A mortgage is likely going to be one of the largest loans you'll take out in your life. It's essential to understand all that goes into the cost and your responsibility in paying it back.
Since monthly payments spread the cost of a mortgage loan over an extended period, it’s easy to forget the total expense. For example, if you borrow $200,000 for 30 years at 6% interest, your total repayment will be around $431,680, more than two times the original loan.
What seems like minor differences in the interest rate can add up to a lot of money over 30 years. For example, if you move that same $200,000 loan up to a 7% rate, the total repaid would be $478,160, which is about $47,480 more than at the 6% rate.
Principal: The amount of money that you initially borrow and will need to repay.
Interest: Interest is the percentage of the principal that you pay for borrowing money. The interest rate is the primary component of your APR. Your interest rate is determined in large part by the current cost of borrowing in the economy and your creditworthiness.
APR (Annual Percentage Rate): The APR is a representation of the annual percentage you will need to pay back on top of the principal. It includes your interest rate, points, fees, and other costs.
Points (Prepaid Interest): A fee you pay to lower your interest rate on a home purchase.
Fees: Fees include application fees, loan origination fees, and other initial costs imposed by the lender.
Term:The total length of the loan. A longer term means lower monthly payments, but higher overall costs as it results in more interest being accumulated. Similarly, a shorter term means higher monthly payments but a lower overall cost.
Escrow account:A savings account set up and managed by your lender to pay important bills related to your mortgage and property.
Multiple factors can change the overall cost of a mortgage, but the interest rate and term length will often have the largest impact.
You repay a mortgage loan in a series of monthly installments over the term, a process known as amortization. Over the first few years, most of each payment is allocated to interest and only a small portion to paying off the principal. By year 20 of a 30-year mortgage, the amounts allocated to each equal out. And, by the last few years, you’re paying mostly principal and very little interest.
Try this mortgage calculator below to see what a realistic mortgage would look like for you.
The amount you borrow, the finance charges—which combine interest and fees—and the time it takes you to repay are the factors that make buying a home expensive. So finding a way to reduce one or more of them can save you money.
Make a larger down payment. The less you borrow, the less interest you’ll pay. Since the interest is calculated on a smaller base, your payments will be lower. And if your down payment is at least 20% of the purchase price, you won’t be required to purchase private mortgage insurance (PMI), which adds to your borrowing costs. The primary drawback to a larger down payment may be cutting too deeply into your savings, making it difficult to cover other expenses.
Consider a shorter loan. With a shorter term, you pay less interest overall on the same principal. You may also qualify for a somewhat lower APR, which would reduce your total cost even more. But your monthly payments will be higher than if you chose a longer term, so you run the risk of committing yourself to larger payments than you can afford.
Make more payments. You can pay more than the amount required by your contract, either by making more payments or paying an extra amount with each regular payment. If you do the latter, be sure to make it clear that the extra amount should be used to reduce principal, not prepay interest. Lenders may offer a bi-weekly payment plan, but managing the extra payments yourself gives you more flexibility and may reduce the loan faster. Be aware that taking this strategy may cause you to pay off before you reach the full term. While that can be a good thing, some mortgages have prepayment penalties, which will charge you a fee for paying your loan off early. Talk to your lender to be sure that you understand all of the terms of your mortgage and the associated fees.
Points are fees that you can choose to pay upfront in exchange for a lower interest rate. Each point typically costs 1% of the total mortgage amount and lowers the interest rate by a fixed amount (often 0.25%). There are two main types of mortgage points: discount points and origination points.
- Discount Points: These are the most common type of points. When you buy discount points, you're essentially paying some of the interest upfront in exchange for a lower interest rate. This can save you money over the life of the loan, especially if you stay in the home and don’t refinance for a long time.
- Origination Points: These are used to cover the lender's costs of making the loan. They aren't tied to the interest rate and might not save you any money in the long run.
Principal and interest are major components of the cost of buying a home, but they aren’t the only ones. You’ll also owe real estate taxes, which can vary dramatically from state to state and from region to region within a state.
The taxes, which are based on the assessed value of your property and the municipality’s tax rate, typically pay for public schools, police and fire protection, highways, and other government services. Assessed value, which is determined by an assessor working for a particular municipality, usually differs, at least to some extent, from both the market value and the appraised value.
There is also the cost of homeowners insurance, which your lender will require to protect its investment and which you should have to protect your equity. You may also be required to have flood insurance, which is separate.
Depending on where you live, you may also need to pay homeowner’s association (HOA) fees, either annually or monthly.
To manage the high annual cost of property taxes and homeowners insurance, your mortgage lender will likely set up an escrow account for you. An escrow account is a savings account managed by your lender for the sole purpose of paying these important bills.
You’ll make required escrow payments as part of your monthly mortgage payment, and those are deposited into your escrow account. When an escrow item is due—such as your annual property taxes—the lender is responsible for paying the bill on time, not you.
Many lenders require escrow accounts under the terms of your mortgage, to make sure you don’t fall behind on these obligations. Some lenders allow you to remove or cancel your escrow account after a period of time, but then you’re on your own to plan for and pay these annual bills.
Your bottom-line mortgage payment includes principal, interest, and escrow, which is property taxes and insurance.
Be sure to consider all the costs associated with a mortgage for a complete picture of what it really costs.
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