Mortgage Basics: Costs
By Lisa Smith
People generally think about a mortgage in terms of the monthly payment. While that payment represents the amount of money needed each month to cover the debt on the property, the payment itself is actually made up of a series of underlying expenses. The down payment and closing costs must also be taken into consideration.
Regardless of whether a mortgage is based on a fixed-rate loan or a variable-rate loan, the series of underlying components that combine to equal the amount of the monthly payment typically includes both principal and interest. Principal simply refers to the amount of money originally borrowed. Interest is a fee charged to the borrower for the privilege of borrowing money.
In a mortgage made up of just principal and interest, the payment will remain the same over time, but the amount of the payment dedicated to each of the underlying components will change. Consider, for example, a $1,000 monthly mortgage payment. The initial years of a mortgage payment consist primarily of interest payments, so the first payment might be $900 dollars in interest and $100 in principal. In later years, this equation reverses, because after each mortgage payment, a portion of the initial amount owed is reduced. Therefore, the majority of the monthly payment at this point in time goes towards principal repayments. Toward the end of the life of the mortgage, the $1,000 payment might consist of $900 in principal and $100 in interest.
Additional Direct Costs
The subcomponents of most, but not all, mortgages also include real estate taxes and insurance. The property tax component is determined by taking the amount of taxes assessed on the property and dividing the number by the number of monthly payments. For most borrowers, that number will be 12, but there are some mortgage programs that offer bi-weekly payments to enable borrowers to pay off their loans more quickly. The lender collects the payments and holds them in escrow until the taxes are due to be paid.
The insurance component will include property insurance, which protects the home and its contents from fire, theft and other disasters. There is another type of insurance that will need to be purchased if 80% or more of the home's purchase price was financed through a mortgage. In this case, the insurance component of the monthly mortgage payment will also include an allocation for private mortgage insurance (PMI). While property insurance protects the homeowner against hazards, PMI protects the lender by minimizing the risk to the lender if the borrower defaults on the mortgage. This safety net enables lenders to sell the loan to investors. (To learn more, read Insurance Tips For Homeowners.)
While principal, interest, taxes and insurance comprise a typical mortgage, some borrowers opt for mortgages that do not include taxes or insurance as part of the monthly payment. When borrowers choose a loan structure that does not account for taxes or insurance, the borrowers are responsible for making those payments on their own, outside of the mortgage payment.
More Than Just the Mortgage
In addition to the money required to cover the mortgage, simply obtaining a mortgage often requires a substantial amount of money to cover the down payment and closing costs. Ideally, the down payment is equal to or greater than 20% of the price of the dwelling. The 20% number is significant because anything below that requires the purchase of PMI, which increases the amount of the monthly mortgage payment.
Closing costs include a variety of expenses over and above the price of the property. These can be divided into two categories: recurring costs and non-recurring costs. Recurring costs include property taxes and homeowner's insurance; one year's worth of each must be paid in advance and put in an escrow account to ensure that the cash is available when it is time for the bills to be paid. Non-recurring costs include fees related to conducting a real estate transaction, and include loan origination costs, title search fees, surveys, credit report costs, origination points, discount points and other miscellaneous expenses. (To learn more, check out Mortgage Points - What's The Point?)
Mortgage Basics: The Amortization Schedule
Origination points, which generally equal 1% of the cost of the loan, are a fee paid to the lender for giving out a loan (a transaction cost). Discount points, on the other hand, are prepaid interest used to reduce the interest rate on the loan. Like origination points, each discount point is equal to 1% of the amount of the loan. Purchasing up to three discount points is not unusual. Paying discounts points reduces subsequent monthly mortgage payments.
Some lenders permit points and closing costs to be financed in the mortgage. Because these costs can be significant, often averaging more than 5% of the amount of the loan, rolling them into the mortgage can result in a notable increase in the monthly mortgage payment.
Initially, borrowers often focus on the amount of money required to purchase the home of their dreams and the resulting monthly payment that will accompany that purchase. Later in the process, they realize that a $300,000 loan is likely to be accompanied by an additional $20,000 to $30,000 in closing costs. Keep these costs in mind when you are shopping for a new home.
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