Many prospective homeowners applying for a mortgage tend to have two concerns before they agree to sign: How much interest will I end up paying, and can I afford the monthly payments?
Unless you're a robot or mathematical savant, chances are you won't be able to calculate these figures off the top of your head. Luckily, programmers have developed several mortgage calculators over the years that can help you quickly and easily answer these questions.
But how do you use these calculators correctly, and to what end? Are all mortgage calculators created equal?
Commonly Used Terms
Mortgage calculators don't always use the same language. It's likely you'll see multiple ways of describing the same thing. For example, one calculator might have a space for "APR" while another asks for the mortgage's "interest rate," when in fact these two terms mean the same.
Here's a brief list of the three core elements all mortgage calculators have:
- Principal: This is the face value of your mortgage on day one and represents the total amount of money you haven't repaid yet. If your mortgage is $400,000 on day one, then your principal is $400,000. A portion of each mortgage payment is dedicated to repayment of the principal. Loans are structured so that the amount of principal returned to the borrower starts out small and increases with each mortgage payment. While the mortgage payments in the first years consist primarily of interest payments, the payments in the final years consist primarily of principal repayment.
- Interest/rate/APR: This is how much interest accrues on your mortgage each year. Most times the calculator will ask you to enter this amount as a percentage and not a decimal unless it specifies otherwise. For example, if you have an interest rate of 4.25%, enter "4.25" instead of "0.0425." The interest rate, the lender's reward for taking a risk on a borrower, has a direct impact on the size of a mortgage payment: If the interest rate on a $100,000 mortgage is 6%, the combined principal and interest monthly payment on a 30-year mortgage would be something like $599.55 ($500 interest + $99.55 principal). The same loan with a 9% interest rate results in a monthly payment of $804.62.
- Mortgage length/number of payments/amortization period: It's assumed that, if you're using a mortgage calculator, you're using it before you take out your mortgage. If that's the case, these terms will be the same. But if you're midway through paying down your mortgage, you would want to find the "number of payments" by subtracting how many you've made from the total expected number of payments to find how many more are remaining. For example, if you have a 30-year mortgage (360 months), but just finished year two (24 months), then you would have 336 payments remaining (assuming your payments are monthly like most mortgages).
And then there are a few more terms:
- Loan-to-value ratio: This is a measure of the size of the mortgage compared to the home's value and is directly affected by the size of your down payment. If you take out a $160,000 mortgage on a $200,000 home after making a $40,000 down payment, your loan-to-value ratio is 80%.
- Private mortgage insurance (PMI): Lenders will typically require you to buy PMI if your loan-to-value ratio is more than 80% – your down payment was less than 20% of the purchase price – and will continue to charge you this premium until it dips to 78%.
- Homeowner's insurance: Often bundled with mortgage payments, make sure you know your homeowner's insurance premium every month (or at least make an educated guess if you don't know it yet).
- Adjustments: If you've taken out an adjustable-rate mortgage, adjustments are how many percentage points your interest rate increases/decreases after a pre-determined period.
- Taxes: Real estate taxes are assessed by governmental agencies and used to fund various public services such as school construction and police and fire department services. Taxes are calculated by the government on a per-year basis, but individuals can pay these taxes as part of their monthly payments. The amount that is due in taxes is divided by the total number of monthly mortgage payments in a given year, so borrowers should look at a past property tax bill or a property tax estimator for the area to know how much this might add to the bill. The lender collects the payments and holds them in escrow until the taxes are due to be paid.
What Mortgage Calculators Do
The most common application for a mortgage calculator is finding the estimated monthly payment for your new mortgage. These calculators run complex formulas to account for your principal, interest rate, and loan length to determine how much you can expect to pay each month.
Some calculators have features that show you how much interest you'll pay over the life of your mortgage. Unless you're paying for your house entirely in cash upfront, you might be surprised to see just how much more money an APR tacks onto your mortgage over time.
The most complex and detailed mortgage calculators will include variables for real world expenses like PMI, home insurance, HOA fees, property taxes and more. Others will include options for adjustable-rate mortgage changes as well. These can help you fine-tune your personal finance plans even further, and give you a comprehensive picture of financing a home.
How Good Are They?
Online mortgage calculators are accurate to the extent that the calculator itself is asking for the right pieces of information and the numbers being used by the individual are accurate. Basically, there are four factors that play a role in the calculation of a mortgage payment: principal, interest, taxes, and insurance, often collectively known as PITI. A good mortgage calculator includes these four components, along with PMI, if applicable.
If the calculator only considers the principal and interest payments associated with the loan and ignores factors such as homeowners insurance or property taxes, it could change the result by several hundred dollars or more every month, giving the user a very incomplete and inaccurate answer to the true total payment amount of his or her mortgage.
How Calculators Can Save You Money
To be fair, lenders are required to abide by federal law and include a Good Faith Estimate and Truth-in-Lending disclosure when you sign for a loan. These documents reveal your mortgage's APR, finance charges, payment schedule and the total price tag of your loan, assuming you make the minimum monthly payments on time and in full.
