If you’ve ever asked yourself, “how do mortgages work?” you’re not alone. It’s alarming how many people don’t know how to use a mortgage to their advantage.
More alarming is how many people will come face to face with a mortgage at some point in their life, yet nothing is really taught about this subject in public schools.
A home is the single largest investment that most people will ever own.
And the majority of these homeowners amazingly don’t understand the basic principles of credit, debt, real estate, and leveraging mortgages to their own benefit.
So how do mortgages work? Let’s start off with the basics of “what makes a mortgage a mortgage”.
The Lifeblood of a Mortgage: Rate, Term, and LTV
Every mortgage is based on 3 components: Interest Rate, Term, and Loan to Value.
Mortgage interest rates dictate your monthly payment and the total amount of interest that you will repay over the life of the loan. So you want the lowest interest rate possible.
This is an under appreciated factor that is easy to understand and leverage to your benefit. Term refers to the amount of time you have to repay the loan. Most mortgages are based on 30 year, 15 year, or 10 year terms.
The longer the term, the lower your monthly payment will be, but the more money you will pay in interest.
For example. Compare two mortgages, both with a loan amount of $150,000 and an interest rate of 6%, but one on a 15 year term and the other on a 30 year.
30 year term mortgage
15 year term mortgage
Although you will pay $366 dollars less per month with a 30 year mortgage, look at the difference in the Total Amount Paid for the two loans. You can see that you save $96,000 dollars in interest with the 15 year term.
So the shorter the term, the less you pay in interest and the faster you get out of debt.
Loan To Value:
Loan to value refers to the size of the loan in relationship to the value of your home.
If you have a home worth $100,000 and you owe $70,000 dollars on your mortgage, you have a loan to value of 70%. This also means that you have $30,000 of equity in the home.
Loan to values of 80% or less will receive the best interest rates. And if you’re above 80% LTV, you can expect to pay the ever so dreaded… “mortgage insurance” (discussed below).
If you have a good mortgage broker, they can help you come up with some creative financing to avoid the interest rate hike and additional, and useless mortgage insurance payment.
Understand You Credit:
Your credit scores are extremely important when applying for a new loan or refinancing your current mortgage. Every lender will base their decision to approve or deny your loan based on your credit scores.
There are a number of factors that influence your scores. But it’s primarily based on your past credit history and the amount of open lines of credit you have.
Factors that have a negative effect on your credit include; late payments on credit cards, car loans, past or current mortgages. 30 day late’s to 90 day late’s are rated accordingly.
Unpaid medical bills, liens against your property, etc. Having multiple lenders pull your credit at the same time will lower your scores.
And the lack of credit history has a negative effect on your scores.
How To Get Good Credit Scores?
In general, all you need to do is have 2-5 open lines of credit and pay your bills on time every month. If you can do this your scores will be fine. See below for typical credit scores and how lenders view those scores as a credit risk.
Debt To Income Ratios:
Debt to Income Ratios are just as important as Credit when deciding if you can qualify for a mortgage. Your debt to income ratio is the ratio between your Gross Monthly Income and your Monthly Expenses. Debt to Income Ratios let you know…
- The monthly Mortgage Payment you can afford
- The maximum Loan Amount you can qualify for
- & indicates if you are living within your means
Debt to income ratios are expressed in two classes, Front End Ratios and Back End Ratios.
Front End Ratios:
Front End Rations are your monthly mortgage payment divided by your Gross Monthly income.
- Don’t forget your mortgage payment consists of 4 parts…
- Principle Payment
- Interest Payment
- Your Home Owners Insurance
- Front End Ratios can vary slightly based on the lending program you can qualify for, but for most lenders, they should be no more than 32% of your gross monthly income.
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Back End Ratios:
Back End Ratios are your mortgage payment plus your monthly consumer expenses (monthly car payment, credit card payments, etc.) divided by your Gross Monthly Income.
- Back End Ratios, in general, are no more than 42% of your gross monthly income. Again, some lending programs fluctuate with this percentage and so it can be as high as 45%.
Your debt to income ratios are the primary basis of deciding the maximum monthly payment you can afford. And this in turn influences the size of the loan amount you can qualify for.
You can figure your debt to income ratios out pretty easily. First, let’s figure out your Gross Monthly Income.
Next, take your Gross Monthly Income and multiply it by 32% to get your front end ratios.
Then for your back end ratios, just multiply your Gross Monthly Income by 42%.
So if you make $25 dollars per hour and work 40 hours per week…
- Your gross monthly income would be $4,333.
- Your maximum front end ratios (a.k.a the maximum monthly mortgage payment you can afford) would be $1,386.56
- And your maximum back end ratios (mortgage payment + all other monthly expenses) would be $1,819.86
Paying Points For A Lower Interest Rate:
Points in the mortgage world refer to percentage points. So 1 point = 1% of the loan amount. Most lenders will allow you to pay points to buy down the interest rate and many times this can be a wise move.
