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Understanding Mortgage Interest

Tuesday, September 25, 2018   /   by Leon Zhivelev

Understanding Mortgage Interest

Understanding Mortgage Interest

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Interest Rate Factors

When lenders set your mortgage interest rate, they consider a wide range of factors, including your credit, loan term, home price and down payment, and whether it’s a fixed- or adjustable-rate mortgage. Knowing these factors can help you figure out how to qualify for a better rate.

The Consumer Financial Protection Bureau offers a calculator for average interest rates based on your credit score, state, house price, down payment and other factors.

Credit score. When you apply for a mortgage, the lender considers your credit score. Your credit score is based on your credit history and represents how safe you are as a borrower. FICO, the most commonly used credit score, ranges from 300 to 850. The higher your score, the better the chances you’ll qualify for a low interest rate.

You need a minimum credit score of 620 to qualify for a mortgage under Fannie Mae or a score of at least 500 to qualify for an FHA mortgage. If your score is between 500 and 579, you could qualify for an FHA loan, but with a down payment of at least 10 percent. If your score is higher than 580, your down payment can be as low as 3.5 percent. VA loans do not have a minimum credit score requirement as lenders will consider your entire financial situation to make a decision. USDA loansrequire a minimum credit score of 640 for automated underwriting, though you may be able to qualify with a lower score if the lender manually underwrites your application.

Home price and loan amount. The more money you borrow for your loan, the higher the interest rate will likely be. Lenders are risking more money with larger mortgages, so they may charge a higher interest rate. There are maximum limits for loans. FHA loan limits vary by area and can be as low as $275,655 and as high as $636,150, depending on the cost of living in each area of the country.

The maximum loan amount for conventional mortgages in most of the country is $424,100, though this can be higher in certain areas or for multiunit properties. If you want to buy a property that costs more than these limits, you can apply for a jumbo loan, also known as a nonconforming loan. Jumbo loans typically charge a higher interest rate because there is a higher amount at risk.

Down payment. Your down payment is the amount you pay upfront for the property, while the mortgage covers the rest. A larger down payment leads to a lower interest rate on your mortgage. You’ll be borrowing less money, so lenders are taking on less of a risk.

If your down payment is less than 20 percent of the house price, you’ll need to buy private mortgage insurance and pay the premiums as part of your mortgage payments. This insurance reimburses the lender if you default on the mortgage.

Loan term. The longer the length of your loan, the higher the interest rate may be. Rates are higher on a 30-year mortgage compared to a 15-year mortgage.

Interest Rate Type

Interest rate type refers to whether your mortgage is fixed or adjustable. At the beginning, lenders charge a higher rate on fixed-rate mortgages.

Loan type. Government-backed loans typically charge lower rates than conventional mortgages, but FHA loans can be more expensive once you factor in other fees, like mortgage insurance.

Points. Mortgage points are a fee you can pay at the start of the mortgage to lower your interest rate for the duration of your fixed-rate mortgage. Each point costs 1 percent of your total loan amount. The interest rate reduction depends on the lender, but it is common to lower your interest rate by 0.25 percent in exchange for every point purchased.

You can also purchase points to lower the initial interest rate on an adjustable-rate mortgage. On a 5/1 ARM, buying points would lower the interest rate for the first five years before the rate adjusts.

The longer you plan on staying in a property, the more it makes sense to pay points. You’ll benefit from the lower interest rate for a longer period of time.

Property type. Lenders change their interest rate depending on the type of property. Single-family homes are considered less risky and have lower rates. Multifamily properties, condos, co-ops and mobile homes are considered riskier, so mortgages for these properties often have a higher interest rate.

Property use. If you plan on using the property as your primary residence, you’ll get a lower rate because people are less likely to default on their homes. On the other hand, if you’re buying a property as an investment or a vacation home, your interest rate will be higher. People are more likely to default on these properties because they’ll still have their primary residence to live in.

Market interest rates. Lenders base their interest rates on market benchmarks such as the Libor or the weekly constant maturity yield on the one-year Treasury bill. Lenders use these rates to compare mortgages to other investment opportunities, such as bonds or lending to the government instead.

Interest variations by state. Where you plan on buying a home can have an impact on your mortgage interest rate. There’s a significant difference between states. Counties, cities and even neighborhoods can have different mortgage rates as well.

Interest rate vs. APR. Lenders are required to provide the annual percentage rate and loan interest rate. When you’re comparing different mortgages, you should consider both the interest rate and APR as you make a decision.

The interest rate is the percentage of the loan you pay for borrowing the money. The APR includes the interest rate and the upfront costs of taking out the mortgage, such as loan underwriting fees, origination fees and points. If you need mortgage insurance, those premiums should be included in the APR.

The APR spreads these expenses over the life of the loan, so you can see how much it costs per year to borrow money once you factor in these charges. A loan with a 3.5 percent interest rate might have an APR of 3.65 percent after it adds in the other expenses.

Amortization. Amortization is how a loan is paid off over time. When you take out a mortgage, the payment schedule is set up so that at the beginning, most of your payment goes to paying interest, not paying down the principal. Later on, more of your money goes to paying off the principal and less to interest.

