Mortgage Information
Preparing for the biggest credit decision of your life
When it comes time for you to shop around for a mortgage, often times you cannot rely on a mortgage broker or bank to decide what type of loan is best for you. A basic understanding of what makes up a loan, and knowing what different loans do for you before you shop, is essential to today's smart consumer.What Makes Up a Mortgage Payment
When you make a payment on a mortgage, there's a lot more to it than just paying money towards the loan, or principal. Interest, insurance and taxes (and Escrow account) will need to be taken into consideration.
INTEREST RATE
The interest rate on a loan is at what percentage of the loan the lender charges every year. As the loan is paid off, the balance of the loan decreases, and so does the money the lender makes from the interest.
For example, on a 30-year loan for a $100,000 mortgage at 5%, the lender will make approximately $5000 from the loan during the first year. The second year, with the loan balance down around $98,000, the lender will make approximately $4,900 from the interest.
Why is the balance of the loan still so high after the first year of payments? Because very little of the payment goes toward the principal, or actual balance of the loan.
For example, on the same loan for $100,000 at 5% interest over 30 years, the payment would be around $600. Of the first payment, $500 goes to the interest, and only $100 going to the principal. The next month, the loan balance is at $99,900 (having paid $100 on the principal). So, 5% of $99,900 is $499.50, which will now be put towards the interest, and $100.50 will be put towards the principal bringing the loan amount down to $99,799.50.
During the last few months of the loan (after 30 years of paying on it), the loan amount will be so low, the amount of the monthly payment going to the interest rate will be only a few dollars, and the rest will go to paying off the loan.
As you can see, a lot of money is going to the interest on the loan over the years. On this example a whopping $149,555.45 is being paid to the lender for the privilege of borrowing their money for the home. So the total amount paid for the $100,000 home is $249,555.45! The loan repayment detail, which spells out how the payments are applied and the total interest paid, is normally shared with borrowers during the loan closing process and is called an Amortization Table.
Finding the best interest rate can save you thousands of dollars over the life of the loan, but you'll want to also take other things into consideration…
MORTGAGE INSURANCE
If you borrow more than 80% of a property's value, you will be required by the lender to have mortgage insurance to ensure you do not default on your payment. Depending on your property's value, this may add between $40 to $100 or more to your mortgage payment each month.
Some lenders will work with you to break up the loan into a first and second loan to avoid this added cost. For example, if home has a market value of $100,000, and you bought it for $85,000, the loan will be 85% of the home's value. A first loan could be taken at $79,000 (bringing it to under the 80% required amount for insurance) and the second loan will be for $6000 to cover the rest.
ESCROW ACCOUNT (For Property Taxes and Homeowner's Insurance)
If you own property, you have to pay taxes on it every year. Instead of paying an exorbitant amount at the end of the year when taxes are due, the amount is broken up between payments that then go into an escrow account set up by the lender. At the end of the year, the total amount should cover (very closely) the taxes on your house, and are paid directly to the county. Some lenders may require this account, while others make it optional.
For example: If you own a $100,000 house in Tulsa, Oklahoma, you can expect to pay $1,000 in property taxes at the end of the year. If you pay monthly, an additional $83.33 will be added to your payment every month to go into your Escrow Account. At the end of the year, that money is paid to the county government.
Once a year, property taxes can be reassessed and your escrow account will need to be adjusted.
The escrow account can also be used to gather money for Homeowner's insurance premiums, to be paid to your insurance company when due.
Closing Costs
Your typical loan can add thousands of dollars in closing costs that the lender will need to be paid. Depending on the loan type, these costs can be added to the loan and then paid to the lender when the loan is approved. This increases the amount of the loan (and the payments), but requires little or no money down from you to get into the property. The most basic items that make up your closing costs are:
POINTS
Points are an up-front fee paid to the lender at closing to lower or increase the rate on the loan. Each point equals one percent of the loan amount.
For example:
LOAN A: $100,000 loan at 0.5 points = $500 charge in points.
LOAN B: $100,000 loan at 1.5 points = $1,500 charge in points.
