What’s in a Mortgage Loan Payment
A monthly mortgage payment is made up of many different elements. When you write your monthly mortgage check, you aren’t just paying toward the principal of your loan. The monthly mortgage payment is also paying interest, taxes, insurance, and possibly other fees. Before we look at the components of a mortgage loan payment let us review the components of the home loan first.
The home loan starts with the principal amount of the loan. The sum of money you initially borrow is the principal balance. Now you look at how long you will have to repay the loan, this is the term. The term of the loan is its duration or the length of time for repayment. Which brings us to the next key term, interest. The interest rate is the mortgage rate at which the lending institution charges you for borrowing the money. Once we have the basics of the interest rate charged, principal balance borrowed and the length or term of the loan we can calculate the monthly mortgage payments.
Amortization is a lending term used to define the repayment of a debt over time. In the early stages of a loan most of the payment will go towards paying the interest on the home loan. In the later life of the loan the monthly payment goes more towards reducing the principal balance. A mortgage’s amortization schedule can provide a detailed look at precisely what portion of each monthly mortgage payment is dedicated to each component of principal and interest.
Let’s take a look at the components of a house payment, and see where your money goes each month.
Principal and Interest Payment - This payment goes towards paying off the loan amount, or principal, and the interest that has accrued over the time period of the loan. You can use a mortgage loan calculator to help you determine possible P&I payment amounts as you consider a loan. You an also look at how much interest and principal repayment you will have over the life of the loan.
Real Estate Taxes - Your mortgage payment will also include one twelfth of the annual real estate taxes each month. Real estate taxes are calculated by the local government taxing authority, not the mortgage company, the lender collects the payments and holds them until the taxes are due to be paid. Lenders pass these taxes on to you monthly, because if they are not paid, the government can have a lien placed against the house. If the owner of the home fails to pay real estate taxes, the government can sell the property in order to collect back taxes. Escrowing these taxes ensures the mortgage lender that they will be paid.
Homeowners’ Insurance - Most mortgage lenders require a homeowners insurance policy for at least the amount of the home itself. The mortgage company often require that the first year of homeowner’s insurance be paid in full at closing. The mortgage company then continually stays ahead on the premium by escrowing 1/12 of the insurance payment with the monthly mortgage payment, which eliminates lapses in coverage on the part of the homeowner. Note that having only enough coverage to cover the value of the mortgage only protects the lender’s interests should the home burn or fall to some other catastrophe.
Private Mortgage Insurance Escrow - If the loan has a loan to value ratio of over 80%, this mortgage insurance covers the lender in case the mortgage holder defaults on the loan. If a down payment of 20% or more is put down, then this is not required. PMI coverage may be dropped once the value of the loan is at or under 80% loan to value. The mortgage insurance costs can be paid in a variety of methods including lender paid insurance in which there is an increase in the interest rate to cover the mortgage lenders cost. The lower the down payment, the greater the loan risk and the more expensive the mortgage insurance will be.
Homeowner’s Association Fees - If homeowner’s association fees are mandatory, than one twelfth of these fees may be added to the monthly mortgage payment. The process of adding homeowner’s association fees to the monthly payment is becoming very uncommon and the responsibility for the payment rests solely with the homeowner.
While principal, interest, taxes and insurance comprise a typical mortgage payment, some borrowers opt for mortgages that do not include taxes or insurance as part of the monthly payment. With this type of loan payment, referred to as waiving escrows, borrowers have a lower monthly payment, but must pay the taxes and insurance on their own.
Balloon Mortgages
Balloon loans have many of the same features of a fixed rate mortgage with one major exception; at the end of a predetermined amount of time the remaining balance of the loan is due in full. These home loans offer a level payment feature during the term of the loan, but as opposed to the 30 year fixed rate mortgage, balloon loans do not fully amortize over the original term. In a balloon mortgage loan contract, the borrower agrees to make a lump sum payment of the loan balance at the end of a certain period, typically two to ten years. At the end of the original term the home loan borrower must pay off or refinance that remaining mortgage balance. That is, the payment is calculated over 30 years but the balance must be repaid sooner.
