap almost always applies to the calculated interest rate and not the introductory teaser rate.
Payment caps and negative amortization
Some ARMs also have payment caps. These differ from rate caps by placing a ceiling on how much your payment may rise during an adjustment period. While this may sound like a good thing, it can sometimes lead to real trouble.
For example, if the interest rate rises during an adjustment period, the additional interest due on the loan payment may exceed the amount allowed by the payment cap–leading to negative amortization. This means the balance due on the loan is actually growing, even though the homeowner is still making the minimum monthly payment. Many lenders limit the amount of negative amortization that may occur before the loan must be restructured, but it’s always wise to speak with your lender about payment caps and how negative amortization will be handled.