Points are charged, or paid, to lower or increase the rate on the loan, so sometimes it is wise to pay the points cost out of pocket to get a lower interest rate. Most lenders will allow you to choose amongst a variety of rate and point combinations for the same loan product. Therefore, when comparing rates of different lenders, make sure you compare also the associated points.
TITLE FEES & ATTORNEY FEES
Every property has a title that affirms who owns it. When the title must change hands from one owner to another (or to a lender, who keeps it until the debt is paid) a title company or attorney can charge multiple fees. These may include:
There may be more or less depending on the lending company. Always get this information up front when shopping for a mortgage loan.
APPRAISAL FEES
When a home is being looked at for consideration by a lender, they want to know that it is worth the amount of money they are lending for it. An appraiser will come out to the home and determine its approximate market value for a fee. This can be anywhere from $100 to $1000 depending on your market. Normally this service includes a copy of the appraisal for you, so that you may review the specifics of the valuation.
LENDER FEES
Sometimes there can be associated lender fees when dealing with certain banks, or lenders who charge for this service. These can include:
Always check for these costs and compare when looking for a loan.
OTHER FEES:
Always check with your lender to see if there are other state or city fees that you may not know about. These may include:
Different Types of Loans
FIXED RATE
The most common of mortgage programs, the interest rate will stay the same throughout the life of the loan, no matter how volatile the market is. During the entire life of the loan, the payments stay the same, calculated out to pay the loan off at the end of the loan. Property taxes and homeowners insurance may increase, but generally your monthly payments will be very stable. This is best when planning on staying in your home for a longer period of time (7-10 years or more).
A typical 30 year fixed rate mortgage takes 22.5 years of level payments to pay half of the original loan amount. With this is mind, the following chart shows what you can expect over the course of our typical 30-year, $100,000 mortgage loan at 5%.
20-YEAR AND LESS MORTGAGES
When the duration of the mortgage decreases, the payments increase to pay back the principle faster. As a direct result of the decreased time, less interest is charged. See the following chart of a 20-year loan depicting our example mortgage:
Less Loan Time = Larger Payments & Less Interest
And even less interest is paid with 15-year and 10-year mortgages:
MAKING EXTRA PAYMENTS
There are also "bi-weekly" mortgages, which shorten the loan by calling for half the monthly payment every two weeks. (Since there are 52 weeks in a year, you make 26 payments, or 13 "months" worth, every year.) Making extra payments in any way goes directly towards your principal. Here, our example loan gets the "13th" payment every year. Notice the difference between making the extra payment and the standard 30 year loan above:
Extra Payment goes directly to paying off principal, shortening the loan time
You can also apply this method directly to your payments without setting up a special program with your lender. Adding an extra $100 to every payment is $1200 every year going directly to the principal. See what a difference this makes:
Remember, any extra money you put towards the loan beyond the pre-determined payments goes directly to the principal, shortening the loan time and subsequently the amount of interest you pay.
ADJUSTABLE RATE MORTGAGE (ARM)
These loans generally begin with an interest rate that is 2-3 percent below a comparable fixed rate mortgage, and could allow you to buy a more expensive home. However, the interest rate changes at specified intervals (for example, every year) depending on changing market conditions; if interest rates go up, your monthly mortgage payment will go up, too. However, if rates go down, your mortgage payment will drop also. There are also mortgages that combine aspects of fixed and adjustable rate mortgages - starting at a low fixed-rate for seven to ten years, for example, then adjusting to market conditions. As a rule the lower the start rate the shorter the time before the loan makes its first adjustment.
ARMs with different indexes are available for both purchases and refinances. Choosing an ARM with an index that reacts quickly lets you take full advantage of falling interest rates. An index that lags behind the market lets you take advantage of lower rates after market rates have started to adjust upward. The interest rate and monthly payment can change based on adjustments to the index rate.
6-Month Certificate of Deposit (CD) ARM
Has a maximum interest rate adjustment of 1% every six months. The 6-month Certificate of Deposit (CD) index is generally considered to react quickly to changes in the market.
1-Year Treasury Spot ARM
Has a maximum interest rate adjustment of 2% every 12 months. The 1-Year Treasury Spot index generally reacts more slowly than the CD index, but more quickly than the Treasury Average index.