However, if you're seeing all of that information for the first time when you sign the loan, then you haven't done your due diligence. And while good mortgage lenders won't pressure or coerce you into signing, seeing all that information for the first time right before you sign can be a bit overwhelming.
That's where mortgage calculators come in. They can help you understand the bulk of your financial obligations before you sign for the loan. Also, these calculators can help you compare the pros and cons of mortgages of lengths, terms, and interest rates, to help you develop long-term plans for financing your home.
How Much Can You Afford?
A mortgage calculator can help you see if you can buy a home. But deciding if you can actually afford a home is more complex.
Generally speaking, most prospective homeowners can afford to mortgage a property that costs between two and two and one-half times their gross income. Under this formula, a person earning $100,000 per year can afford to mortgage between $200,000 and $250,000. But this calculation is only a general guideline.
First, it's a good idea to have an understanding of what your lender thinks you can afford — and to gain a precise idea of what size of mortgage their clients can handle, lenders use formulas that are much more complex and thorough. Secondly, you need to determine some personal criteria by evaluating not only your finances but also your lifestyle preferences.
Purchasing that four-bedroom home with a pool may fulfill some of your goals and dreams; however, it could leave you house poor.
To be 'house poor' means the costs of paying for, and maintaining, your home take up such a large percentage of your income that you don't have little money left to cover other expenses. As grim as that sounds, many people choose to be 'house poor' because they believe ultimately their income will increase as a result of raises and promotions, making that expensive mortgage a smaller and smaller percentage of their monthly expenses.
In order to avoid being house poor consider the following issues before taking on a sizeable mortgage:
- Income: When contemplating your ability to pay a mortgage, ask yourself the following questions: Are you relying on two incomes just to pay the bills? Is your job stable? Could you easily find a job that would enable you to make payments if you lost your job?
- Lifestyle: Are you willing to change your lifestyle to get the house you want? Will you be able to realistically transform your lifestyle to save the money required to pay that hefty mortgage ?
- Tolerance/Personality: Regardless of your income, will having a big mortgage keep you up at night?
From a bank's perspective, your ability to purchase a home depends largely on the following factors:
Front-End Ratio: The front-end ratio is the percentage of your yearly gross income dedicated toward paying your mortgage each month. A good rule of thumb is that PITI should not exceed 28% of your gross income. However, many lenders let borrowers exceed 30%, and some even let borrowers exceed 40%.
Back-End Ratio: The back-end ratio, also known as the debt-to-income ratio (DTI), calculates the percentage of your gross income required to cover your debts. Debts include your mortgage, credit card payments, child support and other loan payments. Most lenders recommend that your DTI not exceed 36% of your gross income. To calculate your maximum monthly debt based on this ratio, multiply your gross income by 0.36 and divide by 12. For example, if you earn $100,000 per year, your maximum monthly debt expenses should not exceed $3,000.
Down Payment: A down payment of at least 20% of the purchase price of the home minimizes insurance requirements, but many lenders let buyers purchase a home with significantly smaller down payments. The down payment has a direct impact on your mortgage payment, and, therefore, also on both the front-end and back-end ratios. Larger down payments enable buyers to purchase more expensive homes.
Beyond the Mortgage
Buying a new home is an exciting adventure. But many prospective homeowners, caught up in the thrill of searching for their dream house, forget to pause and consider the financial responsibilities of homeownership. While the mortgage is certainly the largest and most visible cost associated with a home, there are a host of additional expenses, some of which don't go away even after the mortgage is paid off. Smart shoppers would do well to keep the following items in mind:
- Maintenance: Even if you build a new home, it won't stay new forever, nor will those expensive major appliances, such as stoves, dishwashers, and refrigerators. The same applies to the roof, furnace, driveway, carpet and even the paint on the walls. If you are 'house poor' when you take on that first mortgage payment, you could find yourself in a difficult situation if your finances haven't improved by the time your home is in need of major repairs.
- Utilities: Heat, light, water, sewage, trash removal, cable television, and telephone services all cost money. These expenses are not included in the front-end ratio, nor are they calculated in the back-end ratio. But these expenses are unavoidable for most homeowners.
- Association Fees: Many homes in planned communities assess monthly or yearly association fees. Sometimes these fees are less than $100 per year, other times they are several hundred dollars per month. Ask about association fees prior to making a purchase. Find out about what the fee covers. In some communities, it includes lawn maintenance, snow removal, a community pool and other services. In other communities, the association fee covers little more than the administrative costs of hiring an attorney to encourage everyone in the neighborhood to maintain the exterior appearance of their homes. While an increasing number of lenders include association fees in the front-end ratio, it pays to remember that these fees are likely to increase over time.
- Furniture and Décor: Drive through almost any community of new homes after the sun goes down, and you're likely to notice some interior lights illuminating big, empty rooms, which you can see only because those big, beautiful houses don't have any window coverings. This isn't the latest decorating trend. It's the result of a family that spent all their money on the house, and now can't afford curtains or furniture. Before you buy a new house, take a good look around the number of rooms that will need to be furnished and the number of windows that will need to be covered.