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.
Interest Rate:
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.
Term:
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
Versus
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
- Taxes
- 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.
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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.
Why’s that?
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.
Great article Todd, and I’m one of the 30 year mortgage people, the interest rates are terrible. I learned some great info though, and I appreciate the class. Think I might start looking to refinance to a 15 year note, knew you could save some, money but did’nt know it could be that much….nice work.
Hi Gary,
Glad to hear that you have learned something and can apply that knowledge to better your future. That’s what it’s all about. I thought it was amazing too the first time I heard the difference between a 15 year and a 30 year mortgage. Saving yourself $100,000 is pretty incredible. Thanks for your feedback and comment Gary.
take care,
Todd
Hi,
Hello, my name is Tina from taxes, USA and i am here to tell you people that you are doing a good thing.
This post was very helpful as i am going through the loan process right now.
I really learned a lot from this article and wanted to say thanks.
Thanks
Your welcome Tina and thanks for your feedback on my article, how do mortgages work, wish you the best.
Todd
I enjoyed the article very much. As a real estate agent I would love it if more people had an understanding of debt ratios, pmi, etc. You are right that a home is most people’s largest investment and done wisely can help them to achieve financial gain.
Absolutely, good comment coming from a real estate professional. Thank you as well for commenting on the post. Hopefully this article will reach those who don’t know how mortgages work and they will start to educate themselves and invest in a better future.
Thanks,
Todd
Awesome post! you did a great job educating people on how mortgages work. I learned a few things thats for sure so I thank you!
Best wishes to you,
Crisaly
Hi Crisaly,
Thanks you for your kind feedback and I’m happy you learned something from the post. That’s exactly the point of the article. The more people who can educate themselves about finances, credit, and how mortgages work, the better off they will be.
Cheers,
Todd
Great article Todd. I agree–why don’t they teach this more in schools? So practical and could be tied into a math class of some kind!
Hi Tom,
Absolutely, an economics class or something. It just seems so practical to teach how mortgages work in high school. Before people go out and get credit cards or buy a home. This could really change the American consumer’s over-spending issues that have plagued American society for decades.
Conservative living and frugal spending for a brighter future. Not the most exciting topic, but one that can make life much easier for millions.
Nice to hear from you Tom, have a great day.
Todd
Magnificent web site. A lot of useful info here. I’m sending it to several friends ans also sharing it socially.
And naturally, thank you for all your hard work. Your article on how mortgages work is very clear and detailed.
I didn’t realize that I would need to get pre-approved before I begin shopping for homes. It is incredible that this information is not provided in high school as well.
Keep up the good work.
Nick
Ni Nick,
Firstly, I just wanted to thank you for your positive feedback on my website.
My goal is to help others learn how to grow wealth online and educate people on issues that involve saving and or making money. In this situation with this post on mortgages, I just wanted to provide the correct information that people need to know before they go off into the world and make major financial decisions.
Like I said in the post, I was lucky to get educated about mortgages, credit cards, debt, etc. And so hopefully this article can help others. If you have any specific mortgage questions and you live in the United States, please refer to the two individuals listed in this article.
They deal with mortgage related questions and issues all day long and will be happy to help you out. Just tell them Todd from Learn To Grow Wealth Online recommended them to you. Or you can just say Todd. They’ll know me, I’ve known them for almost 20 years.
Cheers,
Todd
Hello Todd. I just wish that any person considering a mortgage as a way out would read this useful post. The information you provide on topics such as credit,equity, debt, lending programs and refinancing should be a must read for people who just jump on the mortgage wagon without having a clear idea of the impact their actions will have on their financial future. Thanks for providing the necessary information for making the correct choice. Some people end up mortaging their entire lives for lack of financial education. Thanks!
Hilda
Hi Hilda,
You just made me flash back to my mortgage days. It’s sad to see that people enter into a consumer spending cycle that becomes painfully destructive. But if they live within their means and use their homes as an asset, they can begin to build long term wealth.
I think the one thing I want to stress to home owners is that if you are using the equity to pay off your consumer debt through a refinance, then use that savings and sock it back to the mortgage payment. Be disciplined and don’t just go back to poor spending habits. Take the opportunity and run with it, be fiscally conservative and they’ll be glad they did in the years to come.
Thanks,
Todd
Hi Todd, I am feeling a bit jittery reading this because I just realized how little I know about mortgage. I have not bought myself a house yet and I always thought ‘someone’ in the bank will help me sort out the finances when the time comes.
I have to have an insurance that could coupled as a Mortgage Reducing Term Assurance (MRTA) although I don’t really know how it works (I need to check on that). I have a somewhat risky occupation and I am constantly thinking about the financial situation of my next-of-kin.
I have a fairly good saving, low in debt and might get a house in a couple more years. What would your advice be for someone in my situation? Thank you.
