Your mortgage payment consists of PITI - Principle, Interest, Taxes, Insurance. You'll also have to add in your PMI if you have it or your 2nd trust if you have one.
Other monthly expenses which are not included in the mortgage but which should be factored into your budget are HOA/Condo dues and estimated utilities.
Insurance and Taxes
Now, let's go back to PITI. I want to talk about the taxes and insurance first. When you first get your mortgage, the lender has a vested interest in what happens to the house - if you foreclose, etc. - the lender is stuck with your house. For that reason, they don't want to take any chances that the home owner won't pay their taxes and home owner's insurance. So, they divide the yearly amount due by 12 and wrap it into your required monthly mortgage payment. On their side, they hold this money in an escrow account and pay the insurance company and county directly when the insurance and taxes are due. You probably won't receive a bill for either of these things, but if you do, you should let your lender know b/c they have probably already paid it.
Interest and Interest Only Loans
Now, about interest. This is really simple to calculate b/c it's simple interest (he he). You take the principle amount of the loan, multiply by the interest rate (which gives you the yearly amount of interest), and divide by 12 to get the monthly amount.
So, let's say you buy a house for $400,000. You have a 5% downpayment - that's $20,000. And you have a 95% 1st trust - that's a principle of $380,000. The interest rate is 6.5%. So, the interest due in the first month will be $380,000*.065/12 = $2,058.
(Note, for this example, you would also have a PMI or Primary Mortgage Insurance factored into your mortgage - see previous post).
If you have an interest only loan, your mortgage payment will not include any payment toward your principle. But, as with any loan, you have the option to make additional principle payments in any amount at any time. When you do make the principle payments, the amount of your next interest only mortgage payment will be reduced because it will be based on the new, reduced principle amount.
Principle and Amortized Loans
If you have an amortized loan, your mortgage payment will include a principle payment and the sum of principle and interest will be exactly the same each month. The interest portion is still calculated the same way - simple interest. So, what ends up happening is that you pay a lot more interest in the beginning and at some point, you start paying more principle per month than interest.
What happens if you make extra principle payments when you have an amortized loan? It does not reduce the amount of the monthly payment that is due, but it does reduce the life of your loan. So, for example, if you had a 30 year fixed amortized loan, and you consistently made extra principle payment, you may pay off all the principle in 20 years instead of 30 years.
There is a complicated amortization formula that is used to determine the monthly payment that would be required in order to pay off the principle by the end of the loan period. See the link to the wikipedia page for the formula. If you like excel, use the PMT function. And there's a lot of scientific and financial calculators that can do this as well.
I will be happy to provide you with an amortization table for your specific situation if you would like - just say the word.
Here is the link to the wikipedia page on amortization - http://en.wikipedia.org/wiki/Amortization_(business)
Sunday, June 24, 2007
Nuts and Bolts of the Monthly Mortgage Payment
Friday, June 22, 2007
Shopping for a Mortgage
Although I am not a mortgage professional, I do have a detailed understanding of how home mortgages work and I have helped my buyers navigate between the different plans out there to help them decide the best option for them. So here are my thoughts on mortgages and steps to take with your finances up to a year in advance of your home purchase.
A year prior to home purchase
You should check your credit report for errors a minimum of a year before you start looking for a house. You should get all of those errors cleaned up so that your credit score is as high as possible when you do apply for a loan. Your credit score determines your interest rate - the higher the credit score, the lower your interest rate. Keep a close eye on your credit after that and make sure no new errors pop up.
Three months prior to house shopping
Start keeping a detailed record of your income and expenses. Then, use this to get a really clear idea of what type of monthly mortgage payment will be comfortable for you and what types of things you'll have to reduce or cut out if you have that mortgage.
For first time home buyers - you should also go through the exercise of pretending you have that mortgage for these three months. You should put the difference between your rent payment and your expected mortgage payment into a savings account.