Balloon loans can have many different maturities or terms, but most balloons that are first mortgages have a term of 5 to 7 years. Though the term of the home loan is 5 or 7 years, the payment calculation is based on a longer term, generally 30 years but can also be for 15 or 20 years. Sometimes theses home loans are often viewed as close substitutes for an adjustable rate mortgage. They have an initial fixed interest rate period of five or seven years which shortens the interest rate risk for the mortgage company and thus the mortgage rate to the borrower the result is that these home loans generally have a lower mortgage rate than that of a fully amortizing 30 year fixed rate home loan.
Balloon loans can keep the monthly payment lower than standard 30 year fixed rate mortgages but these home loans also have risks. The balloon loan will come due and if you don’t have sufficient funds to pay off the balance or a substitute loan in place this can spell trouble since the borrower will now be in default on the mortgage loan. The general rationale for incurring the added risk of the balloon feature is that since the vast majority of mortgages will never be paid in full because very few people remain in a home for the full length of their mortgage.
When choosing a balloon loan be sure you fully understand the time frames involved and the terms and conditions of repayment or conversion. This loan is generally used by borrowers who are fairly certain they will be moving from the house that they have the balloon loan on.
Avoid Over Paying Mortgage Junk Fees
Additional fees for obtaining a home mortgage that serve no useful purpose are called junk fees. Most fees associated with originating your loan are third party fees necessary to obtain a loan approval, examples are appraisal fee, credit report fee and flood certification fee. Fees that are not necessary and are paid directly to the originating mortgage company are junk fees. Most junk fees do have one main purpose – increase the profits of the firm arranging the loan in addition to the money that make on the mortgage rate.
In order to ascertain which fees are junk and potentially profiting the originator at your expense, you have to compare the costs of the loan. One of the biggest obstacles in obtaining the least expensive loan is being able to accurately compare loan quotes. A mortgage rate quote by itself is of little value. You need the interest rate, term, costs and loan program. Clearly there is no point in comparing the rate and cost of an adjustable rate loan to a fixed rate loan with different terms. Before you attack the junk fees and question the loan officer, evaluate the different loan products and then get a mortgage rate quote with a complete break down of costs.
When you’re going through the process of applying for the loan, you will be given a variety of documents. Mandatory disclosure documents that are given out with every mortgage application make the evaluation exercise much simpler. One such document is the Good Faith Estimate that covers all the costs associated with obtaining the home loan. Federal law requires all mortgage lending institutions to provide a good faith estimate of closing costs within 3 days of the borrower filling out an application. With the Good Faith Estimate you should also receive a truth in lending notice. This is another federally mandated disclosure that spells out the mortgage interest rate over the life of the loan. These two disclosure documents, combined, are the key to evaluating the home loan fees and costs.
On the Good Faith Estimate form the costs of the loan will be itemized by category. Some lenders will charge more than others in various categories. The category of the fee is often not as important as the total amount of the fees. As an example, if lender A charges a $400.00 processing fee and lender B does not, lender A is not necessarily the better deal if lender A charges a $1000.00 origination fee and lender B charges no origination fee. Compare total costs and groups of costs as opposed to focusing on any particular fee that jumps out as being a junk fee.
The first group of fees on a Good Faith Estimate is the fees to cover the lender or originating mortgage lender for their services. This group is the category of fees with the greatest amount of room for negotiation. Here you find the charges for origination fee, discount points, appraisal fee, credit report fee, processing fee, document preparation fee, underwriting fee and perhaps other related charges. Junk fees are almost always thrown into this group. The key is compare similar loans with more than one mortgage lender. The total fees are more important than how any lender breaks them apart.
The second group is the prepaid charges. There is really no room to overcharge here, so negotiating should be irrelevant. On a purchase, the homeowners insurance may go here and the interim interest for the time you have the loan until the start of the first payment cycle would be disclosed here.
The third group is reserve or escrow deposits. These deposits are dictated by the taxing authorities and the time of the closing. Escrow are fairly well regulated, it would be difficult to find abuse in this section.
