Tall on Real Estate Service

J oanne Tarantino, CRS

Mortgage 101

How A Mortgage Works

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 payyment 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. 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 up front, 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 versus 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.

Length Of Your Mortgage

15 year, 30 year, or a bi-weekly 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 in 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 are 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.

Closing Costs

The bundle of fees associated with the buying or selling of a home are called closing costs. Certain fees are automatically assigned to either the buyer or the seller; other costs are either negotiable or dictated by local custom.

Buyer Closing Costs

WhenWhen a buyer applies for a loan, lenders are required to provide them with a good-faith estimate of their closing costs. The fees vary according to several factors, including the type of the loan they applied for and the terms of the purchase agreement. Likewise, some of the closing costs, especially those associated with the loan application, are actually paid in advance. Some typical buyer closing costs include:

The down payment

Loan Fees (points, application fee, credit report)

Prepaid interest

Inspection fees

Appraisal

Mortgage insurance (typically 1 year's premium plus an escrow of 2 months)

Hazard insurance (typically 1 year's premium plus an escrow of 2 months)

Title insurance

Documentary stamps on the note

Seller Closing Costs

If the seller has not yet paid for the house in full, the seller's most important closing cost is satisfying the remaining balance of their loan. Before the date of closing, the escrow officer will contact the seller's lender to verify the amount needed to close out the loan. Then, along with any other fees, the original loan will be paid for at the closing before the seller receives any proceeds from the sale. Other seller closing costs can include:

Broker's commission

Transfer taxes

Documentary stamps on the deed

Title insurance

Property taxes (prorated)

Negotiating Closing Costs

In addition to the sales price, buyers and sellers frequently include closing costs in their negotiations. This can be for both major and minor fees. For example, if a buyer is particularly nervous about the condition of the plumbing, the seller may agree to pay for the house inspection. Likewise, a buyer may want to save on up-front expenditures, and so agree to pay the seller's full asking price in return for the seller paying all the allowable closing costs. There's no right or wrong way to negotiate closing costs; just be sure all the terms are written down on the purchase agreement.

Prorations

At the closing, certain costs are often prorated (or distributed) between buyer and seller. The most common proration is for property taxes. This is because property taxes are typically paid at the end of the year for which they were assessed. Thus, if a house is sold in June, the sellers will have lived in the house for half the year, but the bill for the taxes won't come due until the following year! To make this situation more equitable, the taxes are prorated. In this example, the sellers will credit the buyers for half the taxes at closing.