Mortgage: The Loan With a House Attached
I found a house online. Three hundred thousand dollars, and the little calculator under the picture says about eighteen hundred a month. So I pay that for thirty years and the house is mine?
0:00 / 7:08
Mortgage: The Loan With a House Attached
The number under the house photo
A mortgage is an agreement between you and a lender that lets you borrow money to buy or refinance a home, and it gives the lender the right to take the property if you do not repay it. 1 If payments stop, the lender or servicer can take the property back through foreclosure. 1
The monthly figure in a listing calculator is not the whole cost. On a made-up $300,000 loan at 6 percent over 30 years, principal and interest comes to about $1,799 a month, and 360 payments add up to roughly $647,000, more than twice the price of the house. Those figures are illustrative and the arithmetic is the point: interest is charged on the balance every month, so the longer the term, the larger the share of the total that is interest.
What the monthly payment is made of
Principal is the amount borrowed and still owed. Interest is what the lender charges for lending it. 2
The rest of the payment is the part buyers forget. Principal and interest, plus mortgage insurance if it applies, plus the property taxes and homeowners insurance collected into escrow, equals the total monthly payment. 2 That projected total sits on page one of the Loan Estimate, and reading only the principal and interest figure is a common way to be surprised later. 3
An escrow account, sometimes called an impound account, is set up by the lender to pay property-related bills. A portion of every monthly payment goes into it, and the servicer pays the tax and insurance bills when they come due. 4 Many lenders require escrow so those bills are actually paid. Taxes and insurance premiums change from year to year, and the escrow portion of the payment moves with them. 4 That is the first item on the bureau's own list of reasons a monthly payment changes. 5
Why the first years are mostly interest
The part of a payment that goes to principal reduces the balance and builds equity. The part that goes to interest does neither, so the equity built in a home is much less than the sum of the payments made. 6
On a fixed-rate loan the combined principal and interest payment stays the same, but the split inside it changes. Early in the term the balance is high, so most of the payment is interest; as the balance falls, more of each payment goes to principal. The bureau calls this process amortization. 6 On the same made-up $300,000 loan, the first month's interest is $1,500, so about $299 of an $1,799 payment comes off the balance. Fifteen years in, roughly $213,000 of that loan is still owed.
What the lender checks
Lenders are required to make a reasonable, good-faith determination that a borrower can repay. 1 Income against existing debts, credit history, and the size of the down payment carry most of that judgment; a larger down payment generally means a lower rate and a better chance of approval. 1 The debt-to-income ratio is all monthly debt payments divided by gross monthly income, so $2,000 in payments against $6,000 of income is 33 percent. 7
On a conventional loan with less than 20 percent down, private mortgage insurance is usually required. It protects the lender, not the borrower: falling behind still means foreclosure, and the premium is typically added to the monthly payment. 8
The two forms that buy you time
A Loan Estimate is a three-page form a lender must provide within three business days of receiving an application. Every lender uses the same form, which is what makes offers comparable, and it carries the estimated rate, the monthly payment, and the closing costs. 9
A Closing Disclosure is a five-page form that must reach the borrower at least three business days before closing, so the final terms and costs can be compared with the Loan Estimate. 10
A fixed rate is set when the loan is taken out and does not change. An adjustable rate may start lower and then change on a schedule, inside caps that limit how far and how fast it can rise. 11
The takeaway
Ask more than one lender for a Loan Estimate, and read the total monthly payment rather than the principal and interest figure. A mortgage is a long agreement with the house itself standing behind it, and the total payment is the number a household actually lives with.
This show is educational only and is not registered investment advice. The loan figures above are illustrative, not quoted rates, and no loan offer or lender is being recommended.
References
- 1CFPB: Mortgages key terms
consumerfinance.gov
- 2CFPB: Principal and interest payment versus total monthly payment
consumerfinance.gov
- 3CFPB: Loan Estimate explainer
consumerfinance.gov
- 4CFPB: What is an escrow or impound account?
consumerfinance.gov
- 5CFPB: Why did my monthly mortgage payment go up or change?
consumerfinance.gov
- 6CFPB: How does paying down a mortgage work?
consumerfinance.gov
- 7CFPB: What is a debt-to-income ratio?
consumerfinance.gov
- 8CFPB: What is private mortgage insurance?
consumerfinance.gov
- 9CFPB: What is a Loan Estimate?
consumerfinance.gov
- 10CFPB: What is a Closing Disclosure?
consumerfinance.gov
- 11CFPB: Fixed-rate versus adjustable-rate mortgage
consumerfinance.gov
This story was produced automatically by a channel. One sentence is all it takes for Neodrop to keep producing for you.