The fourth section is the title and closing charges. It is not often you will find a mortgage company that will negotiate the title charges. The primary reason being that the title company or closing company is not related to the mortgage company in most cases. If the title company is related, negotiate this fee as low as possible. Even if they are unrelated, it never hurts to complain about the amount of the charges for title insurance and closing fees.
Even though negotiating and asking questions about the closing costs can be time-consuming, you may be able to save hundreds, or even thousands of dollars at closing. Get another rate quote if necessary from a competing mortgage company. Compare the figures. Ask if the fees can be reduced. Don’t be intimidated; there are an abundance of mortgage companies looking for your business. If the loan officer won’t help you, move on and find one that will. Asking for the best mortgage rate and best terms at the lowest cost is your right.
When you get to the closing make sure the fees that were explained to you at the time of the application and placed in writing on the good faith estimate are equivalent. The purpose of the good faith document is to let you know what loan fees that you may be paying at closing. At the closing you will receive a HUD-1 settlement statement to review and sign, be sure the fees on this document are the same as the fees in the good faith estimate. If you want to question any of the fees on the HUD-1 settlement statement, do it without delay. You may feel as if you shouldn’t question these fees, but you have a right to do so and you should understand all aspects of this process with its cost.
Shop wise. Don’t accept the first offer that comes your way. Closing costs are necessary evils of closing a mortgage for either a home purchase or refinance. However, at times, they are used to increase the income of the mortgage originator or lender in a deceptive manner. It’s the job of a good loan officer to explain all of the costs to you and expect that you may shop around. A good loan officer who does his or her job right should expect that of educated borrower and accept the competition. Any amount of money that you can save at closing will be worth it.
What Is PMI or Mortgage Insurance
PMI or private mortgage insurance is an insurance policy and premium payment that mortgage lenders require from most home buyers who obtain home loans that are more than 80 percent of their home’s value. In other words, buyers with less than a 20 percent down payment are normally required to pay mortgage insurance or PMI. PMI protects a portion of the mortgage lenders loss in case the borrower defaults on the mortgage. Should a default occur, the lender sells the property to liquidate the debt, and is reimbursed by the PMI company for any remaining amount up to the policy value.
A borrower may need to pay up to a year’s worth of premium for this coverage at closing, which can amount to as much as several hundred dollars. PMI is protection only for the lender but its advantage is that by displacing part of the risk, a lender accepts mortgage loans with less than 20% down payment. One obvious way to avoid this extra cost is to make a 20% down payment. There are also other ways to eliminate PMI such as piggy back loans such as; 80-10-10 financing. With a piggy back loan, the borrower takes out a first mortgage for 80% of the properties value and a second mortgage for 10% with 10% of the their own funds. If possible, a piggy back loan can be a first mortgage of 80% LTV and a second for 20%, for a total 100% financing.
Costs vary from mortgage insurer to mortgage insurer, as well as from plan to plan, depending on the loan-to-value ratio, and the particular mortgage loan program involved. For example, a highly leveraged adjustable rate mortgage would require the borrower to pay a higher premium to obtain coverage. Buyers with 5% down payment can expect to pay a higher premium than a borrower with a 10% down payment. Buyers on adjustable rate mortgage generally pay higher premiums than fixed rate mortgages.
The Homeowners Protection Act of 1998 establishes rules for automatic termination and borrower cancellation of PMI on home mortgages. These protections apply to certain home mortgages signed on or after July 29, 1999 for the purchase, initial construction, or refinance of a single-family home. The protections do not apply to government-insured FHA or VA loans or to loans with lender-paid PMI. For home mortgages signed on or after July 29, 1999, your PMI must, with certain exceptions, must be terminated automatically when you reach 22 percent equity in your home based on the original property value, if your mortgage payments are current. Your PMI also can be canceled, when you request, with certain exceptions, when you reach 20 percent home equity in your home based on the original property value, if your mortgage payments are current.
