Financing Your Home
Buying a home is a huge financial decision. The effects of this decision are felt throughout the life of an average person. This is because the average investor does not have the entire cash to buy their home. Hence, they typically pay 25% to 30% of the costs as a down payment. The rest of the money is borrowed from a bank in the form of a mortgage. The typical family borrows three to five times their annual income in the form of a mortgage. This is probably the largest purchase that a person makes within their lifetime. It is also important to get this purchase right because there are significant transaction costs associated with it. Hence, if a person does not like the terms of a mortgage, replacing it can be quite expensive.
This means that they have to pay a significant portion of their income towards mortgage payments. It is therefore important for any investor to know about how mortgage loans work. In this article, we will have a closer look at the working of mortgage loans.
How do Mortgage Loans Work?
The most important thing to realize about mortgage loans is that they are not like savings accounts. There is a misconception amongst many people that when they pay their mortgage, they are paying themselves. Hence, they think that their mortgage is just a tool that forces them to deposit a sum of money into a savings account each year. The problem with this thinking is that it induces people to take on larger mortgages than they can afford.
The reality is that in the initial years, most of the money paid towards a mortgage goes into interest costs. Calculations show that in the first five years, almost 75% of the money paid towards a mortgage goes towards interest payments.
This is because mortgage payments are amortized over time. This means that if you have a monthly payment of $1000, the $1000 may remain constant. However, the composition of the $1000 that will be applied towards principal and interest varies over the period of the loan. In the initial years, almost $800 will go towards interest payments. This is because the principal outstanding will be large, and hence the interest payments will also be large. Over a period of time, the principal reduces. Hence, towards the end of the loan, the same $1000 will be split as $900 towards principal and $100 towards interest.
Components of a Mortgage Loan
The mortgage payment is the final figure which the homeowner has to pay every month. This figure is determined by three major factors, viz. the principal amount, the tenure, and the interest rate. How each component affects the mortgage payment has been listed below:
The bottom line is that the impact of the mortgage decision is not limited to the mortgage itself. The decision is so huge that it impacts the overall income and savings of a person. As a result, it impacts all other financial goals, including retirement planning.
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