The Mechanics of Home Mortgage

May 27, 2005 LOS ANGELES -- The home loan industry can appear a myriad compilation of mathematical equations, seemingly endless red-tape and documents. Most of us, when introduced to the mortgage process are confused. Whether it be a first time home buyer loan or, perhaps an individual who wishes to refinance an inherited residence with a balance, even the most adept analytic person can easily be overwhelmed with numbers, procedure and technical jargon, all of which appear as cryptic gibberish at times.

In this article, we will explain the mechanics of home loans, or in more common terms, "mortgage." We will attempt to make this article as understandable as-is humanly possible by publishing it in layman's terms. Sit back, have a drink of your favorite beverage and allow us to educate you the best way we know how, which is through simplicity.

Financing a home is agreeably the most important financial decision most individuals will make in a lifetime when the dollars are all added-up and the figures are in black and white. Although this is a fact, home buyers only need pay particular attention to a limited number of criteria. Over educating ones-self can be overkill, and unless you are planning on becoming a mortgage broker you likely can scale-down to basics the areas in which you should gain knowledge.

Let's start with rudiments: Even properties which some may consider to be of "low value" by contrast median (or average) home sale prices nonetheless share a common variable with any home on the sales market; all require a significant amount of money in order to make the purchase. It is quite rare that a residential property is valued at less than $80,000 these days, regardless of where the property is situated. Using this low figure, one can assume that, under normal circumstances, in order to purchase a property falling into this envelope the buyer would need to capitalize (raise) at least $72,000, assuming he or she has saved 10 percent ($8,000) as down payment. Most of us working folks can see that this is a considerable amount of "one dollar bills" if you were to pile-up 70,000-80,000 of them.

Because most consumers are not "liquid" (having available cash money) for this amount, logic dictates that there is need to borrow this large sum of money from a financial institution which offers home loans on contingency of repayment in full within an agreed-upon amount of time.

How do these lending companies profit? In short, the bank profits by adding onto your repayment amount an "interest fee," which is generally a small percentage of the amount you repay annually. The actual interest rate a home buyer is assigned is based upon the duration of the loan, down payment amount and certainly depends largely upon the credit rating of the borrower at such time he or she locks the home loan rate. More on interest rate and criteria associated with such further-on in this article.

Most home loans for single family residences, or SFR's, carry a repayment term between 15 and 30 years. With each monthly mortgage payment the borrower chips-away at the "principal" (actual amount borrowed) balance. In the beginning part of the home mortgage repayment term, a majority of the monthly payment is contributed to paying the bank its interest on the loan. As the loan term progresses, an increasingly larger percentage of the payment is contributed toward the principal amount. A simple way to look at it is that principal is paid slowly at first and then considerably more rapidly toward the fruition, or end, of the loan term.

Now we will help you understand how payments are broken-down. There are several fancily-worded parts of your monthly payment. What is actually "in" the payment is actually not very complex. First off, understand that when escrow is used to fund a home finance, the monthly mortgage payment is technically referred-to as a "PITI" payment by the bank. PITI is an abbreviation for the following:

1. "Principal" - Which, as discussed above, is the actual mortgage balance.
2. "Interest" - Which is the gratuity paid to the lending company as reward for their taking financial risk with you.
3. "Taxes" - Which are assessed by various government agencies.
4. "Insurance" - Which ensures that the bank's investment is protected/underwritten in case theft, fire, hurricanes or other disaster should occur.

On the whole, mortgage companies require that taxes and insurance be paid out of escrow. The reason for this is that the lender is in a "comfort zone" (so to speak) right from jump street having eliminated worry over possible tax liens or other losses that could put the typical borrower in a position to where they were not able to repay. There are occasions when a finance company will make allowance to this rule by giving the borrower the option to pay property taxes and insurance in lump sums when they are due. Depending on the type of home mortgage a borrower uses to finance a home, sometimes monthly payments include a separate levy for insurance.

Next let's take a peek at the finer details of mortgage payments. There is a formula used to breakdown each payment to the penny. This formula is called "amortization". Simply put, the amortization schedule details how much goes toward the principal, how much toward interest, etcetera. The amortization charts is constantly morphing, with respect to numbers, with each scheduled payment. The reason is that the lender spreads the interest due over hundreds of payments. It is because of this amortization that the bank can keep monthly payments low and reasonably achievable.

You may be asking yourself how much interest you would actually end-up having paid over the course of, say, 30 years when summed up. This is a good question. Some may experience shock at the actual amount they pay the bank over-and-above the amount owed over the course of a quarter century. Below is a simple outlay of what would be paid in interest to the home finance company over 30 years at a fixed interest rate for a $150,000 mortgage:

Assuming that the mortgage carries a locked, fixed interest rate of 7.5%, a homeowner can expect to shell-out an additional $227,575.83 in interest. This is over and above the actual $150,000, so when you add both together you see a figure totaling $377,575.83. This example assumes that the borrower keeps the residence the entire 30 years.

Common sense dictates that a financing company can not expect the average consumer with a median income to repay $200k+ in the beginning of the loan term, so the interest is amortized, or worded differently: spread over the 30-year term. The monthly payment comes in at a comfortable and reasonable $1,048.82.

Remember this simple rule of thumb: A good way to keep payments on an even keel is to ensure that a lion's share of your payment each month is applied to the interest you owe in the first six years or so of a 30 year fixed interest rate home loan. We'll leave you with a final example: Using the $150,000 home example from above, the first month's payment, would only apply $111.32 toward principal amount owed. $937.50 would be applied toward the interest. Remember that this ratio changes dramatically over the course of time by comparison. So, using the same figure we can see that amortization would make the interest portion of the borrower's second-to-last payment a mere $12.99. That means $1,035.83 of the second-to-last payment would apply to the principal. - Article by Arthur "Guy" Weiss, Mortgage Columnist and Home Finance Market Analyst. Email Mr. Weiss.