PMI fees can be paid in several ways, depending on the mortgage lender and mortgage insurance company used. Home loan borrowers can choose to pay the first-year premium at closing; then an annual renewal premium is collected monthly as part of the house payment. Or the borrower can choose to pay no premium at closing, but add on a slightly higher premium monthly to the principal, interest, tax, and insurance payment. Buyers who want to sidestep paying PMI as a separate payment can use lender paid PMI. In this case the lender raises the interest rate on the loan to absorb the cost of the PMI and no separate payment is passed to the borrower.
Either way it is paid, mortgage insurance is an added cost for obtaining a home loan when the loan amount is greater than 80% of the value of the home. The mortgage insurance is a cost that can adversely impact the budget to buy a home or the budget for mortgage refinancing if not measured and evaluated in advance. To understand all the costs of obtaining a new home and home loan with less than 20% down payment or a refinance above 80% loan to value it is imperative to know what and how mortgage insurance functions.
Home Mortgage Right of Rescission
Under the Truth in Lending Act, the right of rescission is a protection that is given to borrowers that are obtaining certain types of loans. This gives the borrower the right to cancel within three working days of signing the documents for the loan. They can also get a full refund of any funds that have already been paid. The right of rescission is designed to give you the three days to reconsider whether you want the loan in question, which uses your home as collateral. You may have reconsidered a refinance or a home improvement loan that uses your home as collateral, or may have decided to look for other loan options, for example. This three-day period is often called a cooling-off period, and gives you a chance to decide if the loan is what was expected and what you really want to do.
The right of rescission applies to certain types of loans. For example, a refinance with a new lender or a cash-out refinance, in which you are taking money out that is greater than your current mortgage for whatever purposes. It doesn’t apply in every case where you use your home as collateral on a loan. For example, you can’t use a right of rescission on a loan which is used to build or purchase your primary home, when a creditor for your loan is a state agency, or if you refinance or consolidate with your current mortgage lender without borrowing additional funds. The right applies to your primary residence only. It applies regardless of the type of residence; single family home, 2 units, mobile home, condominium or townhouse. It also applies to some installment loans, where a fixed amount is borrowed and the payments are made on a schedule, or to a HELOC (home equity line of credit).
After you sign the loan documents, you have the right to cancel, or rescind the transaction until the third business day at midnight. Business days for the purpose of rescission do not include Sundays or public legal holidays, but they do include Saturdays. The day you sign the contract is considered to be the first day. A Truth in Lending disclosure form will be given to you, which informs you about important disclosure in the contract. The disclosures on the truth in lending form inform you about the credit terms such as the amount you have financed, the annual percentage rate, the finance charge, the payment schedule and the total number of payments. You are also given two copies of a right of rescission notice that explains your rescission rights.
While your transaction is in the three-day waiting period you won’t receive any funds from the loan until after this waiting period is over. If you use your right to rescind when mortgage refinancing and decide to cancel the transaction, you must provide written notice of cancellation to the lender. Be sure to follow the procedures outlined regarding your right of rescission carefully. Visiting the lender without putting something in writing or making a telephone call does not qualify. The lender is required to return any property or money that was given in connection with the loan within twenty calendar days after receiving your notice of rescission, and is required to make sure any action that is necessary to show that the termination of the security interest has been completed.
You can rescind the loan you sign within the three business day for whatever reason you choose as long as the loan type falls under the federal laws for having a right of rescission. During those three days after you sign for a loan, if you find better terms at another lender or change your mind, you may cancel or rescind the loan. All fees or costs to obtain the mortgage loan must be returned to you when you rescind a home loan.
Can You Save Money by Closing a Home Loan at the End of the Month?
In order to understand if you will be able to save money from closing at the end of the month, you have to learn some background information on how the mortgage loan closing costs are determined. You will want to start by comparing renting or rental payments to a mortgage payment. When you pay rent, you normally have to pay the bill at the start of each month for the forthcoming month, which is basically paying in advance. However, with your mortgage payments, the monthly mortgage payment normally pay off the interest that was built up on the principle balance throughout the previous month. Mortgage payments pay the interest in arrears as opposed to how the rent payment is paying for future use.
