Learn how to understand your mortgage payment breakdown. This guide will help you understand how to pay your mortgage and how to save money.
10 Easy Steps to Understanding: First-time homebuyers often don’t know how to make sense of their mortgage payment breakdown. These questions often go unanswered, and although they can be confusing, they’re important to answer so you know where your money is going and what you can do to optimize your spending.
10 Easy Steps to Understanding Your Mortgage Payment Breakdown
Here are the 10 commandments of understanding your mortgage payment breakdown so you have an easier time making sense of it all.
Step 1: Understand Your Closing Costs
This is a fancy way of saying what you’re paying in fees when you buy your home. They will vary from state to state, but there are some standard items here—appraisal fee, the survey fee, title company charges, document preparation fee, and more. Most closing costs typically fall between 2% and 5% of your total mortgage amount. Closer to 2% is common for conventional loans (Fannie Mae or Freddie Mac), while FHA loans are closer to 3%. Closing costs can be paid out of pocket or rolled into your loan amount.
Step 2: Shop Around Before You Shop For a House
Just a few years ago, it was standard to put down 20 percent or more on a mortgage. Fortunately, many lenders are now willing to work with buyers who can only put down 5 percent or less for their initial payment. You may still be asked to pay private mortgage insurance (PMI) if you don’t have at least 20 percent in cash.
Many homebuyers just get an FHA loan so they won’t have to worry about PMI payments. Still, if you choose a conventional loan and decide not to pay PMI, you may need some help from family members. The good news is that parents and other relatives may be willing to lend you money in exchange for an interest rate discount on your mortgage payment.
Step 3: What Goes Into Your Down Payment?
The down payment is also known as your equity. This is what you pay to purchase your home from your lender. Most mortgage lenders prefer that a 20% down payment is made, but in some instances, 10% will suffice (and 0% for veterans). The amount of money you put into a down payment depends on how much you can afford and how much debt you have. Most lenders prefer that no more than 30% be used as debt (including student loans) so if you have any credit card or medical bills to pay off, now would be a good time to do it before applying for a loan.
Step 4: Interest Rates, APR, and Cash Discounts
One way to lower your payment is to make it twice a month instead of once a month. Many people have heard that they can pay their mortgage twice a month, but they don’t know why or how. By paying bi-weekly you are actually taking 13 monthly payments out of each year instead of 12 so you will be repaying your mortgage more quickly and lowering your monthly payment in most cases. To find out if it’s right for you, check with your lender to see if they offer it and if so, go for it!
Step 5: Why Can’t I Pay My Mortgage Bi-weekly?
In most cases, you can’t pay your mortgage bi-weekly because you don’t have a long enough amortization period. Most mortgages are set up with a 360-month (30 years) amortization period. For example, let’s say you purchase a $300,000 home and finance it over 30 years at 6% interest. If your monthly payment is $1,200 that means your required monthly principal and interest payment will be $1,159 ($300,000 x 6% /12 months = $1200 per month; divided by 12 months = $104.33 per month). The extra amount covers the added cost of borrowing for 30 years rather than 20 years and is commonly referred to as escrow for taxes and insurance.
6) How Often Do I Make Payments?
The typical mortgage schedule for most homebuyers looks like monthly payment, but that’s not necessarily true. It’s actually made up of two different parts—the interest and principal. The interest is what you pay to use your money over time; it’s usually a set percentage of how much you borrowed.
The principal is how much your initial loan amount decreases each month until it hits zero and you own your home free and clear. For example, if you have a $200,000 30-year fixed-rate mortgage at 4%, your payments would be $1,078 per month. Of that total amount, $903 goes toward paying down principal while $175 goes toward interest. (Note: This is just an example.)
7) Why Am I Paying Private Mortgage Insurance (PMI)?
According to the U.S. Department of Housing and Urban Development (HUD), for a new loan with a down payment of less than 20%, an insurance premium must be paid on that portion of your loan which exceeds 80% (loan-to-value, or LTV) to protect you from foreclosure should you become unable to pay your mortgage. The insurance premium is typically rolled into your monthly payments, although some loans have added to your closing costs.