Hi Cathy,
It really depends on your location. If you are seeing a steady increase in real estate in your local area, then ask yourself are there any other strong economical factors about that area. Is there new growth, new construction, any new local or international businesses expanding in your area. How does the quality of life rank in your town or city.
These factors will give you a better understanding about the current real estate market where you live. You could also contact a local real estate professional and get their opinion.
I would really encourage you to do this now. If you are in a market that is on the rise, you want to invest now. If you wait a couple of years and the market has slowed down, you have missed out on 2 years of appreciation. If the house is 200K USD and 4.5% appreciation, then you just lost out on $18,400 dollars in appreciation.
If you debt is low and you have some savings, look into your local market. If you need any help and you’re in the US, call the gentlemen that I mentioned on this page. You can reach them either by email or phone. They’ll be happy to talk to you and fill you in.
I haven’t worked in the mortgage field for over 10 years now, so they will be able to guide you better than I can. If you are outside of the US, go check out your bank, your local real estate agent and meet some local professionals. See what they have to say.
You can loose in real estate too. But if you’ve got a good market, you can make some great returns on your investment.
Let me know if you have any other questions Cathy and thanks for your question.
Todd
Hello, Todd
This is a very interesting and thorough article on Mortgages. I’ve never had a mortgage as I choose to rent and I never really understood them that well any way to be honest, lol. Your post has been very helpful and will come in handy when I finally decide to move away from renting.
After reading the part about mortgage insurance, I thought contents insurance was bad enough!
I do agree that schools should teach kids this kind of stuff too!
Do you currently have a mortgage, Todd?
Neil
Hi Neil,
Learning how to leverage a mortgage is an important aspect to grow your wealth. Obliviously depending on the market and location. But when you live in the US with the tax incentives as well as some appreciation in our current economy, it can be extremely helpful to invest in real estate.
I have personally had about 6 mortgages over the years. None since 2010 when I sold my last home and investment property. That was right after I started living part time in Colombia. The rent is so cheap here that it doesn’t make a lot of sense for me to buy property. But if I was living somewhere permanently, I would look into the local market for sure.
If you look above in this article you can find out how to figure out your debt to income ratios, you can really see what you can afford. Then I also have linked a mortgage calculator so that you can plug in your information to see what size of mortgage you can qualify for. If you’re in a good location, check into it. Not sure how the real estate market is in London. But worth looking into.
Thanks for your feedback and question.
Cheers,
Todd
It really is shocking when you look at the numbers like this. Financial education is such a need in today’s environment. So many people become over extended so quickly and then they can never dig out. It’s a shame because they become a slave to debt for years and the only thing they ever worry about is whether they can make the monthly payment. This is a great reminder of how to look at this type of debt and properly manage it.
Thanks for breaking it down in easy to understand terms!
Christy
Hi Christy,
Thanks for the feedback on my “how do mortgages work” article. Yeah, I just wanted to get some of this basic information out there to help anyone who has a mortgage or will have one in the future. It’s very true that our public school system in United States could do a better job at educating young people about basic finances, credit, and debt before they enter out into the world. It’s sad to see someone get so far into debt at such a young age.
I am planning on putting together a money management guide for young folks in the future. Hopefully with education, I can help others out before it’s too late. If you haven’t seen my article on how to actually make money using your credit cards, you should check it out right here.
Thanks again for your comments, always appreciated.
Todd
This is a subject that definitely should be covered in school. I really don’t understand why they teach nothing about finance. Of course, many mortgage lenders don’t seem to understand math very well either. I’ll give you an example: When I bought a house back in 2000, I was waiting for approval on a loan (that I was pre-qualified for) in which my mortgage payments would have been $555 per month. When it came time for a letter of commitment (they waited till the very last day!) There was a “problem”.
They decided I couldn’t afford $555 per month. Even though I was paying $600 per month for rent and was never late! However, I was able to find lenders who thought I COULD afford to pay $750 per month!
I think the whole mortgage lending industry is a big racket!
Steve
Hi Steve,
Most likely what happened to you was that you had one broker who was trying to qualify you for the best loan program at the time. Those programs usually have tighter Debt to Income Ratios, probably around 32% on your front end ratios.
Then the second broker you worked with most likely went and used a lender that offers slightly higher interest rates, but allows for higher font end ratios, maybe around 40% of your monthly income.
This would then change what your mortgage payment could be explaining the difference in what you would qualify for.
It sounds like your mortgage brokers just didn’t do a good job explaining the situation.
Also, back in 2000 the mortgage industry wasn’t heavily regulated. So when rates drop down, and back in 2000 they were around 7% (which was historically pretty low), everyone and their brother jumped into the mortgage industry. More sales people and less true mortgage officers that know what they are doing.
