January 4th, 2016 9:20 AM by Jackie A. Graves, President
home with a mortgage is probably the largest financial transaction you will
enter into. Typically a bank or mortgage lender will finance 80% of the price
of the home, and you agree to pay it back – with interest – over a specific
period of time. As you are comparing lenders, rates and options, it’s helpful
to understand how interest accrues each month and is paid.
Simply put, every month you pay back a
portion of the principal (the amount you’ve borrowed) plus the interest accrued
for the month. Your lender will use an amortization formula to create a payment schedule that
breaks down each payment into paying off principal and interest. The length or
life of your loan also determines how much you’ll pay each month.
Stretching out payments over more
years (up to 30) will generally result in lower monthly payments. The longer
you take to pay off your mortgage, the higher the overall purchase cost for
your home will be because you’ll be paying interest for a longer time period.
In the beginning of the loan, the principal gets paid off slowly as most of the
payment is applied toward paying interest. Toward the end of your loan, very
little of the payment will be applied toward interest, and most of it will go
toward paying the principal down. Online, you can use an amortization calculator to get an understanding of how
interest is more expensive at the beginning of a loan.
Banks and lenders generally offer two
types of loans:
Fixed Rate: interest
rate does not change.
interest rate will change under defined conditions. Sometimes referred to as a
variable-rate or hybrid loan.
Here's how these work in a home
mortgage: The monthly payment
remains the same for the life of this loan. The interest rate is locked in and
does not change. Loans have a repayment life span of 30 years; shorter lengths
of 10, 15, 20 years are also commonly available. Shorter loans will have larger
monthly payments that are offset by lower interest rates and lower overall
Example: A $200,000 fixed-rate
mortgage for 30 years (360 monthly payments) at an annual interest rate of
4.5%, will have a monthly payment of approximately $1,013. (Taxes, insurance,
escrow are additional and not included in this figure.) The annual interest
rate is broken down into a monthly rate as follows: an annual rate of, say,
4.5% divided by 12 equals a monthly interest rate of 0.375%. Every month you’ll
pay 0.375% interest on the amount you actually owe on the house.
Your first payment of $1,013 (1 of
360) applies $750 toward interest and $263 toward the principal. The second
monthly payment, since the principal is a little smaller, will accrue a little
less interest and slightly more of the principal will be paid off. By payment
359, most of the monthly payment will be applied toward principal.
mortgage (ARM): Because the interest
rate is not locked in, the monthly payment for this type of loan will change
across the life of the loan. Most ARMs have a limit or cap on how much the
interest rate may fluctuate, as well as how often the interest rate can be
changed. When the rate goes up or down, the lender recalculates your monthly
payment so that you’ll make equal payments until the next rate adjustment
occurs. As interest rates rise, so does your monthly payment; each payment
applies to interest and principal in the same manner as a fixed-rate mortgage,
over a set number of years. Lenders often offer lower interest rates for the
first few years of an ARM, but then rates change frequently after that – as
often as once a year.
* The initial interest rate on an ARM is significantly lower than a fixed-rate
* ARMs can be attractive if you are
planning on staying in your home for only a few years.
* Consider how often the interest rate
will adjust. Example: 5/1 year ARM has a fixed rate for five years, then every
year the interest rate will adjust for the remainder of the loan period.
* ARMs specify how interest rates are
determined – they can be tied to different financial indexes such as one-year
U.S. Treasury bills. Ask your financial planner for advice on selecting an ARM
with the most stable interest rate.
Example: A $200,000 5/1 adjustable-rate mortgage for 30
years (360 monthly payments) starts with an annual interest rate of 4% for 5
years, and then the rate is allowed to change by .25% every year. This ARM has
an interest cap of 12%. Payment amount for months 1 through 60 is $955 each.
Payment for 61 through 72 is $980. Payment for 73 through 84 is $1,005. (Taxes,
insurance, escrow are additional and not included in these figures.) You can calculate your costs online for an ARM.
A third option – usually reserved for
affluent homebuyers or those with irregular incomes – is an interest-only mortgage. As the name implies, this type of loan
gives you the option to pay only interest for the first few years, and it's
attractive to first-time homeowners because of the low payments during their
lower earning years. It may also be the right choice if you expect to own the
home for a relatively short time, and intend to sell before the bigger payoff
A jumbo mortgage is usually for amounts over the conforming loan limit, currently $417,000 for all
states except Hawaii and Alaska, where it is $625,000; additionally, in certain
federally designated high priced housing markets such as New York City, Los
Angeles and the entire San Jose-San Francisco-Oakland area, the conforming loan
limit is $625,000.
Interest-only jumbo loans are also
available, though usually for the super-wealthy. Structured similarly to an
ARM, the interest-only period lasts as long as 10 years. After that, the rate
adjusts annually and payments go toward paying off principal. Payments can go
up significantly at that point. (You may be interested in 5 Risky Mortgage Types To Avoid.)
* Escrow and other
fees. You’ll need to budget
for other items that will significantly add to the amount of your monthly
mortgage payment, such as taxes, insurance, and escrow costs. These costs are
not fixed and can fluctuate. Your lender will itemize additional costs as part
of your mortgage agreement.
* Should you pay a
little extra each month? In theory, paying a
little extra each month toward reducing principal is one way to own your home
faster. Financial professionals recommend that outstanding debt such as from
credit cards or student loans be paid off first, savings accounts be
well-funded, and then consider paying extra each month. Calculate your savings online.
*Interest is a tax
deduction. If you itemize
deductions on your annual tax return, the IRS allows you to deduct home
mortgage interest payments; for state returns, the deduction varies. Check with
a tax professional for specific advice regarding the qualifying rules. For many
home owners, this mortgage interest deduction is one of the largest write offs
they can ever take advantage of.
favors home buyers via the tax code, and for many families, the right home
purchase is the best way they can build an asset as their retirement nest egg.
Also, if you can refrain from cash-out refinancing, the home you buy at age
30 with a 30-year fixed rate mortgage will be fully paid off by the time you
reach normal retirement age, giving you a low-cost place to live when your
earnings taper off. In spite of the turmoil following the financial crash of
2008 and the subsequent collapse of the housing bubble, home ownership is
something you should consider in your long-term financial planning.
By Joy Toltzis Makon – To view the original
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