Savings
Even after the home purchase, you should have two months of living expenses in savings as an emergency fund. Don't empty the bank for your home purchase. Life is full of unexpected surprises.
A month prior to house shopping
You should have your loan approval in hand before you start looking at homes. This is something that I have often seen buyers overlook or ignore. When you make an offer on a home, your approval letter should be included with the contract. Not only does the offer look unattractive to the seller without an approval letter, but it can be very overwhelming to deal with a contract at the same time as mortgage shopping. I had a buyer that actually backed out on me the night we were supposed to write the offer because he had just started talking to lenders and was thoroughly confused. We ended up writing the offer three days later - after I gave him a crash course on mortgages.
It is best to talk with two or three local lenders and compare their rates and plans. Internet lenders may not know the taxes or other charges that are typical for your particular state and you may end up with a nasty surprise at the last minute. The bottom line is you should work with someone that you can talk with in person. I can provide you with referrals if you would like - I have an especially good one for first time home buyers that are strapped for cash.
ARMs
The 30 year fixed option is not usually the best option for folks in the DC area, unless you are buying your permanent home. A lot of people just compare rates on 30 year fixed mortgages but they are not going to live in that house for 30 years. So, if it is likely that you will move again in a few years, there might be better rates for mortgages with ARMs. This is not an interest only loan. It is a fully amortized loan where the rate is initially fixed for some number of years and can adjust after that. If you move, you would have to obtain a new loan for the new property at new rates regardless. So the only risk with an ARM loan is if major life circumstances prevent you from moving again when you had planned. It is a risk you must carefully consider.
Interest Only Loans
An interest-only loan is one where the required mortgage payment does not include a principle portion. So if only the required payments were made, the only equity in the home would be based on the appreciation of the house value. The nice thing about this loan is that if you do make principle payments, the required monthly payment will decrease which is not true for amortized loans.
If the interest rate is lower on an interest only loan, this might be the best option for someone who has discipline and will make principal payments. It is ideal for someone with fluctuating income or someone who is fairly certain they will be making a lot of money in a few years.
PMI vs. 2nd Trust
If your downpayment is less than 20% of the sales price, you will be required to either pay Primary Mortgage Insurance (PMI) or to have a 2nd trust.
PMI is tax deductible as of 2007 so it is coming back into the market now. There are two types of PMI - the monthly payment option as well as the financed option. The financed option is where you pay a lump sum for the PMI - like $3000. It gets financed into your loan so you don't actually see this. The financed option usually ends up being cheaper for the buyer. As soon as your loan to value ratio is 80%, you can request that the PMI be removed.
The 2nd trust plus downpayment plus 1st trust will equal 100% of the sales price. For example, you may have 5% down, 15% 2nd trust, and 80% 1st trust. The interest rate for the 2nd trust is higher than the 1st because it represents higher risk for the lender. With this option, you must pay the full amount of the 2nd trust, regardless of the house value. Also, you may not be able to borrow money against your house if you have a 2nd trust - people frequently do this for home improvements, etc.
In order to compare the two, you should do a side-by-side of how much is going toward principle and how much is tax deductible interest/PMI for each plan. I have spreadsheets that I use to do this that I would be happy to share with you.
Summary
Depending on whether you have a limited monthly payment you can afford, whether you are planning on moving within a few years, your risk tolerance, and/or whether you are just trying to put the maximum amount of principle toward your house every month and the least amount of interest/PMI, you will need to decide on the mortgage plan that is best for you.
I highly recommend being cautious in order to avoid financial stress in the future. You should decide on a maximum monthly payment and stick with it during your home search. AND, your maximum monthly payment should not be at the top edge of what you can really afford or require a significant lifestyle change if that will be difficult for you.
No one can predict the future - you can't know if your house will appreciate significantly by the time you are ready to sell or if it will be a buyer's market or seller's market or what life circumstances will cause you to have to sell.
Please feel free to e-mail me or post a comment if you have questions or would like to discuss any of these topics further.