PMI can add hundreds — even thousands — to what would otherwise be a very small mortgage payment. The only way out is either making enough money to bring your home equity above 80% or refinancing into a loan without PMI. If you’re stuck paying PMI, try not to let it get you down. You’ll save so much more in interest over time by keeping your mortgage as long as possible. Plus, once your equity reaches 20%, most lenders will stop charging PMI anyway!
8) How Does Escrow Affect My Monthly Payment?
First off, escrow is an amount that you pay to your lender each month on top of your principal and interest payment. This amount is used to pay taxes and insurance for your home. The easiest way to understand it is a protection plan against increasing costs over time. Taxes and insurance have traditionally gone up year-over-year, but with an escrow account, you don’t have to worry about those increases affecting your monthly budget as much.
That doesn’t mean there aren’t additional costs – if any taxes or insurance rises dramatically – but in general, you can rest assured that when it comes time to do a tax or insurance bill, you will have enough funds in escrow to cover them. Of course, nothing ever goes exactly according to plan – so always be sure to keep some extra cash in your checking account just in case. If anything changes drastically, contact your lender immediately so they can discuss other options with you.
A common misconception is that all mortgages require an escrow set up; however, most loans today allow borrowers to opt out of their standard escrow features by making a one-time payment at closing. The more involved explanation would be: If you get into a situation where you no longer want an escrow setup because your taxes/insurance has stayed steady for years now (or perhaps even decreased), then you are allowed to make one lump sum annual payment towards these two bills instead of paying every month into an escrow account.
9) If I Pay More Than My Monthly Payment
Yes, if you pay more than your monthly payment, you are decreasing your loan term. However, you will also be increasing your interest payment because you are paying off less principal each month. In other words, if you can afford to pay extra toward your loan each month without putting yourself in debt or spending money that isn’t yours (like a 401k), then by all means go for it!
Just don’t overspend in order to shorten your loan term. That’s not good for anyone. And remember: The best things in life are free! Take time with your family and friends; read a book; learn something new—whatever makes you happy is a worthwhile investment. If you do decide to pay down your mortgage early, we recommend using bi-weekly payments. You’ll have more cash at hand during those months when there aren’t as many bills due and you won’t have to worry about accidentally missing a regular monthly payment.
You can change your mortgage rate after closing? When should I do it?: It depends on what kind of home loan you have, but generally speaking, yes, if rates drop after closing, there may be an opportunity to refinance into a lower rate. If so, we recommend comparing quotes from multiple lenders before making any decisions.
10) What Determines How Much I’ll Pay Each Month?
The biggest determinant of how much you’ll pay each month is your interest rate. The lower it is, the lower your monthly payment will be. That said, interest rates aren’t all that matter. How long you take to pay off your mortgage also determines what you’ll pay in interest and how much you’ll ultimately owe. You see, a 30-year mortgage means a 30-year loan (well, actually slightly less than that).
This means more interest over time because all those payments add up to one giant, compounded bill by the end of three decades. If you’re willing to make extra payments or refinance before then, though, you can reduce what you owe significantly. One last thing: If your home’s value rises substantially during your initial period of ownership.
And it’s not an investment property—you might want to consider refinancing into a 15- or 20-year loan so that some of that equity gets paid off sooner rather than later. If home prices fall instead, though, don’t bother refinancing unless you have other compelling reasons for doing so. It may look like a good idea now but could bite you down the road if things go south.
Also Read: 8 Tips To Stay Budget Conscious
Where do you get most of your information about home loans? Do you feel like you fully understand what your mortgage payment breakdown looks like each month? If not, don’t be embarrassed.
You’re not alone—there are a lot of people out there who feel like they have no idea how their loan works. Hopefully, after reading these ten commandments, you’ll be able to take some steps towards understanding your own mortgage payments.