This mix has an impact on your finances. You get a tax deduction for paying interest on a mortgage for your primary residence, but there’s no deduction for paying off the principal. However, as you pay off your principal, you own more of the property outright, which builds your net worth. Paying off interest does not build your net worth.

Additional Mortgage Costs

Your mortgage will have other costs on top of the principal and interest. You’ll have additional expenses to close the mortgage and maintain your loan. These expenses include homeowners insurance, property taxes, closing costs and local fees.

Homeowners insurance. Lenders usually require you to buy homeowners insurance as part of your mortgage. This insurance would pay to repair damages after problems like fires, lightning strikes and vandalism. Lenders use your home as collateral in case you default, so they require insurance to protect their investment.

Property taxes. Local governments charge property taxes to fund their operations. Property taxes can be a substantial part of your monthly payment and, in some areas, may be more than what you’re paying for the loan. Be sure to research local property tax rates before buying a home.

Association fees. If you buy a property in a planned development, there may be a homeowners association that maintains the neighborhood. You will pay the association a fee to cover your share of the maintenance.

Private mortgage insurance. If your down payment is less than 20 percent of the total purchase, the lender will likely require you to buy private mortgage insurance. This insurance pays the lender if you stop making payments and default on your mortgage. You’ll need to pay private mortgage insurance premiums as part of your mortgage payment.

Once you’ve paid off 20 percent of the property, you can request that the lender end the PMI. The lender is legally required to remove the insurance requirement once you’ve paid off 22 percent of the property. Make sure to ask once you’ve paid off 20 percent so you don’t pay for this insurance any longer than you have to.

FHA, VA or USDA fees. If you take out a mortgage through the FHA, VA or USDA, the government agencies will charge their own fees to support the program. Even with these fees, VA and USDA loans are typically less expensive than conventional mortgages. However, the extra FHA fees can make these loans more expensive than conventional mortgages.

Additional Costs Can Add Up

Mortgage insurance can cost between 0.3 to 1.5 percent of the original loan amount per year. Homeowners insurance costs on average about $1,000 or more per year. Median property tax rates range from 0.18 to 1.89 percent, depending on the state, according to Tax-Rates.org.

For example, if you take out a $200,000 mortgage with a 30-year term and 3.5 percent fixed rate, your mortgage payment will be $898 per month and $10,776 per year. Additionally, if you pay 1 percent for property tax, 0.75 percent for mortgage insurance and $400 a year for homeowners insurance, you will pay an additional $3,900 annually, increasing your costs by 36 percent each year. Make sure you budget for these other expenses.

Mortgage Closing Fees

Property Evaluation Fees

Appraisal fee. Your lender will hire an appraiser to estimate the fair market value of the property as it evaluates your mortgage application. It could charge you for the expense. The average appraisal costs about $300 to $700, according to the Federal Reserve.

Survey fee. You may need to pay for a survey to transfer the title. The survey maps out the exact borders of your property to show what you’re buying. This costs roughly $200 to $800.

Home inspection. While lenders typically do not require it, a home inspection is recommended. The inspector can identify problems with the property so you can make an informed purchase. A home inspection costs about $250 to $400.

Flood determination assessment. If you’re in an area where flooding could be an issue, the lender could ask you to make an assessment to determine whether your property is in a flood zone.

Loan Fees

Application fee. Some lenders will ask that you pay an upfront application fee before they will review your mortgage application. They may include the appraisal as part of this fee so that can get started right away. The typical application fee costs about $100.

Credit report fee. It costs money to access your credit report, so lenders may ask you to pay the fee. Others will include it as part of their application fee.

Origination fee. Once your mortgage has been approved, the lender will charge an origination fee to set up the loan. This is a percentage of your entire loan and usually ranges from zero to 1.5 percent of your mortgage amount.

Attorney fees. Some states require you to have an attorney present when you close your mortgage. Even if you aren’t required to hire one, attorneys can help you review the documents to make sure the deal is fair. This fee depends on the attorney’s rates.

Mortgage broker fee. If you worked with a mortgage broker to find your loan, her or she will charge a fee. The fee is a percentage of the total loan, typically 1 to 2 percent. Either you, the lender or the seller will pay the fee, depending on what you negotiate.

Prepaid interest. After you close your loan, there will likely be a gap of several days or weeks before your first mortgage payment is due. The lender will ask you to prepay the mortgage interest for that period of time so you’re up to date on interest by the time you make your first loan payment.

Title Fees

Lender’s title insurance. Lender’s title insurance protects the lender in case of legal issues with ownership of the property. For example, if someone files a lawsuit alleging the previous owner wasn’t legally allowed to sell the property, title insurance covers the lender’s legal expenses. Lenders usually require you to purchase this insurance on their behalf. The average lender-only policy costs about $1,000.

Owner’s title insurance. If you want to protect yourself against legal issues from transferring the title, you can buy owner’s title insurance. It would cover the legal costs in case of future issues with the title.


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