When you want to close on your house, you are generally able to do so at any time during the month. As an example let’s say your closing date is on October 15, which would mean that your first mortgage payment is due on December 1st. In order to maintain a level of homogeneity in the mortgage securities market most all primary mortgage payments are due on the first of the month. This payment on December 1st would include the interest for November since monthly mortgage payments pay the interest in arrears. However, what about the 16 days of October that remains between the closing on October 15 when you receive the money or the keys to the new home and November 1? The amount of interest that would be due for the rest of that month is paid at closing, which is sometimes called pre-paid interest or interim interest. You will notice that the closer to the latter part of the month you close on your house, the smaller the interim interest payment will be since there are fewer days from the home loan closing to the beginning of the next month.
If you are currently renting, but intend on purchasing a home, you will probably want to settle for an end-of-the-month closing because you will be able to be moved out of your rental home and into their new house before the next month’s rent is due.
Because of this, many people decide to close at the end of the month. By closing at the end of the month you wont save money but since the purchase closing requires the down payment, closing costs and the interim interest, it does reduce the cash needed to close significantly. On a standard purchase transaction this is a real financial outlay, which many homebuyers could desperately do without. However, if you aren’t concerned with having to pay an interim interest payment, than you will not likely be concerned about which day you close on the new home loan.
The role of interim interest in a refinance may be very different. In many cases a homeowner will add the amount of money needed for their refinance based on their home mortgage balance including any type of closing costs and escrows and any interim interest that is involved. Therefore, many homeowners considering a mortgage refinance assume that if they close at the end of the month the closing costs are lower. However, the main calculation many borrowers forget is the build-up of interim interest within their old mortgage loan.
You will find that many borrowers will call their current mortgage lender at the very beginning of the month to find out how much their principle balance is so they can make a payoff. The borrowers intention is to make the last payment on the old mortgage and keep the interim interest down on the new one. Many borrowers will find that if they decide to close near the end of the month, their payoff is much higher than the original quote. This is because of the amount of interest that has accumulated throughout that month on this home loan.
These individuals who are considering a mortgage refinance will not pay that month’s mortgage payment. An example of this would be if the closing on your mortgage refinance wasn’t until October 15, many borrowers wouldn’t pay their October 1st payment. They can successfully do this because many mortgage lenders will not count a payment as late till the 15th of each month. While this is not suggested many individuals still continue to perform their home mortgage refinance in this manner. However, they will quickly find out that at closing they will have to pay interest not only for September (which was what the October 1st bill was covering) but also interest for half of October.
If you wait to close at the end of the month it may seem like you are saving money. Of course, you are doing a mortgage refinancing for a reason. If that reason is a lower mortgage interest rate or a consolidation to pay off debts at a higher rate, it never pays to wait. The longer you wait to close the more interest you are accruing on your existing mortgage, since its rate is higher than the new mortgage refinance, you are paying more money each day you wait to refinance. Better to pay interim interest on the lower mortgage rate of the new home loan than a higher mortgage rate on the home mortgage you are refinancing.
There are some mortgage lenders that will give you something called an “interest credit” when you close for the first five days of a month. This is a credit of interest during these five days, which will ultimately be included within the upcoming payment. When there is an interest credit, the first payment will be on the very next month. An example is if you close on the 2nd of January, instead of 28 days of interim interest and a first payment March 1st, you will get a two day interest credit and the first payment will be due February 1st.
FHA loans actually accumulate interest from the beginning of the month to the end of the month no matter when they were paid off. Because of this, when you’re paying off an FHA home loan, you will need to properly time the closing so you do not have to pay double interest. FHA does not calculate the interest daily on an existing mortgage loan.
The bottom line is that the closing date may save money for out of pocket costs versus costs added to the loan amount but the ultimate savings is really only an accounting issue. The interest for the mortgage loan has to be paid one way or another regardless of when the loan closes.
