Here at Money Gouge we strive to provide foundational knowledge to help expand your financial mastery. This article is a building block to do just that. Use this reference to explore all types of mortgages listed in other articles found on this site.
What is a mortgage?
A mortgage is a loan from a bank that allows you to buy a property if you do not have enough money to buy it in cash. You pay the bank back over a set term usually 15 or 30 years. The bank makes money off the interest you pay. The interest rate is essentially the “price” of the loan. Generally, banks keep the interest rates of mortgages close to whatever the current rate of the federal reserve is. Without going too far down the rabbit hole, the federal reserve is a bank that lends to banks. Other factors such as your credit score or ability to purchase some of the house directly (down payment) may also affect your interest rate.
Interest rates on a 15 year loan are typically lower than a 30 year mortgage. A 15 year loan will save you a lot of money over time compared to a 30 year. For example, a $200,000 loan at 3% interest will costs you $248,609.00 over a 15 year mortgage. You will pay $48,609.00 in interest. The same $200,000 loan with 3% interest will cost you $303,540 if you choose a 30 year loan. This is because interest increases at an exponential rate over time. Keep in mind you’re paying that $200,000 twice as fast with a 15 year mortgage so the monthly payment will be higher. If you are able to afford the payments a 15 year mortgage will save you a lot of money that would have been wasted on interest.
Typically the bank will require you to put 3.5-20% down. With some loans, such as a VA loan you are not required to put any money towards buying a house. That will not be the only cost to you in this process. There are a lot of administrative costs known as closing cost. Here are some components of closing costs:
- The first mortgage payment
- Title Fee
- Closing or Escrow Costs
- Homeowners insurance
- Mortgage Points
- Loan Origination Fees
- Appraisal Fee
- VA Loan Funding Fee or FHA Loan UFMIP
Title Fee: This is the cost charged to you by the title company. The title is the legal ownership of the house. The title company ensures the person you are buying from actually owns the house and that the ownership (title) is transferred to you on closing.
Escrow and Insurance Cost: When you start a mortgage with a bank they often pay the homeowners insurance and the property taxes for you. These are both annual expenses but they are part of your monthly payment. The annual cost divided by twelve is the cost of this monthly payment known as escrow. When you close on a house you typically split the property taxes with the current owner for the year. Basically they pay for the months they lived there and you pay for the months you will live there. The first year insurance premium is also due. Keep in mind that you will still have to pay the escrow cost the first year. That ensures the money is in the account when the bank pays them for you after the first year.
Mortgage Points: Recall that the interest rate you pay on a loan is what the bank is charging you for taking it. You can pay an upfront fee to lower the interest rate known as the mortgage or discount point. One point will lower your interest rate by .25% and costs 1% of the loan. ($200,000 loan = $2000). If you have extra cash on hand it might be worth it to pay for points. Points will save you more on a 30 year loan then a 15 because interest is higher on a 30 year. If you want to see how one point would affect your potential mortgage use this calculator.
Loan Origination Fee: Some lenders will have a loan origination fee. Typically this is .5-1% of the loan. Loan origination fees are avoidable and not every lender charges them. These fees are supposed to cover “administrative” or “origination” cost. This fee is totally avoidable and it’s worth considering other lenders if your current lender is charging you this fee.
Appraisal Fee: Usually less than $500. An appraisal is a third party assessment of the value of the home. It also establishes how much your mortgage can be. Banks will not give you a mortgage that is higher than the appraisal value of the home. Fortunately, this is a very rare case. This may be an issue if you are trying to purchase a fixer upper property that could have significant defects.
VA Funding Fee: Unique to the VA Loan. When you use a VA Loan the VA will back the bank up to 25% of the loan if you default. In order to mitigate risk to the taxpayers this fee is charged to every person who uses the VA Loan. Here are the VA Loan funding fees for different buyers.
|Down Payment||Funding Fee(% of loan)|
|First VA Loan||<5%||2.3|
|Subsequent VA Loans||<5%||3.6|
FHA UFMIP (Up Front Mortgage Insurance Payment): This is similar to the VA funding fee, it can be up to 1.7% of the loan value. Secures the lender against a loan that is riskier to them. A FHA loan is riskier to lenders because you can put a down payment of as little as 3.5% which is less than the normal 20%.
You do not always have to pay closing costs. You can ask the seller to pay them for you or with Loans such as the FHA and VA you can add closing costs to the overall loan amount. This allows you to close with little to no money out of pocket but have a larger mortgage as a result.
What does a mortgage payment consist of?
- Principle and Interest (P & I)
- Property Taxes
- HOA– If applicable
P & I- This is the monthly mortgage payment. It makes up the largest part of your mortgage payment. The monthly payment is calculated by taking the total cost of the loan (including the interest) and dividing it by 360.
Though this number will remain the same over the life of a fixed rate loan the amount of this number that goes towards interest will be the highest in the first year and then decrease every year. This is broken down month by month in the amortization schedule which your bank should provide for you while you are shopping for a mortgage. On a 30 year mortgage you will pay mostly interest for the first 10 years!
Money Gouge Tip
Your equity will build much faster in a 15 year mortgage than a 30 year. If you can afford it, this is definitely a smart move. You will save tens of thousands of dollars in interest. Freeing yourself from a mortgage payment is a significant step towards financial freedom. If the payments on a 15 year loan are too large, paying an extra $50-100 a month when able will drastically reduce the interest you pay and shorten a 30 year mortgage.
Escrow Expenses: This includes insurance, property taxes and HOA (Home Owner’s Association) fees. When looking for a house you need to be hyper focused on what these expenses will be for two reasons:
- They do not build equity in your house. These expenses do very little to build your wealth
- They are annual. Any increase in cost can dramatically increase mortgage payments because it is only divided by the twelve months of the year.
