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Mortgage Basics and Terminology
Now that we have talked a little bit about whether you should buy a house and the types of mortgages available, we will review some key terms that you will need to be familiar with in order to understand the detailed explanations of each kind of mortgage which are coming up in the next several posts.
When you take out a mortgage, many people assume that out of each monthly payment, say 5% of the payment goes towards interest and 95% goes towards the principal. In fact, payments are structured such that most of your payment in the first few years goes toward interest, and the rest goes toward reducing the principal, or outstanding balance. Each month you pay a little less interest and a bit more principal even though the monthly payment remains the same. If you pay extra toward the principle, your monthly payment won’t change but it reduces the amount of interest paid over the life of the loan since there is less outstanding balance to charge interest on. What this means is that in the first several years of the mortgage, your payments are primarily paying off the interest.
For example, if you take out a $165,000 mortgage at 4.5% for 30 years, your monthly payment will be about $800. Your first monthly payment consists of about $600 in interest and only $200 goes towards the principal. After 5 years, your $800 payment includes about $550 in interest and $250 towards the principal. After 5 years (60 payments), you still owe $150,000! You have made $48,000 in payments, but almost all of that has gone towards the interest on the loan, not the principal. I encourage you to play with a couple of calculators to see for yourself how this works. Bankrate.com has a pretty straightforward one one here.
The annual percentage rate (APR) is the annualized interest rate for your loan. This is different from the advertised rate on your mortgage. For example, a mortgage comparison site is offering a rate of 4.125% with an APR of 4.188% Why is that? This loan has $1,447 in lender fees. These are one-time fees such as an origination fee that often get distributed over the life of the loan. That fee is effectively the same as paying more interest. The APR accounts for any additional fees that get rolled into the loan. Therefore, this total cost of borrowing allows you to make apples-to-apples comparisons between different loan products.
Closing fees include charges for appraisals, credit reports, title insurance, recording deeds, state and local taxes, and other miscellaneous processing fees. Lenders will charge you money for the privilege of applying to borrow money. This is the origination fee. The estimated closing costs for my last house were about 2% of the value of the loan.
Debt to Income Ratio
This tells the bank how much of your income you will be spending on your mortgage and other debts. Lenders, like landlords, don’t want to take on the risk of your house payment being too much a chunk of your finances. 42% is a common threshold (that is, you should be spending no more than 42% of your monthly income on your various debt payments). So if you make $4,000 a month, don’t expect to be approved for a mortgage payment that’s any higher than about $1,600 – less if you have any other debt.
Keep in mind that this debt to income ratio includes all current debts, not just the mortgage: credit cards, car payments, personal loans, and mortgages on any other properties that you own. Physician loans exclude student loans from this math, but other types of mortgages also include student loans in this ratio.
Loan to Value Ratio
If you get foreclosed on, the bank has to sell the house to get its money back. So if a house is worth $100,000 but you pay $120,000 for it and then get foreclosed on, the bank can only expect to get $100,000 when they sell it. To keep them from getting left in a hole, the bank is going to require a down payment to make up the difference. Some lenders might allow you to borrow 5% above the appraised value to cover some expenses like minor maintenance, blinds, or moving costs. This isn’t a guarantee, and if you are that close it could be a sign you are paying too much for the house.
Private Mortgage Insurance (PMI)
Lenders want a house to have equity, which is the difference between what the house is worth and what you owe on it. This is so that if you get foreclosed on, they won’t find themselves underwater on your house. Conventional mortgages typically require a 20% down payment. If you don’t have 20% of the value of the loan, they may allow you to take out PMI which makes the bank whole in the event the house is foreclosed on. PMI is expensive. It can cost 1% of the total loan amount each year, so if you buy a house with a $200,000 loan that PMI will mean you have to pay $2,000 a year on top of your monthly payments. It’s possible for PMI to go away once that 20% threshold is reached, but policies vary and sometimes place minimum lengths of time or other barriers in place.
Mortgages are a commodity. It doesn’t really matter who you get your mortgage through. This is because mortgages are bought and sold among banks and investors every day. What’s important to you as the borrower is who is servicing your mortgage. For example, if I get a mortgage with Bank of America it could have sold that mortgage to somebody else days or weeks after I closed. Bank of America would most likely continue to service the mortgage, so I would still write my checks to them, see it in my account, etc. If the servicer changes you’ll be given plenty of notice and instructions on how the switch is being handled through official notices. But this means it isn’t worth taking a loan with worse terms in order to get the loan through a company you know and trust, because they could easily sell the loan to someone else tomorrow.
Full disclosure: My wonderful spouse, who knows more about these things than I do, assisted me in writing this post.