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The Mechanics of Home Mortgage
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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:
- "Principal" - Which, as discussed above, is the
actual mortgage balance.
- "Interest" - Which is the gratuity paid to the
lending company as reward for their taking financial risk with you.
- "Taxes" - Which are assessed by various government
agencies.
- "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.
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