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:
- Principal Amount: The principal amount has a direct relationship with the mortgage payment. This means that a higher principal amount would mean a higher monthly payment as well. Financial planners are of the opinion that if a person is paying more than 25% of their monthly income towards mortgage payments, then their finances could be damaged. It is recommended that the home value should be between three to four times the annual household incomes.
Many people have borrowed too much money to invest in their homes. This has created a new situation called house poor. The details of this phenomenon have been described in another article. The bottom line is that even if banks are ready to lend more money to an individual, it would be advisable to keep the principal amount low. This is the reason why financial planners often advise individuals to make higher down payments and reduce the amount of money to be borrowed.
- Tenure: Most home loans made in the United States have a tenure of 30 years. This means that most of the working life of an individual is spent to make mortgage payments on this loan. However, nowadays, a lot of people are opting for 15-year mortgages as well.
It needs to be understood that increasing the tenure has a disproportionate effect on the monthly payment. This means that if you double the tenure of your loan and keep the other factors constant, the payments will more than double. This is because of the fact that these loans charge compound interest. As a result, if the money is outstanding for a longer duration of time, the interest costs increase disproportionately.
- Interest Rates: Interest rates are the most talked about aspects of home financing. This is because this is the variable part of the loan. Also, interest rates are extremely important because this is the largest loan that a person will be taking in their lifetime.
Hence, a difference of even a single percentage point could make a huge difference. This is the reason that diligent home buyers tend to negotiate their interest rates hard with several banks.
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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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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- Process of Financial Planning
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- Three Types of Income
- Misconceptions about Personal Finance
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- Going From Financial Goals to a Financial Plan
- Components of a Financial Plan
- Personal Financial Statements
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- Dollar-Cost Averaging
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- The Phenomenon of House Poverty
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