It just depends on how long you plan on staying in your current mortgage.
If you plan to sell or refinance your home in a couple of years, then it wouldn’t make sense to buy down the interest rate.
But if you plan on having a mortgage for 15 to 30 years, buying down your interest rate will save you thousands of dollars.
Let’s say you’re getting a 30 year mortgage for 250,000 dollars at an interest rate is 5.5%. You’re monthly payment (principle & interest payment) would be $1,419.47.
If you can buy your interest rate down by 1/2 percent for 2 points, that would put your interest rate at 5%. The cost of the 1/2 percent is 2 points, or 2% of your loan amount, which is $5,000. Your new payment would be $1,342.05.
So you would save $77.42/mo. Over a 30 year term, that’s a total of $27,871. Minus out the cost of $5,000 dollars, and you save yourself $22,871 dollars. Buying down the rate in this situation would be recommended.
If you only plan to be in the home for 5 years, this only saves you $4,645 dollars. So it doesn’t make sense to buy down your interest rate in this scenario.
Talk with your mortgage professional to see what makes sense for you and your financial situation.
Mortgage Insurance: What A Ripoff
Mortgage Insurance is a mandatory requirement from the lender when the loan amount is greater than 80% of the value of the home or purchase price. It insures the lender if you default on the loan.
So basically, you are paying the lender’s insurance premium on a monthly basis. Not a good thing.
Your mortgage broker should have some suggestions on how you can get around paying this premium. Sometimes you can get a second mortgage so that your loan amount is at or below 80% of the value of the home or purchase price.
How to Make Mortgages Work For You?
Pretty much all loans can be broken down into two classes, Fixed Loans & Variable Loans. Fixed loans have a fixed interest rate and term. So a 30 year loan with a fixed interest rate at 5% is an example of a fixed loan.
With a fixed loan, each month a portion of your payment is going to pay your principle & interest balance.
Using an amortization schedule, you can see exactly how much each monthly payment is being applied to principle & interest.
A variable loan is like a revolving line of credit or a credit card. The interest rate varies slightly each day.
The monthly payment is usually a minimum payment that repays a portion of the interest that has accrued during the month.
If you just pay the minimum payment on a variable loan, the remaining interest will be added to the balance. So your loan amount will actually increase.
This is why credit card debt can be so devastating to people if they can’t pay the entire balance. The loan balance continues to increase and it becomes more difficult to get out of debt.
How to Structure Your Debt:
In general, you want to have debt that is structured as fixed loans.
You also want all your debt structured in the form of a mortgage if possible.
With a mortgage, you have the ability to deduct the yearly interest payment as an itemized deduction to reduce your taxable income.
In other words, you get a huge tax break by having your debt in the form of a mortgage. This does not occur with consumer debt like car loans, credit card debt, student loans, etc.
When people consider refinancing their mortgage, they usually do so for a couple of reasons.
- To get a lower interest rate
- Pull out cash from equity in the home
- Save money by switching to a shorter term
- And consolidate their consumer debt
Many times it’s a combination of these reasons. Maybe you can get a better interest rate, pull out some cash to do some home improvements, as well as consolidate some consumer debt to save on your monthly expenses.
The Ideal Refinance Situation…
Say you have $100,000 mortgage at 7% and $60,000 in consumer debt at 12%. Your mortgage payment is $665/mo, and you consumer debt is over $900/mo. Your total monthly expenses are $1,565/mo.
Will assume the house value is $220,000, so plenty of equity to work with. Let’s say current interest rates are 5.5% and you’ll refinance to a 30 year mortgage.
So in this scenario, you can refinance all your consumer debt under a new mortgage.
What does this do for you financially?
You will incur the expense of the refinance, which is usually around 3% of the loan amount, so just shy of $5,000.
Your new loan amount will be $165,000 at 5.5% giving you a monthly payment of $936/mo. You will have decreased your monthly expenses by $629/mo.
You also will receive the tax benefit now on 60,000 of consumer debt. And if you take the monthly saving of $629 and apply that to your new mortgage payment, you will get out of debt in 12 years.
“This is exactly how you want to look at any refinance situation.”
You want to get a lower interest rate, decrease your monthly expenses, and re-apply the saving to your new monthly payment.
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Mortgage Professionals, You Can Trust:
Making a mortgage work for you is not too difficult with the right help.
There are a lot of mortgage programs out there and it’s incredibly beneficial to have an experienced lender to guide you along the way.
Whether you are refinancing your current mortgage or applying for a new home loan, you want to get the best deal for your financial situation.
How do mortgages work? Well I hope I have made that clear as well as how to use them to your advantage.