Facts about Adjustable Rate Mortgages
An adjustable rate mortgage, called an ARM for short, is a mortgage with an interest rate that is tied to a financial index rate set by the marketplace, and your payment will move up and down as interest rates adjusts rates up or down. The interest rate and your payments are periodically adjusted up or down as the index changes. It’s obvious that if rates go down, that’s good for you. In addition, you often get a lower starting rate because you’re sharing interest rate risk with the lender. However, if rates rise, that’s not good. There is an element of risk in adjustable rate mortgages.
An index is an interest rate that lenders use to determine interest rate changes on your mortgage loan. As the indexed rate moves up or down, so does the rate on your loan. Common indexes used by lenders include rates for short or mid term Treasury securities, but there are other indexes such as the cost of funds index, the LIBOR rate, and the prime rate. The index your mortgage uses is a technicality to determine the fully indexed mortgage rate, but it can affect how your payments change.
The margin on the loan is the lender’s markup. It is an interest rate that represents the lender’s cost of doing business plus the profit they will make on the loan. The margin is added to the index rate to determine your total interest rate. The margin will always stay the same during the life of a loan even if the overall rate adjusts down or up. It is the index that adjusts, not the margin. When comparing mortgage lenders, you must consider both the index and the margin rate being offered.
The adjustment period is the period between potential interest rate adjustments. You may see an ARM described with adjustment periods yearly. In this case loan during the first year your interest rate will stay the same as it was on the day you signed your loan papers. After that period the interest rate will adjust to the index rate at that time plus the margin. This number is the fully indexed rate and will be the basis for the mortgage payment until the next adjustment cycle. This example was as ARM with an annual adjustment–meaning adjustments could happen every year. Some ARMs adjust more frequently, or adjust sooner, or later.
Some adjustable rate loans have features that protect you against sudden or large shifts in rates. They do this by placing a cap on the total number of percentage points that the rate can rise. Caps are broken down into adjustment period caps and annual caps. The adjustment period cap limits the amount the rate can rise above the starting rate by a predetermined limit at the anniversary of the adjustment period. The lifetime interest rate cap will place a ceiling on the highest rate change the interest rate can be over the life of the home loan.
If payments can go up, why should you consider an ARM? You might qualify for a larger loan with an ARM. The initial interest rate for an ARM is lower than that of a fixed rate mortgage, where the interest rate remains the same during the life of the loan. A lower rate means lower payments, which might help you qualify for a larger mortgage loan. Also, you may not plan to remain in your house more than a few years. If you like to move frequently or must move frequently because of your job, you may benefit from the initial lower rate of an adjustable rate loan. The possibility of mortgage rate increases isn’t much of a factor if you plan to sell the home within a few years.
You also may have a reasonable expectation of increases in your personal income. Or, you may anticipate adding an income to your home through marriage, or a younger or older relative with an income. You don’t want to bet on increases in household income, but you can consider it if you really believe it will happen.
Some ARMs have a convertible feature that allows the loan to be converted to a fixed-rate mortgage. However, they have conversion requirements and the mortgage rate to which the loan will convert is dependent on the market at that time which may take away the savings you realized with the initial lower mortgage rate.
Payment caps are confusing feature found in a select category of ARMs. Payment caps limit how much your monthly mortgage payment can change during an adjustment period. The confusion many customers have experienced is that the payment cap does not stop the interest rate from changing. In a situation in which the rate goes above the amount used for the payment cap, negative amortization will begin. Negative amortization occurs when an ARM has a payment cap that keeps monthly payments from covering the cost of interest. The unpaid amount is added back to the home loan, where it generates even more interest debt. If this continues you could make many payments, but still owe more than you did at the beginning of the home loan. Negative amortization is one of the really bad things that can happen with ARMs in rare circumstances. This is a situation to avoid if possible, unless you fully understand the risk s involved.
If you consider an adjustable rate mortgage, know how changes in the interest rate will change your payment. It’s one thing to acknowledge that the payment will go up, but it’s entirely another thing to see what the actual payment will be, especially if it falls outside of your budget. As always, don’t hesitate to ask as many questions as it takes to help you understand every aspect of ARMs and other home loans that are offered to you. Mortgage lenders are required to give you written information to help you compare and select a mortgage loan, but additional discussion is almost always required.