First Home Buying

PITI is the acronym that describes the contents of your monthly mortgage payment: Principal, Interest, Taxes and Insurance. So when you see those internet banner ads offering an unbelievably low mortgage payment, realize that – along with the possibility that they’re completely bogus – they might not be telling you the whole story.

Principal

This is not the administrator with whom you had frequent run-ins in middle school. Alas, this kind of principal is not your pal at all, but rather it’s the amount you told the seller you’d pay them for their house. Over the course of many years.

Interest

Interest is the amount of money the bank charges you for borrowing their money. When you start out on a conventional 30 year mortgage loan, almost your entire payment will be interest. The ratio between interest and principal changes on a sliding scale so that by the time the final payment of the 30th year rolls around, you’re paying mostly principal. In other words, the lender gets most of their profit up front because you pay large chunks of the interest balance within the first few years, and gradually less as time goes on.

If you consider how few mortgages actually last 30 years without a piece of property being refinanced or sold, you understand why lending can be such a rewarding business. If you know anything about foreclosures, you can then consider how lenders who were expecting to be rewarded so well ended up doing so poorly when they got stuck with tons of foreclosed property. They tried to take advantage of people interested in a good first home buying experience and ended up paying for it. For you, the homeowner, interest is the price you pay for living the American Dream. It really only has one positive quality: it’s tax-deductible, so every cent of interest you pay on your mortgage reduces your taxable income. More on how interest works here.

Taxes

Usually, if you have a good municipal system and a worthwhile lender, your property taxes are rolled into an equity account and paid for you once or twice a year depending on local procedure. The lender calculates the amount you should be charged in property taxes per year, based on the assessed value of the property and the tax rate of the city or county where the property is located. This amount is divided by the number of mortgage payments you’re scheduled to make in a year (usually twelve, but not always), and is added on top of your principal and interest. Since the year-over-year value of a home is likely to change at least somewhat, and municipalities often alter their tax rates as well, your monthly payment may shift up or down slightly over the course of your mortgage.

Insurance

There’s another page on this site that explains how mortgage insurance works in detail, but to put it basically, mortgage insurance is meant to protect your lender from you defaulting on your loan and causing them lots of headache. It doesn’t necessarily always accomplish that goal, but you pay it as long as you owe the lender more than a certain percentage of the value of your home, and you stop paying it once you’ve paid off at least that amount (usually 20%). Like mortgage interest, mortgage insurance is tax-deductible.

Ah, good old interest. When you’re paying interest, it isn’t very interesting at all. If you’re on the receiving end of interest payments, you’ll eventually understand where the old adage comes from that says “you’ve got to have money to make money.” Understanding how interest works in a mortgage loan is a little bit of an endeavor, but I’ll do my best to boil down the semi-complicated math so it makes (at least hopefully a little more) sense.

Interest, to put it in its simplest terms, is money that you pay to borrow money. When you put your hard-earned cash into a savings acount at the bank, the bank is borrowing your money, so they pay you interest on that money. In a mortgage loan, the opposite is true; the bank or lender lets you borrow its money and charges you a fee to pay it back over time. The amount of that fee is called the interest rate.

Compound Interest

Let’s ease into this, if we can. The vast majority of mortgages are paid off on a monthly basis. We know this and can assume that it will be true for your mortgage. The interest rate your lender has quoted you, however, is expressed as an annual figure. So if your mortgage rate is 6%, that’s the amount of interest you’re paying on the balance per year.

This means that when you first take out your loan and every time you make a payment thereafter, you pay interest based on your monthly rate, not the annual rate.

So if you had a 6% yearly interest rate on your mortgage, you’d get the monthly rate by dividing 0.06 by 12, which is 0.005, or one-half percent.

Amortization

Muerte, mort, mortis. These words mean “death” in Spanish, French, and Latin, respectively. No, that doesn’t mean that your mortgage will kill you (although some people might disagree). The word amortization is derived from a similar linguistic thread, so you can think about it as the process of “killing” your mortgage loan. You are paying off the balance over time, and the amount you owe diminishes with each payment made.

If you’ve ever looked at an amortization table, you’ll note that at the beginning of a mortgage the borrower’s monthly payment is mostly interest. Contrary to popular belief, this is not some kind of scam the lender uses to take profits early. It does work out very nicely for them though, doesn’t it?

What this phenomenon actually represents are two important facts that you need to remember when trying to understand mortgage loans:

• The monthly interest you owe on each payment is based on your loan’s remaining balance.
• Interest is always paid before principal.

Let’s use the example in the Compound Interest section above; we had a 6% yearly interest rate, which, divided by 12 months (or 12 payments per year) worked out to 0.5% monthly interest.

If we apply that to a loan for $50,000, our first interest payment would be 50,000 x 0.005 = $250.

Using the first rule above, we’ve calculated the first payment’s interest based on the loan’s remaining balance of $50,000. We also know that according to the second rule, interest is always paid first, before principal. That means that the first $250 of our payment will go toward interest, and the remaining amount in the payment is applied to the balance of $50,000.

