How Loans Work

Excluding property taxes and insurance, a traditional fixed-rate mortgage payment consist of two parts: (1) interest on the loan and (2) payment towards the principal, or unpaid balance of the loan.Many people are surprised to learn, however, that the amount you pay towards interest and principal varies dramatically over time. This is because mortgage loans work in such a way that the early payments are primarily in interest, and the later payments are primarily towards the principal.

 In The Beginning... You Pay Interest
To help calculate monthly payments for loans based on different interest rates, lenders long ago developed what are known as "amortization tables." These tables also make it fairly easy to calculate how much money of each payment is interest, and how much goes towards the principal balance.

For example, let's calculate the principle and interest for the very first monthly payment of a 30-year, $100,000 mortgage loan at 7.5 percent interest. According to the amortization tables, the monthly payment on this loan is fixed at $699.21.

The first step is to calculate the annual interest by multiplying $100,000 x .075 (7.5 %). This equals $7,500, which we then divide by 12 (for the number of months in a year), which equals $625.

 

If you subtract $625 from the monthly payment of $699.21, we see that:

$625 of the first payment is interest

$74.21 of the first payment goes towards the principal

 

Next, if we subtract $74.21 (the first principal payment) from the $100,000 of the loan, we come up with a new unpaid principal balance of $99,925.79. To determine the next month's principal and interest payments, we just repeat the steps already described.

Thus, we now multiply the new principal balance (99,925.79) times the interest rate (7.5%) to get an annual interest payment of $7,494.43. Divided by 12, this equals $624.54. So during the second month's payment:

$624.54 is interest

$74.67 goes towards the principal

 

 Equity
As you can see from the above example, even though you pay a lot of interest up front, you're also slowly paying down the overall debt. This is known as building equity. Thus, even if you sell a house before the loan is paid in full, you only have to pay off the unpaid principal balance--the difference between the sales price and the unpaid principle is your equity.

In order to build equity faster--as well as save money on interest payments--some homeowners choose loans with faster repayment schedules (such as a 15-year loan).

 

 Time Versus Savings
To help illustrate how this works, consider our previous example of a $100,000 loan at 7.5 percent interest. The monthly payment is around $700, which over 30 years adds up to $252,000. In other words, over the life of the loan you would pay $152,000 just in interest.

With the aggressive repayment schedule of a 15-year loan, however, the monthly payment jumps to $927-for a total of $166,860 over the life of the loan. Obviously, the monthly payments are more than they would be for a 30-year mortgage, but over the life of the loan you would save more than $85,000 in interest.

Bear in mind that shorter term loans are not the right answer for everyone, so make sure to ask your lender or real estate agent about what loan makes the best sense for your individual situation.

6 Steps to Financing a Home

1. Prepare for the Purchase: Begin early to establish sufficient savings so that you can pay the required from a minimum of   (2.5% or 5% to 10% or to 20%, depending on the Loan Program you are qualified for) that lenders require for down payment. You may be asked by the lender to provide bank statements as proof of sufficient down payment, so set up a savings account well in advance of your house search.
2. Research Your Credit History: It is a good idea to check your credit rating before applying for a mortgage in order to identify and resolve any potential problems. National credit reporting agencies have been known to make mistakes in their credit reports. Contact all three major credit reporting companies to be sure your record is accurate.
3. Minimize Your Debt: Lenders often consider the amount of debt you have a significant factor in determining how much of a loan to grant. A simple way to increase your improve your credit standing is to reduce the balances of credit card charge cards and auto loans.
4. Determine How Much You Can Afford: Assess the three most important factors that determine how much you can afford to spend on a new home:

* Down payment - most loans require a down payment of minimum of 2.5% or 5% or 10% or 20% of the home price. Offering a larger down payment may qualify you for special loan packages.

* Ability to qualify for a mortgage - most lenders figure that your monthly mortgage payment should range between 25 and 28 percent of your gross monthly income. A credit report is also requested to verify your debt repayment history and available credit.

* Closing costs - typically range between two and five percent of the loan amount. These costs are due in cash at the time of closing.

5. Obtain Pre-Approval for a Loan: Pre-approval from a local lender is not the same as pre-qualification. Pre-qualification means your income, assets, and present debt are estimated in an informal way to help determine what price home you can afford to buy. Pre-approval by a mortgage lender means you have successfully obtained a written commitment from the lender. A formal application must be submitted and your financial information is verified.
Pre-approval is beneficial to you because it gives you leverage in negotiations. Sellers prefer pre-approved buyers because they know their home sale won't be delayed or canceled due to the buyer's inability to obtain financing. In addition, pre-approved buyers can sometimes lock in lower interest rates before they even find the house they want to purchase.
6. Discuss Mortgage Rates: It is helpful to understand the different types of mortgages and the effect different interest rates will have on your financial situation. Review recent mortgage rate trends and discuss the implications of differing rates with a lender to ensure that you are making a wise decision when locking in interest rates.
With your pre-approval commitment in hand, you are ready to begin your search for a new home.