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How Mortgage Loans Work

Excluding property taxes and insurance, a traditional fixed-rate mortgage payment consist of two parts: (1) interest on the loan and (2) payment towards the principal, or unpaid balance of the loan.

Many people are surprised to learn, however, that the amount you pay towards interest and principal varies dramatically over time. This is because mortgage loans work in such a way that the early payments are primarily in interest, and the later payments are primarily towards the principal.

In the beginning... you pay interest
To help calculate monthly payments for loans based on different interest rates, lenders long ago developed what are known as "amortization tables." These tables also make it fairly easy to calculate how much money of each payment is interest, and how much goes towards the principal balance.

For example, let's calculate the principle and interest for the very first monthly payment of a 30-year, $100,000 mortgage loan at 7.5 percent interest. According to the amortization tables, the monthly payment on this loan is fixed at $699.21.

The first step is to calculate the annual interest by multiplying $100,000 x .075 (7.5 %). This equals $7,500, which we then divide by 12 (for the number of months in a year), which equals $625.

If you subtract $625 from the monthly payment of $699.21, we see that:

• $625 of the first payment is interest
• $74.21 of the first payment goes towards the principal

Next, if we subtract $74.21 (the first principal payment) from the $100,000 of the loan, we come up with a new unpaid principal balance of $99,925.79. To determine the next month's principal and interest payments, we just repeat the steps already described.

Thus, we now multiply the new principal balance (99,925.79) times the interest rate (7.5%) to get an annual interest payment of $7,494.43. Divided by 12, this equals $624.54. So during the second month's payment:

• $624.54 is interest
• $74.67 goes towards the principal.

Note: In Canada, payments are compounded semi-annually instead of monthly.

Equity
As you can see from the above example, even though you pay a lot of interest up front, you're also slowly paying down the overall debt. This is known as building equity. Thus, even if you sell a house before the loan is paid in full, you only have to pay off the unpaid principal balance--the difference between the sales price and the unpaid principle is your equity.

In order to build equity faster--as well as save money on interest payments--some homeowners choose loans with faster repayment schedules (such as a 15-year loan).

Time versus savings
To help illustrate how this works, consider our previous example of a $100,000 loan at 7.5 percent interest. The monthly payment is around $700, which over 30 years adds up to $252,000. In other words, over the life of the loan you would pay $152,000 just in interest.

With the aggressive repayment schedule of a 15-year loan, however, the monthly payment jumps to $927-for a total of $166,860 over the life of the loan. Obviously, the monthly payments are more than they would be for a 30-year mortgage, but over the life of the loan you would save more than $85,000 in interest.

Bear in mind that shorter term loans are not the right answer for everyone, so make sure to ask your lender or real estate agent about what loan makes the best sense for your individual situation.

Different Types of Loans
Below is a table that explains the differences in common types of loans available.  Chart below is for sample informational purposes only, please consult your mortgage provider for details.

 

	FHA	VA	CONV
Down Payment	3% Down Payment, ALL Funds may be a Gift REFI - 85% Cash-Out	No Down Payment (subject to available eligibility) Remaining elegibility x 4 = Max. Loan Amount If sales price is more than Max. Loan Amount, a down payment of 25% of difference is required. All funds may be a gift Cash-out Refi = 90% LTV	Minimum 5% Loans over 80% LTV - 5% must be buyers own funds (not gift funds) If loan is 80% or less, all funds may be a gift 2 Family - 90% LTV 3-4 Family - 75% LTV
Maximum Loan Amount	1-Family = $154,896 2-Family = $198,288 3-Family = $239,664 4-Family = $297,840 MIP Can be added to these amounts (1.5%) If greater than 2-Family, must have 3 months PITI in reserve. May use 75% of rental income from appraisal (or need leases to qualify)	$240,000 with Full Eligibility Funding Fee can be added if total does not exceed $240,000	1 Family = $333,700 2-Family = $427,150 3-Family = $516,300 4-Family = $641,650 Loan amounts exceeding these amounts are Jumbo Loans
Points	Cannot be financed Can be paid by seller or borrower (subject to limit described under "closing costs")	Cannot be financed Can be paid by seller, borrower, or may be gift funds from relative	Cannot be financed Can be paid by seller or borrower (subject to limits described under "closing costs")
Closing Costs	Can be financed Up to $200.00 of inspection fees can be financed Maximum Seller Contribution towards closing costs and points is 6% of the loan amount -AND- Seller may pay 3% of down-payment	Funding Fee can be financed Borrower or Seller may pay Maximum seller contribution towards closing costs is 4% (does not include discount points)	Cannot be financed Can be paid by borrower or seller Maximum seller contribution toward points and closing costs are:  95% LTV = 3%  90% or less = 6%
Prepaids	MIP can be financed or paid in cash One time financed MIP is 1.5% of the Base Loan Amount -AND- Monthly MIP = Base Loan Amount x .50%/12 Prepaids include: 1st year Hazard Insurance premium 2 monthly installments of taxes and ins.  and MIP Seller may pay prepaids or may be a gift No upfront MIP on condos required (only monthly MIP)	Cannot be financed Can be paid by seller or borrower Can be a gift Can possibly be paid by mortgage company thru premium pricing.	Cannot be financed Cannot be paid by seller PMI rates vary with LTV and PMI Co. PMI can also be financed as a one time premium on fixed rate loans. 85% LTV may not be require PMI.
Qualifying Ratios	Debt to income ratios are currently based on Gross monthly income 29% for housing expense (inlcudes PITI) 41% for monthly installments and revolving debt, includes new PITI and child/spousal support 2/1 Buydown allowed - borrower may qualify at 2% below note rate	Debt to income ratio is based on gross monthly income Maximum is 41% for PITI + monthly obligations, including child care expense and child/spousal support Borrowers must also meet residual income guideline set by the VA	Debt to income ratios are based on gross monthly income (installment debt with less than 10 remaining payments are generally not used to qualify) 28% for PITI (incl. PMI) 36% for PITI + monthly obligations (child care not included) All borrowers must have 2 months PITI as reserves after closing
Assumability	Yes - buyer must be credit approved	All loans closed as of 3/1/88 require buyer to be approved by the VA upon loan assumption Eligibility is not released unless new approved VA buyer's eligibility is used to replace original Vet's	Most loans are subject to program requirements
Miscellaneous	Condos must be FHA approved Bankruptcy - Chapter 7 - discharged 2 years - credit re-established Bankruptcy - Chapter 13 - Need trustee approval - Credit re-established - Paid for 1 Year No investment loans	No investment loans Co-borrower should be spouse Bankruptcy - Chapter 7 - discharged 2 years - credit re-established Bankruptcy - Chapter 13 - Need trustee approved - Credit re-established - Paid for 1 year	Minimum down payment on non-owner occupied is subject to Program/Investor (minimum is 90% LTV) All Bankruptcy's to be discharged 4 years and credit re-established.