Different regions will have different norms for these numbers. For example, Florida has lower property taxes then the Northeast but insurance can be expensive or difficult to get because of hurricanes.
Money Gouge Tip
You need to mitigate HOA fees as much as possible. While HOA’s can add value to a neighborhood, overpaying hundreds of dollars a month to an HOA is an absolute waste of money. Choose a comparable neighborhood that has a competitive or lower HOA fee and put that money to work by paying extra to your mortgage or investing it.
Types of Mortgages
Fixed: Interest rate remains the same over the length of the loan. You can play around with the estimated mortgage costs using this calculator.
There are multiple types of fixed interest mortgages which are discussed in more detail below
What are fixed rate mortgages good for?
Fixed rate mortgages are good for residential properties because your mortgage payment will remain relatively stable. They are also great for rentals because the stability allows you to set your rent for a long term lease without risk of the mortgage cost changing.
Keep in mind your mortgage payment can still change based on property taxes or insurance.
Money Gouge Tip
Buying a home for personal use will allow you to get a lower mortgage rate then a pure investment home. This means you will have a lower mortgage and be able to pocket more from renting your house out at higher price. You can get started in rental properties by buying a house at your current duty station and then renting it once you move.
Types Of Fixed Rate Mortgages
Conventional: Not backed by any government entity such as the FHA (Federal Housing Administration) or VA (Veteran’s Affairs).
Accessible to buyers with at least a 600 credit score (you want to be in the 740 and above category for the lowest rates). Qualifications vary by lender because they are not regulated by a government agency. Typically, you will pay PMI (Private Mortgage insurance) for putting less than 20% down.
Private mortgage insurance: is a monthly cost that gets added into your mortgage. It protects the lender against losses from a riskier loan. If you put less than 20% down or have a lower credit score you may be required to pay PMI. PMI does not count towards your equity as it is an on top cost.
Additional info on a Conventional Mortgage can be found here.
FHA: Backed by the Federal Housing Administration these loans are available to people with at least a 580 credit score. They allow you to put down only 3.5%.
To qualify you will need:
- 3.5% down payment
- Steady employment and debt to income ratio of no more than 50%
- Money for closing costs
- Up Front Mortgage Insurance Premium (1.75% of total mortgage amount) is added to your loan
Up Front Mortgage Insurance Premium is a fee that you pay because of the low down payment. It is added to a pool of money known as the mutual mortgage insurance fund that protects lenders against losses from unpaid loans.
VA Loan: Available to active duty, reservists, veterans and certain families of servicemembers. They allow you to buy a home with zero down payments and roll the closing cost into the loan. See our article (The Ultimate Guide To The VA Loan). As of, 2020 the VA Loan no longer has a limit for members who are using it for the first time. If you have used it before, your future eligibility is either $510,400 or $756,600 minus the amount you used on your previous loan.
Jumbo Loan: Jumbo loans are used for high costs properties that are beyond the costs the government supported conventional loan will support. That’s $510,400 in most zip codes or $756,600 for high cost areas. This excel sheet from the VA has all the zip codes in the US. VA loans no longer have this cap as of 2020 but this still applies to FHA loans.
Understanding a Jumbo Loan:
- Interest rates are usually slightly higher
- 20% down is required
- Excellent Credit Required (740 and above)
In general these loans are for high earners with excellent credit and low debt to income ratios who are buying luxury real estate.
Adjustable Rate Mortgage (ARM)
ARM (adjustable rate mortgage): Your mortgage rate is locked for the first few years and then adjusts within allowable limits at set periods. The adjustments are based on the prevailing rate set by the federal reserve at the time of the readjustment.
ARM’s contain a lot of financial jargon so they are best explained by an example:
A 5/5 Arm at 2% Interest
The first 5 describes the number of years the interest rate will be locked. The second 5 is the number of years between readjustments. So this loan will be fixed interest at 2% the first five years and then be readjusted every five years thereafter.
By how much will it readjust? Is there a maximum interest rate?
First cap: The specific amount that a loan interest rate can change on the first adjustment. Lets say the first cap is 2.5%. At year 5 your mortgage rate is readjusted. It can go up , down, or not move at all but it cannot go up more than 2.5% for a total interest rate of 4.5%.
Subsequent caps: The max amount that a loan interest rate can change on subsequent adjustments. Lets say subsequent caps are 1.5%. Depending on what rates are at the 10 year mark it can be readjusted from the previous 4.5% up or down 1.5%. Lets say it goes up 1.5% now your interest rate is at 6%.
Lifetime cap: The max amount that a loan interest rate can change over the life of the loan. For this example lets say it is 6%. Now on subsequent adjustments your rate can be lowered but if prevailing interest rates go higher (8%) you are capped at 6 and it will never be adjusted past that.
Even if you hit the cap, your rates will continue to be reassessed every 5 years until the loan is done. Again you will have the opportunity to lower them but they will never go above the cap (6% for this example).
These ARM rates were pulled from a bank’s current offering at the time of publishing. ARMS’s can be difficult to understand but they are generally most useful for homeowners who do not plan to own a home for more than 5 years.
If you want to play around with the cost of an ARM loan use this calculator.
What are Adjustable Rate Mortgages good for?
ARM’s usually start with a lower interest rate than a fixed rate mortgage. If you are only planning on staying in a home for five years or less an ARM will significantly lower your payment in that period. An ARM may also make sense if interest rates are high. You will start with a lower interest rate than a fixed and the interest rate could readjust down over the life of the loan if interest rates go back down.
For any additional questions you may have about mortgages, contact us.