Mortgage calculation involves a lot of math—some of it simple, some of it quite complex. Understanding how banks and lenders calculate your mortgage payment will help you understand your loan on a high level and build it into your long-term prosperity strategy.
Let’s start by understanding first, what is a mortgage?
Second, let us learn the different parts of a loan, such as interest rate, principal balance and term.
The principal balance is your loan amount. This is the lump-sum of cash your lender wires to escrow to close the deal. The principal balance becomes a liability on your balance sheet as property owner. In a fully-amortized loan, each monthly loan payment (also known as an “installment payment”) consists of a certain amount of principal repayment and interest payment (sometimes referred to as “P&I”).
The principal repayment portion of your payment reduces the principal balance. You can also make extra payments, over and above the minimum installment amount, to reduce the principal balance further. To retire the debt and clear the title, you must usually pay off the remaining principal balance, at a minimum. This is usually mandatory before you sell the property.
The interest rate, or note rate, is generally associated what a lender charges you for the service of lending the money for your home purchase, usually in the form of a percentage of the outstanding balance. The interest rate on a mortgage is expressed as an APR—annual percentage rate. One-twelfth of the APR, also known as the monthly rate. The monthly rate is applied to the principal balance for each of the twelve months out of the year. A loan servicer is the company that collects your monthly mortgage payment from you. The servicer generally gets paid a certain percentage of your note rate to service the loan.
In a fully- or partially-amortized loan, the principal balance decreases a little with each payment, which reduces the loan balance you owe interest against. This means that the longer you keep the loan, the less and less interest you pay each year, even though the payments stay the same.
The loan term is the length of the repayment period, the maximum time you have to retire the debt. The most common mortgage loan terms are 15 years (180 monthly payments) or 30 years (360 payments), other options may include 10 year, 20 and 25 years.
Calculating Mortgage Payment
Calculating mortgage payment can be a bit complex at times. You. must take the principal, interest, taxes, home owners insurance, home owners association and possibly other additions. For a 30-year arm or 30-year fixed rate loans, the lender calculates the mortgage payment to create an amortization schedule. This is a schedule of principal and interest payments that fully pays down the entire principal balance to zero by the last payment on the schedule.
This is harder to do than it looks. You can’t just divide the principal balance of your 30-year loan by 360 (the number of payments) and multiply that number by the monthly rate. With that schedule, you would end up paying outrageously high interest on a tiny loan balance halfway through the loan.
Instead, the lender does complex math to calculate the mortgage payment amount. This satisfies the monthly interest rate against the entire remaining balance, plus just enough principal repayment so that next month’s payment reflects interest payment at the monthly rate. Plus enough principal to create the same effect next month, all while keeping the monthly payment the same throughout the entire loan.
This math is kind of magical, and hard for many people to wrap their minds around. The key takeaways are:
- Your payment amount stays the same.
- You never pay more interest than the monthly rate assessed against the remaining principal balance.
- With each payment, your principal repayment gets larger, while your interest payment gets smaller.
This means that, with the same payment amount at both the beginning and the end of the loan, you are generally paying more interest early in the loan, and more principal at the end of the loan.
Fortunately, online mortgage calculators are there to do the math for you. In conclusion, simply enter the principal balance (or the home price and your down payment), enter the interest rate and loan term, and let the computer do its thing!
How Much House Can I Afford?
The classic homeowner’s mortgage question of how much I can afford, depends on many factors, including:
- How much money do you have to put down?
- How big of a monthly payment can you afford?
Remember that the mortgage payment isn’t the only expense of homeownership. This is especially important to understand if you are currently renting and get a flier advertising mortgage payments far below what you are paying in rent. Yes, the mortgage payment may be lower … but the mortgage isn’t the end of the story as far as monthly payments go.
One piece of mortgage jargon to be aware of is PITI—“principal, interest, taxes, and insurance.”
Property taxes and property insurance are two fees that are associated with a property, or parcel. You need to consider when deciding if you can afford the monthly payment on a house. There may also be an HOA fee, and smart homeowners may also budget for repairs.
Many lenders require that you fund an escrow account for the payment of property taxes and property insurance. This is. to ensure you don’t skip these essential payments. In conclusion, this means your monthly debt service will be higher than just the principal and interest payments.
How Is My Interest Rate Determined?
Some people hear in the news about “the Fed raising interest rates” and wonder how that will affect their ability to afford a home. There are many reasons why interest rates vary, generally the market looks at the 10-year US treasury as a guide. Influencers of mortgage rates may also include but not limited to the Fed, investors, lenders, market demand and many other reasons that are known and unknown.
The Federal Reserve in general, controls the statutory rates at which banks can lend to each other. The Fed however can influence the market by expanding money supply or decreasing it. Thus controlling the value of the US dollar. Without getting too deep into currencies, there is an inter-market analysis relationship between the US dollar and commodity prices. Think of it as a teeter totter effect. Also, the Wall Street Journal pointed out, “A strong dollar makes U.S. Real Estate less attractive to Foreigners as well.1,2
Lenders may also raise the rate to slow demand, and in some scenarios rates may be influenced by Fannie or Freddie as an add on fee.
Lenders take that Treasury Bond rate and add a markup. How much they mark it up depends on the borrower’s credit score. The lower the credit score, the lender may request a higher mark up on the note rate above the bond rate. A lower credit score usually means a riskier borrower, and the lender expects to be compensated for that extra risk with more interest.
How Much Money Do I Need to Put Down?
There are many different mortgage loan programs, it depends on the program you qualify for. Due to various mortgage loan programs, this means the down payment could vary. This could change your mortgage calculation for your payment. To understand this better, call New Century Financial Mortgage a call as everyone has a unique situation and can-not be painted with the same paint brush. Thus, a customized approach to ones’ mortgage plan may prove best.
For educational purposes only, if you put a 20% down payment, this usually qualifies home buyers to avoid paying mortgage insurance. From the lender’s perspective, this means they are lending at 80% loan-to-value (LTV). The home purchase price (or appraised value, whichever is less) alone would equal par, or the 100% of the term “loan-to-value. For every 1% of money that you put down, you may deduct it from 100%. The total percentage of your down payment, minus 100%, equal the total loan-to-value you may borrow.
In general, a lender may lend higher LTV for a borrower’s primary residence vs a second home or investment property, depending on the situation. If a lender lends at 90% LTV, the buyer only has to make a 10% down payment, plus closing costs.
If a lender will lend at 95% LTV, the buyer only has to make a 5% down payment plus closing costs.
A rule of thumb is, FHA loans may require as little as 3.5% down, Fannie Mae and Freddie Mac may allow down to 3%, while USDA and VA may qualify for no money down, of course this all depends on what you qualify for. Again, these lower down payments only apply to the purchase or finance of a primary residence.
Your total monthly payment
- References: https://www.wsj.com/articles/strong-dollar-makes-u-s-real-estate-less-attractive-to-foreigners-1431713598
***”The principal, interest and MI payment on a $330000 30-year Fixed-Rate Loan at 2.5% and 90% loan-to-value (LTV) is $1,380.90. The Annual Percentage Rate (APR) is 2.876% with estimated finance charges of $11,000. The principal and interest payment does not include taxes and home insurance premiums, which will result in a higher actual monthly payment. Rates current as of 09/09/2020. The APR is calculated using the Actuarial Method. Some exclusions may apply.”