6-Month Treasury Average ARM
Has a maximum interest rate adjustment of 1% every six months. The Treasury Average index generally reacts more slowly in fluctuating markets so adjustments in the ARM interest rate will lag behind some other market indicators.
12-Month Treasury Average ARM
Has a maximum interest rate adjustment of 2% every 12 months. The treasury Average index generally reacts more slowly in fluctuating markets so adjustments in the ARM interest rate will lag behind some other market indicators.
ARM Definitions:
Index - The index of an ARM is the financial instrument that the loan is "tied" to, or adjusted to. When the index goes up, the rate goes up. The most common indices, or, indexes are the 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI). Each of these indices move up or down based on conditions of the financial markets.
Margin - The margin is one of the most important aspects of ARMs because it is added to the index to determine the interest rate that you pay. The margin added to the index is known as the fully indexed rate. As an example if the current index value is 5.50% and your loan has a margin of 2.5%, your fully indexed rate is 8.00%. Margins on loans range from 1.75% to 3.5% depending on the index and the amount financed in relation to the property value.
Interim Caps - All adjustable rate loans carry interim, or interest rate caps. They determine how fast or slow your rate changes after the market has changed. Many ARMs have interest rate caps of six-months or a year. There are loans that have interest rate caps of three years. Interest rate caps are beneficial in rising interest rate markets, keeping your rate low for the cap period, but can also keep your interest rate higher than the fully indexed rate if rates are falling rapidly.
Payment Caps - Some loans have payment caps instead of interest rate caps. These loans reduce payment shock in a rising interest rate market, but can also lead to deferred interest or "negative amortization". These loans generally cap your annual payment increases to 7.5% of the previous payment.
Lifetime Caps - Almost all ARMs have a maximum interest rate or lifetime interest rate cap. The lifetime cap varies from company to company and loan to loan. Loans with low lifetime caps usually have higher margins, and the reverse is also true. Those loans that carry low margins often have higher lifetime caps.
NEGATIVE AMORTIZATION
With an ARM loan, and also a Graduated Payment Mortgage (see below) a borrower can have a payment cap that limits how much they are obligated to pay every month. But when the rate changes, and creates a payment larger than the cap, the extra amount doesn't just go away, it is added to the loan. This can create Negative Amortization and can create very scary results for those who may be forced to sell due to relocation or any other situation. Their loan could be at a higher amount than when they took it out!
For example, if a borrower takes a 20-year ARM out for $100,000 on a home that is worth exactly that, with a $700 payment cap, they could find themselves owing $800 each payment, due to changing interest rates. This extra $100 goes to the loan, and in two years, if they tried to sell the house, their loan payoff amount would actually be $102,400! They didn't obtain any equity in their home - they lost it!
FLEX-PAY (Interest-Only) OPTION
An option some lenders offer is a flex-pay, or interest-only option, that allows a borrower to pay only the interest for an amount of time, usually 1-5 years. This is a nice option for getting into a more expensive house that you plan to sell in a few years, hoping the property increases in value during the time you are there (since nothing will be paid toward the principal during the flex-pay option). This option is like renting the house from a lender, and when the flex-pay period is finished, a higher payment will kick in, to start paying off the principal.
BALLOON LOAN
Balloon loans are short-term mortgages that have some features of a fixed rate mortgage. The loans provide a level payment feature during the term of the loan, but as opposed to the 30 year fixed rate mortgage, balloon loans do not fully amortize over the original term. Balloon loans can have many types of maturities, but most balloons that are first mortgages have a term of 5 to 7 years.
At the end of the loan term there is still a remaining principal loan balance and the mortgage company generally requires that the loan be paid in full, which can be accomplished by refinancing. Many companies have other options such as a conversion feature at the end of the term. For example, the loan may convert to a 30 year fixed loan at the thirty-year market rate plus 3/8 of a percentage point. Your conversion can be guaranteed based on certain criteria such as having made your last 24 payments on time. The balloon mortgage program with the conversion option is often called a 7/23 Convertible or 5/25 Convertible.
GRADUATED PAYMENT MORTGAGE (GPM)
The GPM is another alternative to the conventional adjustable rate mortgage, and is making a comeback as borrowers and mortgage companies seek alternatives to assist in qualify for home financing.