Now, the mortgage lending industry is highly regulated and mortgage brokers have to pass a series of test and be certified. Much like a public accountant.
That is why I highly recommend Scott and Matt. I’ve known them for almost 20 years and they do right by people. They know how to structure loans to give the customer the advantage and they explain the process all along the way.
Whomever you work with, it’s important that you can trust them and that they explain exactly what is going on during the process.
Then there is no confusion at the time of the closing.
Thanks for your feedback and hope this answer helps explain your situation.
Take care,
Todd
Actually, the first mortgage per-approval I got ($555 per month) Was with a loan officer at a local bank!
My debt ratio’s where good but, the loan officer didn’t take into account that I paid weekly child support which was garnished from my wages.
I specifically mentioned up front that I had child support obligations and the garnishment was right there in black and white on the pay stubs I was required to give them at the initial meeting.
I still think the mortgage industry (as a whole) is a racket. I know there are good people in the business who want to do right by people.
Maybe a “necessary evil” is more appropriate than “racket”.
Sounds like your loan officer didn’t do his job correctly. I know people have a bad perception of the mortgage industry from everything that went down in the US during 2007/2008. But it’s a real industry, with improved standards, and it’s a real job. A challenging and stressful job at times.
And just like in any profession, there are scandalous people. But there are also professionals that have developed long-term businesses and careers and those are the mortgage brokers that you want to deal with. Most of them are more concerned with making their clients happy than worrying about their commission.
I recommend the two gentleman because I’ve worked with them on numerous transactions and they’ve always been honest and done right by me.
Thanks for your comment Steve, appreciated.
Cheers,
Todd
Crazy that we are not taught this in school! Not only information about how mortgages are formed and how they work, but about our credit scores. Mine is finally very good after all the lessons I have learned the hard way. I will be keeping all of this in mind – rates – term – LTV – when I start shopping for a house. Thanks for laying it all out there in simple terms, step by step, Todd, I am going to have to bookmark your site and learn some more ways to improve my financial aptitude… work smarter not harder right! Is there a benefit to getting a pre-approved loans before I go house hunting?
Hi Busy Girl,
I agree with you 100%, it’s amazing how many people don’t know how mortgages work. As well as credit. That was one of the reasons I was inspired to write this article. Before I started working in the mortgage business, I didn’t understand credit, mortgages, or anything about this area of life. Once I did, I was also amazed at how many clients I spoke with that were also a bit “clueless” about this subject.
I hope this article will help inform others about how to get their financial situation in order, including their credit.
As for your question. You absolutely need to get pre-approved for a mortgage before starting the house hunting process. Otherwise you are just potentially wasting your time. Get pre-qualified with a reputable mortgage broker and you will know exactly what you can afford in a mortgage payment and your max home purchase price.
If you need any help with credit or pre-approval, call the gentlemen I refer at the bottom. You can trust them to guide you along the right path with your financial situation.
I stress this because I have seen so many people get themselves “over-extended” in their mortgage payment because some lender lead them in the wrong direction.
Being talked into a higher priced home for your first purchase can ruin you financially. If you have a mortgage you can’t afford, then you will be stressed, short on money, and at risk for serious credit and financial problems. All issues that seriously decrease our quality of life.
And that’s the last thing you want to do when you get into a new or first home. Many new homeowners forget that multiple purchases (like housing improvements or furnishings) occur when people buy a new home. Be careful with this too. Especially if you are putting down a sizable portion of your savings as a down payment.
Thanks for your feedback and have a wonderful day.
Todd
Hi Todd
Honestly, I think mortgages are way too costly, but thank you for providing some pertinent information to handle it more efficiently and effectively.
Hi Vanessa,
You are welcome. Mortgages can be expensive. But if your rent is comparable to the monthly cost of a mortgage, you will find a way to decrease your tax liability and leverage appreciation if the value of your home increases.
Then after a couple of years you will have gained a decent amount of wealth if you pick a home in a good location.
If you pick a home that is in a progressive section of growth in your town or city, you can expect to see a decent return on your investment.
To give you a practical example, say you buy a home for 150K USD. If the home receives 4% appreciation per year, after 2 years your home value would be over 162K USD. So you would have made $12,000 plus you would be able to “write off” your interest payments on your taxes that would give you a sizable return on your tax return.
Compare that to paying rent on a home with a similar payment.
Maybe the payment is a couple hundred dollars less per month. So after 2 years of renting, you save $2,400. Which would you rather have? 12K in equity, potentially 8K cash back on your tax return or save $2,400?
If I’m living in a set location and can afford the mortgage/home, and the cost of rent is similar to the mortgage payment, then I’d choose the real estate investment versus renting.
Real estate investing is not a risk free investment, but that’s the whole concept with investing, risk versus reward.
Anyways, best of luck to you and your financial prosperity and thanks for your feedback.
Todd