Making Sense of Mortgages
Closing costs, PMI, ARM, escrow…figuring out what makes up your mortgage can be complicated. With so many factors to consider, how do you make sense of it all? Well, you can start by breaking down some of the most common terms and considerations you’ll come across, which is exactly what we’ll do here.
Taxes and insurance
Here’s one of the biggies. When you own a home, you have to pay taxes and insurance. Now, homeowner’s insurance is self-explanatory: it protects your home. Tree falls on it? Covered. Someone slips and falls on your sidewalk? Ouch – but covered.
Tax amounts are based on region, value, school district, and more. And, because they both create added costs on top of your standard principal and interest payment, it’s critical to consider them when you’re working on a mortgage budget. Depending on your mortgage, you may even be required to escrow these costs into your overall monthly payment.
An escrow is a type of account that budgets your taxes and insurance costs into monthly averages – an account tied directly to your mortgage. So, if your annual insurance premium is $500 and your total taxes are $4,000, your monthly escrow payment would be $375 (4,500 / 12 = 375). This $375 is then added to your mortgage payment and placed in your escrow account. When the bills come due, your escrow automatically disburses the funds to the payees. This makes escrow very convenient – it's just done and over with. Most mortgages require an escrow if your loan to value is 80% or higher.
Loan to Value (LTV)
Your loan-to-value (LTV) measures your equity – how much your home is worth versus how much you owe on it. Put simply: if you have an $80,000 mortgage on a home worth $100,000, then you have an LTV of 80%. Your LTV can impact what mortgage program you qualify for, whether you need PMI and an escrow, and more.
Private Mortgage Insurance
Commonly known as PMI, this insurance helps the lender recover their investment if you stop making payments and face foreclosure. It’s generally required for mortgages with an LTV over 80% and adds an additional cost to your escrow – which could be tens of dollars, could be hundreds. Thankfully for you and your wallet, in most instances, your PMI requirement is removed when you achieve 78% LTV.
You’ve probably heard of this one before. This is the amount paid upfront on your home, determining your LTV and therefore your need for escrow and PMI. How much you pay is dependent on your savings budget but also your mortgage program. Some programs require as little as 5% down, others 10% or more. For others? It’s 0% down.
You’ve also probably heard of these before. And they can be a lot. Closing costs include a number of items: origination fees charged by the lender, title and settlement fees, taxes and prepaid items like homeowners’ insurance or homeowners' association fees, and even attorney costs.
Fixed or ARM?
A fixed rate mortgage means your interest rate doesn’t change during the term. An adjustable rate mortgage (ARM), though, can see fluctuations in your interest rate over time, resulting in changes to your payment. The amount and frequency of these changes are determined by the terms of your specific program. There are pros and cons to each type of mortgage, ranging from lower initial rates to more generous down payment requirements, meaning you should speak with a representative to help determine which option is best for you.
Understanding ARM numbers
5/1, 10/1, 15/15 – what do those numbers mean? Knowing that the rate on an ARM adjusts, the first number is how long the introductory rate is constant for, and the second number conveys how often that rate can change afterward. For example: a 10/1 ARM means that the rate is constant for the first ten years, then it can adjust annually for the remaining 20.
Floors, ceilings, caps, and margins
You've probably noticed these things on a rate sheet. These terms determine an ARM’s rate changes. Put simply, the floor is the lowest your rate can go, regardless of changes to the overall index. Likewise, your ceiling – sometimes called the “lifetime cap” – is the highest that your rate could adjust. Adjustment caps effectively place a limit on how much your rate can change during one adjustment period. Finally, your margin is the number added to the index at the time of the adjustment, determining your new rate.
A point is one percent of your mortgage amount – paid to your lender, not your principal – that effectively buys you a lower interest rate (meaning that one point for a $100,000 mortgage would be $1,000). Whether a point is worth it or not is up to you and your lender to decide – they’ll help you crunch the numbers.
Alright, we've made it to the bottom of the page. As you can see, there's a lot that goes into having a mortgage, but I hope this helps clear up some of the confusion. Remember: your home is a big investment, so it pays to have a good grasp of what you're getting into.