Unlike an ARM, GPMs have a fixed note rate and payment schedule. With a GPM the payments are usually fixed for one year at a time. Each year for five years the payments graduate at 7.5% to 12.5% of the previous years payment.
Unlike the ARM that only has a chance of going into negative amortization, the GPM is setup to go increase the amount of the loan as the first payment trickle in. That's because the first payments are lower, then slowly increase every year. For example, take a look at our $100,000 loan on a typical 7.5% GPM:
The lower qualifying rate of the GPM can help borrowers maximize their purchasing power, and can be useful in a market with rapid appreciation. In markets where appreciation is moderate, and a borrower needs to move during the scheduled negative amortization period they could create an unpleasant situation.
TERMS OF CONVERSION OPTIONS
Another item to look after is what terms the lender provides for converting the loan from one type of loan to another during the mortgage duration. For example, this is helpful when starting as an ARM to avoid large payments, then switching to a fixed rate at a higher payment when your income increases.
2nd MORTGAGE LOAN (EQUITY LOAN)
When you have enough equity in your home to take a loan out on it for home improvements, to pay off high-interest credit cards, other loans, or just use it for whatever you want, you'll have to look into a 2nd Mortgage loan. This loan is borrowed against your home just like the first, and if you default on it, the lender could try to take your home, sell it and use the funds to cover themselves.
2ND MORTGAGE LINE OF CREDIT
This loan is just like a 2nd Mortgage Loan except that it offers an open line of credit, much like a credit card. Once the loan is paid down, the credit can be used again for whatever you like. If you pay only the payments (which are normally interest-only payments) the loan balance is never paid down.
BRIDGE LOAN
Sometimes, to be able to get a lower interest rate on a loan, a lender will do a bridge loan. This means the lender will give a loan, the immediately turn around and refinance at a lower rate. Even though the interest rate may be good for some, the closing costs can double because of the two loans. Make sure you always get the straight scoop from your lender before sitting down at the closing table.
When Shopping For a Mortgage Loan
Beyond the basics of the loan, there will be additional things you will want to be on the look-out for:
LOCK-IN PERIOD
The lock-in period, is the time frame in which the quoted interest rate is guaranteed. Even if interest rates skyrocket the next day, you still have the option to secure your loan at the quoted rate. Lock-ins of 30, 45 and 60 days are common. Some lenders may offer a lock-in for only a short period of time (15 days, for example). Usually, the longer the lock-in period, the higher the price of loan.
PREPAYMENT PENALTY
Mortgage companies are in the business of making money off of your loan interest. If you should completely pay off a loan, by refinancing with another lender or simply by paying it off in full, they would lose their lucrative interest rate money from the first few years. So, a lot of lenders tack on a prepayment penalty that ranges anywhere from $300 to $2000 in case you pay off your loan early (usually 2-3 year time period, but could be as high as 5 or even 10 years). This ensures that they make money no matter what. There are many lenders who do not have a prepayment penalty on their loans. However, if you plan on staying in your home, choosing a prepayment penalty clause may assist you in lowering your overall interest rate.
SAVING YOU THE MOST MONEY
Whether you're looking for the traditional fixed rate, or looking to get a more expensive home, and save on payments with a GPM or ARM, the single most money-saving item on the loan is what interest rate you can qualify for. If your credit doesn't allow you to negotiate on your terms, then you may not have a say in what loan you can afford.
How much is it worth to clean up your credit report? Let's look at what a difference even one interest point can make:
Our $100,000 mortgage over 30 years compared from 7% to 8% shows a difference of $25,478 in savings over the life of the loan. That's 25 grand! Does improving your credit score now make a difference! All the difference in the world. Not only does it save you tons of money in the long run, but over $50 on your payment every month.
Solving Your Credit Problems
Your credit report influences your purchasing power, as well as your chances to get a job, rent or buy an apartment or a house, buy insurance or even rent a car. Accurate negative information can stay on your report for seven years. A bankruptcy can stay on your report for 10 years!
It is possible, and legal, to clean up your credit report. Join over 80,000 people who have used Lexington Law firm to improve their credit score and get back on track to better credit. To learn more about our services, please visit www.lexingtonlaw.com.
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