When a home buyer purchases their first home, they usually take out a loan. This loan is commonly referred to as a “mortgage”. First time home buyers may not give much thought to what is actually happening when they borrow money from a lender to purchase their home. They find a lender, jump through numerous “hoops” to get qualified, then go to a “closing” or “closing of escrow” to seal the deal.
The new home owners grab their keys and excitedly move in. But there is more to this story, and it’s the part that few first time buyers ever really understand. It’s about what really happens when you buy a home using a typical mortgage loan.
A buyer will sign a lot of documents during the closing, and the attorney presiding over the closing explains each one briefly to the buyer. But the closing attorney (or title company) is usually working on behalf of the lender. While they will tell the buyer what they are signing, in general terms only, they will not explain the details of what impact these documents will have on the buyer. Buyer’s don’t usually bring their own attorney to a closing, so they shrug off those general details and sign away.
In Georgia, the closing attorneys often say: “If you don’t pay, you don’t stay“, when explaining the documents as the buyer signs the stack of “loan papers”. But what the buyer is actually doing is signing the deed to their new home back over to the lender, as collateral for their loan.
In states that practice “non-judicial” foreclosure, including Georgia, Arizona, California, Michigan, Nevada and about 25 others, the buyer actually signs their deed to the property over to the mortgage company, who then agrees to give that ownership back when the buyer meets the terms of the note. The primary action the buyer is engaging in is”mortgaging the property”. A Security Deed means that a buyer is granting property title to the lender. It also comes with a “Power of Attorney” the buyer must sign, granting the lender the right to repossess the property if the buyer becomes in default of the loan contract, simply by advertising their “intent to foreclose”, for 30 days in the local newspaper.
In non-judicial foreclosure states, a foreclosure can be completed from start to finish in a 30 day window. Generally it’s about two months from foreclosure notice, to actual courthouse auction.
And then there’s that note you signed, with the payment terms such as the amount of the monthly payment and the interest rate. But what really happens with the interest on that home loan you just got?
Let’s say your credit is average. Chances are your interest rate will be around 5%. Not quite the really low advertised rate, but lower than they’ve been historically. Anyway, buyers don’t give a lot of thought to how those interest rates are actually calculated or how they get paid out. It’s all in the “amortization schedule” you should receive with your closing documents, but that’s just a big string of numbers; who wants to read that anyway?
For example, let’s say you are borrowing $150,000, at 5% interest for 30 years, after paying 5% down, on an FHA insured loan, which allows for your lower down payment amount. Your principal and interest payment will be $805.23 per month.
You will also have an additional amount added to your mortgage payment to cover your property taxes and your insurance. These will vary significantly depending on the location of the home, and the type of property you have. But for this example, let’s say that they total $1,500 per year for property taxes, and $700 per year for homeowners insurance. Add them together – $2,200 and divide by 12 months = $183.33
So, your Principal, Interest, Taxes and Insurance payment, (your PITI) will be $988.56 per month. For 30 years. And don’t forget that FHA funding fee, to help cover the cost of FHA insurance claims. It’s been raised in 2012 due to higher default rates, so, you’ll pay an up front fee to FHA, and roughly $20 per month for our $150K loan. That comes to about $240 per year for Private Mortgage Insurance.
The real reason most folks are underwater on a home they’ve owned for 10 years or even longer, is the fact that interest on your loan is collected on the front end. When you first start paying on your loan, your payment will be allocated mostly to interest for the lender. Only a very small portion will be used to pay down your actual loan. This is called “amortization” and it’s the big reason why someone can pay on a home for years and still owe much more than the home is worth.
With mortgage amortization you’ll pay on a 30 year mortgage for about 18 to 20 years before you actually begin paying more in loan principal, than you are paying in interest. For almost 20 years, the lender collects interest first, leaving you to pay down your loan from year 20 to year 30.
If you had bought your home in December of 2000, with the first payment of $805.23 for principal and interest, you’d pay $625 for interest, and $180.23 paid towards the loan balance itself. By 2010 you would have paid over $63,000 in interest, about $25,000 on your loan balance, FHA fees of $2400, along with taxes and insurance payments totaling about $22,000.
During that time you paid an estimated $112,400 in mortgage payments. You paid down a total of $25,000 on your loan balance, leaving you owing a loan balance of $125,000. And to boot, by the time you had paid that much, the market had tanked, and your home has dropped from a value of $150,000 down to about $100,000, or less.
This is the primary reason why so many homeowners are in trouble. Mortgage Amortization insures that the lender will collect the vast majority of their interest first. This is because that 5% interest rate on your mortgage is calculated as 5% of the ENTIRE balance for each year. If you owe $150,000 in year one you’ll pay about $7449 in year one, just for interest. If your interest rate were to jump a mere 1%, in the above example, it would add another $33,000 in interest to the cost of your loan.
The idea is that you are paying your interest rate on the entire balance, every single year, so the interest expense for the first twenty years is likely to be more than the entire amount you originally borrowed.
With interest rates below 5% for the best credit, and housing prices in some areas actually lower than the cost to build new, today’s housing market is an incredible value for those who are able to take advantage of it.
But because of the way that loan amortization works, the smart approach is to plan to prepay at least $100 each month on your mortgage principal from the very first mortgage payment. Prepayments must be applied to the loan principal, and will allow you to save tens of thousands of dollars in interest.
You’ll save tons of cash, pay much less for your loan, and you’ll pay down your loan much faster. And best of all, you’ll keep more of your own money, by giving less of it to the bankers. You can win the home ownership game and win big now that you know the mortgage secrets that they hope you don’t know. ***
Donna S. Robinson is a 16 year veteran of the real estate industry and a staff writer for Realty Biz News. Get free real estate investing lessons, and receive notices on hot investment properties by joining her email list on her website at www.RealtyBizConsulting.com