In the following month, since the balance is less than the original $50,000, we’re only paying our monthly rate (one-half percent, in this case) on that lesser amount. The trend continues so on and so forth. Since less money is going toward interest each month as the balance decreases, more of that money goes into paying down the principal.

Payments on a fixed-rate mortgage are the same every time, and a more complex formula is used to figure out what your exact monthly payment needs to be in order for you to pay down the principal in the amount of time your loan is set for. This page is intended to show you how interest works though, not to tell you how to figure out your monthly payment. If you need to do that, check out our handy interactive mortgage calculator.

Annual Percentage Rate

One last note about interest. You’ve probably heard the term APR before, and a lot of people are confused about what that really means. Well, to put it bluntly, the basic interest rate you get on your loan is fine and dandy, but the actual percentage you’re paying to borrow the money increases when you include any fees, insurance, or points you have to pay on the loan. The APR is not necessarily representative of the real cost of borrowing, but it does provide a decent standard that can be used to compare various lenders and loans. Any fees that would otherwise be “hidden” in the advertised rate must be included in this figure.

You’re probably used to hearing the question “How much home can I afford?” After all, it’s on just about every financial website in existence. There are calculators for figuring this out, too. In thinking about your first home, I’d challenge you not to ask yourself this question at all. The more appropriate question would be “How much home do I need?”

Needs vs. Wants?

I’m not going to get into a needs vs. wants discussion. My purpose for this website is to give you tons of information about buying your first house, not to preach to you about how to spend your money.

But Consider This

But let’s say you have $10,000 to spend on a car, so you start looking at cars that cost $10,000. How long will it take for your eye to wander over into the next row at that beautiful piece of machinery that costs $11,000? If there really were such a thing as an “easy payment” (kind of an oxymoron, if you ask me), it wouldn’t be so bad. But no matter how much information you give them, someone who is going to take your money will never know just how you interact with your finances.

I had a loan officer tell me that I could afford much more house than I was asking him to approve me for. The reason I didn’t have him increase my approval limit is that I know how much I can afford, much better than the numbers on my paycheck or in my investment account can tell a lender’s calculator. They figure in average amounts for food and other necessities when they come up with their debt-to-income ratio.

But what if I like to spend $400 per month on clothes? I would be ashamed if that were the truth, by the way. Sometimes people have other hobbies and interests that take up their money too. The closer your mortgage pushes you to the limit of your finances, the less you’ll have to spend on other things you enjoy.

I have to stop thinking in terms of what I can afford and start asking myself what I’d do now if I still made the same salary that I did five years ago. The truth is, it would be a financial disaster of epic proportions! But that doesn’t stop me from wondering if financial freedom is more of a state of mind than a state of my bank account.

With all the factors that go into deciding your loan terms, keep in mind that some of these are determined by you; others are and always will be beyond your control. An investor’s ability to judge whether you are a good candidate for a loan, and if so, how large that loan should be, comes from two factors: your financial status, and the current economic environment.

Financial Status

When you talk to a loan officer and express interest in procuring a mortgage loan, they’re going to ask you a few questions about your personal finance. Be ready to provide honest and accurate answers to these questions; anything else will only make things hard on you in the long run and may get you into trouble.

The loan officer will ask about your job; who you work for and where you work, how much money you make, and how long you’ve been employed there, along with other sources of income you may have from renters, a side job, or freelance work. They’ll want to know about any assets you have besides your monthly income such as savings or investment accounts, cars, and a rough estimate of the total value of the other merchandise and personal property you own. Your place and length of residence will also be in question; if you currently own any other houses, and if you have ever filed for bankruptcy.

The officer will probably inquire as to any debt you have incurred – credit card balances, back taxes, liens or other loans. They may ask if you know what your credit score is, but whether you do or not, they’ll check it for you. All of this information will be used to figure out what your debt-to-income ratio is and therefore how much you can borrow. The debt-to-income ratio is a measure of how much a mortgage of a given amount would cost you each month versus how much you make in an average month. Target DTI ranges vary depending on the type of loan you end up with, but they typically hover somewhere around 30% of your gross income.

The Fed Funds Rate

Just wanted to insert a quick note on the fed funds rate and a crash course in economics, for any who may not have the background of how this works. The Federal Open Market Committe (FOMC) is in charge of setting interest rates based on the economic climate in the United States. Banks are always lending money to and borrowing it from one another. The fed funds rate is the interest rate that banks use to lend money to each other overnight. This is one way the FOMC (hopefully) keeps events like the Great Depression from happening in the future; it’s a way of manipulating our supply of money (incidentally, called the money supply) so that people aren’t spending and saving too much or too little.

When interest rates go down, it’s usually to stimulate a slow economy. Lower interest rates promote borrowing, because money becomes cheaper to get and easier to spend. A rate hike should happen when money is being spent too freely and prices are going up at a more rapid pace than is sustainable. The goal of our economy is to promote a strong and steady growth rate; we want to grow, but not too fast. So changing interest rates like this maintains a certain degree of control over our system and balances the economic scales for the most part. Now back to how this affects your home loan.

