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First time home buyer series : Deciphering a Mortgage Payment

This is a guest post from Tali of Zillow.com. As we have started looking into buying our first home, when Tali contacted me about writing a guest post, I asked if Zillow could take up a topic that will be useful for all first time home buyers. I will be writing my own series of posts on what I have learned hunting for our first home starting next Monday, but before that here the post from Zillow.

Mortgage payments are often a homeowner’s most expensive and complex monthly cost.  In the whirlwind of buying a home, the clarity of fees and terms can become blurred, misunderstood or forgotten.  After purchase, a homeowner may know the amount of their monthly payment but not understand where their money goes or what exactly it’s paying for. When homeowners fully understand their mortgages, they are better prepared to pay on time and more informed to consider options that can decrease their overall costs.  Mortgages are long-term loans for buyers that are financed by lenders.  Loans vary depending on the lender, type of program, interest rate, state laws, government programs and overall terms.  However, mortgages all include four standard elements referred to as PITI: principal, interest, taxes and insurance.  Some mortgages require a fifth cost, private mortgage insurance, or PMI.

Principal

A mortgage principal is the total amount of money borrowed from the lender.  A homeowner’s principal is the difference between the price of the home and the down payment. If the buyer provides a down payment of 20 percent of the selling price, the principal will be the remaining 80 percent borrowed from the lender.  The more money the buyer pays in the down payment, the less money the buyer needs to borrow from the lender, decreasing the principal.  Conversely, a smaller down payment requires a higher principal.  The final amount of the loan is called the principal.

Generally, homeowners pay a portion of their principal each month. In the first years of a loan, monthly mortgage payments consist of more interest than principal.  Over time, payments toward the principal increase, and the interest payments decrease.  Most loan terms allow homeowners to apply additional money toward their principal on any mortgage payment.  If the principal is paid off ahead of schedule, the amount of total interest paid by the borrower decreases, reducing the overall cost of the mortgage.

Interest

Mortgage interest is the amount paid to the lender for borrowing money, in addition to the principal.  The interest compensates the lender or loan servicer for the risk in loaning money to the borrower.  Mortgage interest is expressed as a rate or annual percentage of the principal.  For a standard loan, the interest rate is fixed, meaning the rate stays the same throughout the life of the loan.  However, the cost of insurance decreases as the borrower pays off the balance of the principal.

Lenders set interest rates individually.  The rates are their price for loaning the borrower money.  Rates are fairly consistent between local lenders but can vary dramatically when comparing properties in two separate locations.  The lender offering the lowest rate is generally the best option.  Other factors to consider are origination fees, loan program options and loan terms. Interest rates directly affect the size of the monthly mortgage payment.  Depending on the type of loan program, the higher the interest rate the less the buyer can afford to borrow.  When the interest rate is low, the monthly cost of the mortgage remains manageable.  Therefore, a monthly payment to purchase a big, expensive home at a low interest rate may cost the same as it would to buy a small, inexpensive home at a high rate.

Credit scores heavily determine the interest rate the buyer is offered by the lender.  Buyers with high credit scores appear financially responsible and low-risk to lenders.  When a lender loans money to a buyer with a low credit score, the risk of losing their money is much greater.  Lenders taking on more risk require higher interest rates.  For that reason, borrowers with high credit scores more frequently get approved for lower interest rates, which reduces borrowers’ monthly mortgage payments and total mortgage costs over the life of the loan.

Taxes

Property taxes are required for all homeowners.  Each county determines the annual property taxes.  Buyers can locate the annual taxes for a property through the seller, the local agent or through the local tax assessor.  Zillow provides tools for buyers to decipher mortgage costs, including the estimated monthly cost for taxes.  Each property listed for sale includes a link to the county’s tax assessor website for additional tax information.

The terms of the loan may specify how the property taxes will be paid.  Some lenders require the buyer to set up an account funded with a portion of the property taxes prior to closing.  Such accounts are referred to as escrow accounts; they hold funds until the loan servicer disperses them.  Other loan terms require a tax payment each month.  Annual property taxes are the homeowner’s obligation, but the payments are often managed by the lender to ensure no tax liens are issued, which can jeopardize the mortgage.

Homeowner’s Insurance

The lender will require the buyer to purchase homeowner’s insurance, also referred to as hazard insurance.  This type of insurance protects the homeowner’s personal property and home in case of a fire, theft or natural damage or disaster.  Depending on the loan terms, if the homeowner does not buy insurance, the lender can purchase homeowner’s insurance on behalf of the homeowner, called force placed insurance.  This option is generally more expensive and provides less coverage for the homeowner.

Like property taxes, some loan terms require homeowner’s insurance funds to be added to the escrow account.  The lender disperses the insurance payments on schedule to avoid late or nonpayment by the homeowner.  If there is a lapse in payment, insurance coverage stops and any damage to the property could burden the homeowner’s ability to pay the mortgage.

Private Mortgage Insurance (PMI)

Private mortgage insurance is paid by the borrower to the lender to protect the lender’s investment.  This type of insurance is only required for some loan programs, and commonly when the buyer’s down payment is less than 20 percent of the selling price of the home.  Until the owner has 20 percent equity in the home, the loan is considered high risk.  Private mortgage insurance is required to spread that risk between the lender and the mortgage insurance company.  The buyer pays the lender PMI, and the lender then pays the insurance company.  If the buyer cannot repay the loan, and the lender cannot recover the cost after foreclosing the property, then the mortgage insurance company pays the lender.

Specified in the loan terms, PMI may be paid up front or in monthly increments as part of the mortgage payment.  The cost of PMI differs based on specific factors of the loan.  The borrower’s credit score is a major determinate of PMI cost, along with the total amount of the loan, whether the borrower will be occupying the home and loan-to-value ratio.  Typical PMI costs can range from .19 percent to 1 percent of the principal.

Private mortgage insurance does not continue for the life of the loan.  Lenders require PMI to be paid for a fixed period of time, or until the balance of the principal reaches 80 percent.  Some lenders require the homeowner to pay for a new appraisal before canceling PMI. Private mortgage insurance provides an opportunity for borrowers with low credit scores to get approved for loans by reducing the risk to the lender.

In conclusion, it’s imperative for homeowners to understand the different elements of their mortgage payments in order to responsibly pay and track their payments.  When homeowners are informed, they may recognize and take advantage of payment options that reduce their total mortgage cost.  Prospective home buyers should also study the five features detailed above to better comprehend what to expect and look for when committing to future mortgage terms.

Suba’s note : As I mentioned in the opening paragraph, I will be starting my series on buying the first home next Monday, let me know if there are any questions that you want to see addressed. I will happy to include that.

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