Know Your Home Mortgage
(Updated December 2014)
You can't blame a person for spending endless hours researching the latest whiz-bang electronics gizmo or hot new fashion item. Shopping for fun stuff is, well, fun. Shopping for mortgages, on the other hand, can be as grueling as finding a parking space at a shopping mall on the day after Thanksgiving.
However, the more you know about a mortgage, the smarter you'll be when it comes time to find one, or refinance the one that you currently have. A little knowledge could save you a lot of money, both on a short- and long-term basis. Here are four must-know definitions to help you on the road to home loan enlightenment:
If you can't put more than 20 percent down on a first mortgage, a lender will most likely require you to carry Private Mortgage Insurance (PMI). It's designed to protect the lender from losses in the event that you default on your loan.
The cost of PMI varies, depending on your credit score and the size of your down payment, but it generally runs from about one-half to one percent of the amount borrowed, per year. In other words, it's like adding another one-half to one percent onto your interest rate.
PMI is not permanent. You can apply to have PMI canceled once your loan balance drops below 80 percent of your home's current value (80 percent loan-to-value ratio). Furthermore, your lender must cancel PMI once your loan balance drops below 78 percent of the home's original value through normal amortization, i.e., your regular monthly payments.
PMI is not used on FHA loans, which have their own mortgage insurance. Also, you can't cancel FHA loan insurance if you originally put down less than 10 percent on the loan. Other mortgages may have lender-paid mortgage insurance (LPMI) which follows somewhat different rules, but still can be canceled once you reach an 80 percent loan-to-value.
Shopping for a mortgage can be a challenge. You can't just compare interest rates on competing offers. You've also got closing costs and discount points to take into consideration, which can significantly affect the end cost of the mortgage, and can make a lower-rate loan a worse deal than one with a somewhat higher rate.
The APR, or annual percentage rate, is a way of expressing the total cost of a mortgage in the form of an interest rate. It basically totals all the closing costs and points and determines how much additional interest would be needed to pay those costs as part of the loan. So if the interest rate is 4.5 percent, the APR may come in at 4.85 percent or something thereabouts.
APR is a convenient way of comparing different loan offers but it isn't 100 percent accurate. For example, it assumes you'll pay off the loan over its full term, rather than refinancing or selling the home a few years down the road. And it can't account for the potential effects of rate resets on an ARM (adjustable-rate mortgage). But it's a good rule of thumb.
On most mortgages, you don't actually have to make your monthly payment by the due date to avoid late fees. That's because mortgages usually have a grace period of one to two weeks after the due date during which you can still make your payment without paying a penalty. In fact, it won't even be reported as late or carry any negative consequences. Think of it as a "hard" due date following the "soft" official due date.
A grace period provides a cushion for the irregularities of mail delivery, so that if you mail your payment by the due date, you can be pretty sure it will be received before the end of the grace period. Of course, many people prefer to make their payments electronically nowadays. If you do that, you may find that some lenders will charge "convenience" fees for payments made during the grace period that they don't charge on payments made by the due date.
Amortization is the process by which your mortgage is gradually paid off. As you make your mortgage payments each month, part of the payment goes toward paying down the loan principle and the rest goes toward interest.
Early on in a mortgage, most of the payment goes for interest and very little toward principle. That's because interest is charged based on how much you still owe and you haven't made much progress toward paying down the principle yet. But as time goes by and you pay down principle, the part of your monthly payment that goes toward interest shrinks and the part that goes toward principle gets larger. So in the last few years of the loan, you're paying down principle very fast.
Amortization is important to understand because it lets you see how fast you'll be building equity in your home. It helps you make decisions such as whether refinancing to a new mortgage rate would be a good decision, whether it would be worth buying a home now if you're planning to move again in a few years and in calculating how much faster you could pay down your mortgage by paying a bit more every month.
The timetable by which you pay down your loan balance is called an amortization table and a chart that details the whole process over the life of the loan is called an amortization table. Most mortgage calculators can produce these, making it easy to see how varying payments, interest rates, etc. will affect how quickly the principle is paid down.
Prior to the crash, it was common for certain adjustable-rate mortgages to have minimum payments that didn't even cover the monthly interest charges, so the difference was added to the principle. Such "negative amortization loans" got a lot of unwary borrowers in trouble back then. These days, however, you're extremely unlikely to encounter such loans in the residential mortgage market, unless you're a wealthy borrower looking to arrange unconventional financing for a high-end property.
Granted, there's more joy in learning about an ipod as opposed to a mortgage loan. However, the more adept you can become at knowing your home mortgage, the more money you'll have for the fun stuff. And that should be music to your ear.