4.2 Mortgage terms and amortization

Mortgages are the backbone of real estate finance. They allow buyers to purchase property without paying the full price upfront. Understanding mortgage terms and amortization is crucial for making informed decisions about home buying and financing.

This section breaks down key mortgage concepts like principal, interest, and loan terms. It also explains how payments are calculated and allocated over time. Knowing these basics helps borrowers compare options and manage their mortgages effectively.

Key Mortgage Terms and Implications

Mortgage Definition and Collateral

Top images from around the web for Mortgage Definition and Collateral

• 

  NY View original

  Is this image relevant?

• 

  Mortgage Foreclosure - Free of Charge Creative Commons Finance image View original

  Is this image relevant?

• 

  Mortgage View original

  Is this image relevant?

• 

  NY View original

  Is this image relevant?

• 

  Mortgage Foreclosure - Free of Charge Creative Commons Finance image View original

  Is this image relevant?

1 of 3

Top images from around the web for Mortgage Definition and Collateral

• 

  NY View original

  Is this image relevant?

• 

  Mortgage Foreclosure - Free of Charge Creative Commons Finance image View original

  Is this image relevant?

• 

  Mortgage View original

  Is this image relevant?

• 

  NY View original

  Is this image relevant?

• 

  Mortgage Foreclosure - Free of Charge Creative Commons Finance image View original

  Is this image relevant?

1 of 3

• A mortgage is a loan used to purchase real estate where the property serves as collateral for the lender
• If the borrower defaults on the mortgage, the lender can seize the property to recoup their losses (foreclosure)
• Mortgages are secured loans, meaning they are backed by the value of the collateral (the property)
• Unsecured loans, such as credit card debt, do not have collateral backing them

Principal, Interest, and Annual Percentage Rate (APR)

• The principal is the original amount borrowed from the lender
• Interest is the cost of borrowing money, typically expressed as an annual percentage rate (APR)
• APR includes the interest rate and other fees associated with the mortgage, such as origination fees and mortgage insurance
• A higher APR means the borrower will pay more in interest over the life of the loan
• For example, a $200,000 mortgage with a 4% APR will have a higher total cost than the same mortgage with a 3.5% APR

Loan Term and Residential Mortgages

• The loan term is the length of time over which the borrower agrees to repay the loan
• Residential mortgages typically have loan terms of 15 or 30 years
• Shorter loan terms result in higher monthly payments but less total interest paid over the life of the loan
• Longer loan terms have lower monthly payments but more total interest paid

Down Payment and Private Mortgage Insurance (PMI)

• The down payment is the upfront portion of the purchase price paid by the borrower
• A larger down payment reduces the amount financed through the mortgage
• Private mortgage insurance (PMI) is often required when the down payment is less than 20% of the purchase price
• PMI protects the lender against default by the borrower
• Borrowers can request to have PMI removed once they reach 20% equity in the property

Closing Costs and Fees

• Closing costs are fees associated with finalizing the mortgage
• These fees can include appraisal fees, title search fees, and origination fees
• Closing costs are typically 2-5% of the purchase price and are paid by the borrower at closing
• Some lenders offer no-closing-cost mortgages, where the fees are rolled into the loan balance or the interest rate is increased

Mortgage Payment Calculations

Amortization Schedules and Payment Composition

• An amortization schedule is a table detailing each periodic payment on a mortgage over the loan term
• The monthly mortgage payment consists of principal and interest
• In the early years of the loan, a larger portion of each payment goes towards interest
• Later payments increasingly pay down the principal balance
• Borrowers can request an amortization schedule from their lender to see how their payments are allocated over time

Mortgage Payment Formula and Variables

• The mortgage payment formula is: $P = L[c(1 + c)^n]/[(1 + c)^n - 1]$
• $P$ is the monthly payment
• $L$ is the loan amount
• $c$ is the monthly interest rate (annual rate divided by 12)
• $n$ is the number of payments (loan term in years multiplied by 12)
• For example, a $200,000 loan with a 4$954.83

Extra Payments and Loan Payoff

• Extra payments applied directly to the principal can shorten the loan term and reduce total interest paid
• Borrowers can make extra payments on a regular basis or in lump sums
• Some lenders may charge prepayment penalties for paying off the loan early
• Borrowers can use online calculators or consult with their lender to see how extra payments affect their loan payoff timeline

Loan Term, Rate, and Down Payment Impact

Loan Term and Total Interest Paid

• A longer loan term results in lower monthly payments but higher total interest paid over the life of the loan
• Shorter loan terms have higher monthly payments but less total interest paid
• For example, a $200,000 loan with a 4% interest rate would have the following monthly payments and total interest:
  • 15-year term: $1,479.38 monthly payment,$66,287.94 total interest
  • 30-year term: $954.83 monthly payment,$143,738.99 total interest

Interest Rates and Monthly Payments

• Higher interest rates lead to higher monthly payments and increased total interest paid
• A 1% difference in interest rate can significantly affect the monthly payment and total interest
• For example, a $200,000 loan with a 30-year term would have the following monthly payments:
  • 3% interest rate: $843.21
  • 4% interest rate: $954.83
  • 5% interest rate: $1,073.64

Down Payment and Loan Amount

• A larger down payment reduces the loan amount, resulting in lower monthly payments and less total interest paid
• Conventional loans typically require a minimum 5% down payment
• FHA loans allow for down payments as low as 3.5%
• VA and USDA loans may offer 0% down payment options for qualified borrowers

Adjustable-Rate and Balloon Mortgages

• Adjustable-rate mortgages (ARMs) have interest rates that can change over time, affecting monthly payments and total interest paid
• ARMs often have lower initial interest rates compared to fixed-rate mortgages
• Balloon mortgages have lower initial payments but require a lump sum payment at the end of the loan term
• Borrowers should carefully consider their ability to afford potential payment increases with ARMs or balloon payments

Principal Balance Changes Over Time

Principal Balance Definition and Initial Amount

• The principal balance is the remaining amount owed on the mortgage at any given time
• At the beginning of the loan term, the principal balance is equal to the original loan amount
• For example, if a borrower takes out a $200,000 mortgage, their initial principal balance is$200,000

Payment Allocation and Principal Reduction

• Each monthly payment reduces the principal balance, with the amount of reduction increasing over time
• In the early years of the loan, most of each payment goes towards interest, so the principal balance decreases slowly
• As the loan progresses, a larger portion of each payment is allocated to the principal, accelerating the decrease in principal balance
• For a $200,000 loan with a 4$186,000

Late-Term Principal Reduction and Tracking

• Toward the end of the loan term, the principal balance decreases more rapidly as a larger portion of each payment is applied to the principal
• In the final years of the loan, the majority of each payment goes towards principal reduction
• Borrowers can track their principal balance using an amortization schedule or by requesting a statement from their lender
• Knowing the current principal balance can help borrowers make informed decisions about refinancing, selling, or paying off their mortgage early