Economic Environment

When you apply for a home loan, the lender wants to give you money. You’ve got to have it to make it, of course, and the way lenders make it is by setting the interest rate at which they lend money a few percentage points higher than it costs them to get that money in the first place. So a high fed funds rate means a bank has to pay more to get money. In turn, they have to charge you more to borrow it from them so they can still turn a profit. The average interest rate set by banks is called the prime rate, and in the United States it is generally about 3 percent above the fed funds rate. Banks use the prime rate to set their own rates for loans as they see fit.

What happened in the subprime mortgage meltdown was that lenders were offering loans at values less than or very close to the prime rate. These were called “teaser rates” because the terms of the loans they were attached to specified that they were only to last for a short period of time when compared to the overall length of the loan. When the introductory periods began to expire and many found themselves unable to make payments, a rash of foreclosures took place and banks were swamped with huge inventories of vacant properties.

Real estate values plummeted, and banks could no longer sell these homes anywhere near the amount they had lent the original borrowers. Then, due to increased supply and lacking demand, some of the leftover homeowners who had purchased at high prices bought second homes and voluntarily let their first, overpriced ones go into foreclosure. Some didn’t mind the extreme negative effect this had on their credit scores – after all, credit scores can be fixed over time, and in the end they were left with much more affordable housing.

Your Rate

Your rate will be determined mostly by your credit score; if you have a solid credit history and little debt you can count on your rate being fairly close to the average. If you’ve had some trouble paying things off on time in your recent past, though, you may be stuck with a higher rate. Refinancing is one way you can remedy this in the future, but you’ll want to wait and make sure a refinance is worth your while.

Shopping around for interest rates and loan terms is the only surefire way to get the best possible mortgage loan for your home. Since market conditions sometimes change rapidly, you could find that your available interest rate fluctuates as you search, so look for additional benefits besides the rate when you look around.

Investing in You

One thing everybody should realize is that they are not entitled to a mortgage loan. Nowhere in our federal or state legal system does it state that every individual has the right to receive a loan of any kind. You do have the right, however, to be judged solely on your financial status, and not on the basis of any of the other usual factors associated with discrimination of any kind; race, religion, gender, age, marital status, etc.

So when a lender agrees to provide you with the funds you need to achieve a personal goal, with the agreement that you will then pay them back for those funds plus interest, the lender becomes an investor in you. They are helping you to create a better future for yourself in exchange for a fee: additional money charged in interest on top of the loan they’ve provided you with.

Your Bank

Sometimes starting with your bank can be a worthwhile option. If you already have a checking or savings account with a financial institution and you have been a customer of theirs for awhile, they may offer you special incentives for using their lending programs. Your bank should never be the only lender you shop with, however; it would be unwise to assume that they’ll automatically give you the best rate and terms for your first home buying goals simply because you’ve done business with them before.

Other Banks

Once you have received a quote from your bank, go around to some other banks and talk with an associate or manager in the branch. Let them know you’d like to get some information about their mortgage loans and discuss your options. Most of the time they are more than willing to help you with this as selling mortgages is one of their primary business ventures. Check BankRate.com for average national rates and you’re likely to find similar numbers to what you’ve been offered. These rates assume that you have good (or at least decent) credit, which is one of the major factors that determines your loan terms.

Mortgage Companies

A mortgage broker, often referred to as a loan officer, works with a mortgage company to shop loans of clients around with different banks and lenders. The loan officer earns commissions each time she matches a borrower with a lender, so they are essentially working as your proponent to sell you to the investor.

Whereas a loan officer working with a bank knows exactly what information and paperwork that bank needs in order to approve your loan, a private mortgage broker will collect the information she thinks will do the trick and put it in front of several lending institutions. Each financial institution has its own policies and procedures when it comes to the approval process, so even after a private loan officer has received everything she needs to make her own assessment of you she may still ask for additional information as time goes on, depending on who her most promising investors are and what they’ve asked her to furnish.

Paying Down Points

The most important thing to remember when finding a lender, as mentioned above, is to be aware of the additional terms their loans provide in addition to the interest rate they offer. Some rates seem too good to be true until you notice that these loans include points.

Paying down points basically involves paying an upfront fee in exchange for a slightly lower interest rate. You may be able to pay down a quarter or a half of a point, lowering your interest rate from, say, 6.5% down to 6.25 or 6. Fees vary but are generally a few thousand dollars depending on the loan amount.

Deciding whether to pay down points is a decision that can be made fairly quickly. Does the loan require points to be paid down? Do you have the money to afford paying down points right now (or between now and whenever your loan will begin)? For how long do you expect to own the home? Generally the deeper you get into a mortgage the more sense paying points makes, because a lower interest rate will benefit you more as time goes on. With each lower payment, you’re essentially saving money by having that lower rate.