The Nuts and Bolts of a Mortgage

by Sophia Bera on March 14, 2016

If you’re considering buying a home for the first time, there are a lot of terms thrown around that make the process seem pretty daunting. The one you’ve probably heard of? The mortgage.

Much like rent, your mortgage payment is due monthly. But what does that payment cover? How do you get approved for one in the first place? And how do you even know what you can afford?

I PITI the Fool

A mortgage payment is made up of four components. Together, they spell out the acronym PITI. (And if you ever forget that, just think, “it’s a PITI my mortgage payment is so high!”)

  • Principal: This is the original balance of money you were loaned. So, a $100,000 mortgage has a $100,000 principal.
  • Interest: The lender is loaning you money and charging you interest for the privilege. The interest is paid on the principal only.
  • Taxes: Your property taxes fund projects in your city. The amount you pay can vary from year to year, because it’s recalculated by the government annually. The annual cost can be divided into monthly payments that are grouped in with your mortgage payment.
  • Insurance: Two kinds of insurance make up part of the mortgage payment — homeowners insurance and private mortgage insurance, or PMI. If you put less than 20% down when you buy a home, you’ll pay PMI, which amounts to 0.5% to 1% of the principal amount.

Okay, I Know What a Mortgage Is. Duh. How Do I Get One?

If you’re ready to get the home-buying process started, get pre-approved for a loan. Shop around — banks or mortgage brokers will offer you a number of options, and you can pick which lender you like best. The lender will look at things like your income, credit score (ideally above 680!), and current other debts to determine how much of a loan you can afford to pay back.

Pro Tip: If your score is less than a 680, consider delaying your home purchase and focus on improving your credit score.

Start by pulling a copy of your credit report on www.annualcreditreport.com and eliminate anything in collections. Anything in collections will continue to negatively affect your credit each month that it stays on your credit report.

If you can aggressively pay off debt and eliminate other monthly payments, this will help improve your debt to income ratio and also free up monthly cash flow, making a mortgage payment more affordable.

Ultimately, a higher credit score could lead to a lower interest rate on your mortgage. A difference of .25% on your mortgage could save you thousands of dollars over the life of your mortgage. Why waste money on interest when you could spend 6-12 months improving your credit and being in a better financial position to buy?

If you already have a high credit score but are having difficulty obtaining a mortgage because of some unique property features you may want to look into obtaining a mortgage through a local credit union. They have some of the most attractive closing costs that I’ve seen, and they also have the ability to hold a mortgage “in house,” meaning that they don’t sell the mortgages to other lenders and are able to close mortgages that may have unique requirements.

How Much Can I Afford?

Lenders will let you use 28% of your pre-tax monthly income on the mortgage payment for your primary residence. Let’s say you make $75,000 a year, or $6,250 per month pre-tax. You total mortgage payment shouldn’t exceed $1,750 per month.

Keep in mind the other costs of homeownership. Buying a home comes with some pretty large up-front costs: your down payment, closing costs (about 3-7% of the home’s value), and other fees.

Recurring expenses include maintenance, HOA or condo fees, utilities, and even increased commuting costs if you moved further away from your office. When you’re figuring out what you can afford, don’t forget to factor in these costs.

WARNING: You will likely get approved for a much higher mortgage than you should take on. That doesn’t mean you need to raise your budget to match it! Don’t take on more of a home than you can handle.

If you have a lot of other debt such as car payments and student loans, I highly recommend that you spend time eliminating these monthly payments before adding a mortgage to the mix. Think of how much easier it will be to afford a mortgage if you’re not paying $500 a month toward your student loans!

Can We Talk About Down Payments?

Your down payment is the part of your home purchase price that you don’t borrow from a lender. The ideal is a 20% down payment, because that’s the minimum you need to put down to avoid paying PMI.

However, it’s not the best option for all homebuyers to put down 20%. Any time you dedicate a big chunk of your cash to one thing, that cash can’t go toward anything else. You might need some of your cash for emergency savings, debt repayment, or to keep on hand for other expenses. It might make sense for you to put less than 20% down!

If you’re moving from one home to another and had a lot of equity in your last home, you don’t need to put all of the equity down on the next home, but often times we think this is what we are “supposed to do.” (I think we got this idea from older generations.)

Pro Tip: I highly recommend that you consider using the equity from the sale of your home to pay off other debt, thus eliminating other monthly payments. Instead, put a smaller down payment on the next home even if it means you have to pay PMI. This might mean you free up $1,500 in monthly cash flow but have to pay $200 a month in PMI. You still have an additional $1,300 to use towards your other financial priorities like retirement savings, college savings, and other goals.

Mortgage Terms of Endearment

When you’re evaluating the type of mortgage to get, pay attention to two things:

  • The term: The length of time you have to pay back the loan.
  • The rate: How much interest you pay on the principal.

Usually you hear of 15- or 30-year loans (though you can get 10-, 20-, 25-, or 30-year loans). The longer the term, the less you pay each month. This also means that the longer the term, the more you’ll pay in interest.

Interest rates can be fixed or variable. A fixed-rate loan gives you the stability of easy-to-anticipate monthly payments for the life of the loan, so you can budget for housing costs in the long term. This is a less risky option, but you do have the chance of paying more in interest if you happen to buy when interest rates are high.

Adjustable-Rate Mortgages (ARMs), offer a lower initial interest rate that later re-adjusts on a regular basis. If interest rates drop, you’re in luck. If they go up, your rates go up, which can make budgeting for housing costs difficult. ARMs can be better options for homebuyers who plan to relocate in the short term, before their interest rate can rise.

Pro Tip: Since interest rates are hovering at a historical low, I would highly recommend that you lock in a fixed-rate mortgage and avoid an ARM.

Is Refinancing the Magical Cure for a High Interest Rate?

Yes and no. Refinancing is when you already have a loan, but you find another loan with a lower interest rate. You use the new loan to pay off the old loan, and then pay off the rest of the new loan over time. The goal is to lower your monthly payments.

Refinancing is expensive. Those closing costs and fees from when you first buy a home happen all over again (this could be thousands of dollars!). Here’s how to calculate if the cost is worth it: Diving the closing costs by the monthly amount you’ll save after refinancing.

The result is how many months it’ll take to repay the closing costs, before you can apply the monthly savings to other expenses. If you plan to stay in your home beyond the amount of time it’ll take to repay those costs, refinancing is an option. If you’re planning to relocate soon, it might not be worth the expense.

Pro Tip: If you can refinance to a lower-term mortgage and cut a significant number of years off the life of the loan, while also reducing your interest rate by at least .75%, then I would highly recommend refinancing (i.e. refinancing from a 30-year fixed rate at 4.5% to a 15-year fixed rate at 3.75%).

Do What’s Right For You

Now that you know more about what taking on a mortgage entails, I’ll give you the advice I give to a lot of my clients: Buying a home is not always a better option than renting at every stage of your life!

If you’re ready to stay in one place for a long time and have adequate savings (and little to no debt), buying a place could be the right thing for you now.

If you’re focused on aggressively paying down debt right now, you need the flexibility to move in the short term, or you live in a city with really high real estate prices, renting might come out on top in your case.

The decision to buy a home is an emotional one, but let your rational side do the math and the research while you’re making your choice.

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