1. MORTGAGE BASICS
2. HOME EQUITY BASICS
3. CREDIT BASICS
MORTGAGE BASICS: Understand How It Works
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A mortgage is a long-term loan that a borrower obtains from a bank, thrift, independent mortgage broker, online lender or even the property seller.
The house and the land it sits on serve as collateral for the loan. The borrower signs documents at closing time giving the lender a lien against the property. If that borrower doesn't make payments as agreed, the lender can take the home through foreclosure.
Because mortgages are such large loans, consumers pay them off over long periods -- usually 15 to 30 years. Their monthly payments gradually whittle away the principal balance, slowly at first then rapidly toward the end of the loan.
What's in a payment?
When escrow is used, a monthly mortgage payment is called a PITI payment. That's because each one covers a portion of the following four costs:
Principal -- the loan balance
Interest -- interest owed on that balance
Real estate Taxes -- taxes assessed by different government agencies to pay for school construction, fire department service, etc.
Property Insurance -- insurance coverage against theft, fire, hurricanes and other disasters
Depending on the kind of mortgage a borrower has, the monthly payment may also include a separate levy for private mortgage insurance (PMI) or government-backed mortgage insurance premiums.
The breakdown of each payment (the amount that goes toward principal, interest, etc.) changes over time because mortgages are based on a repayment formula called amortization. That's a fancy term meaning the lender spreads the interest you owe on the mortgage over hundreds of payments so that the overall loan is as affordable as possible.
How does amortization work?
Here's how principal and interest change over the life of a loan |
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Payment number |
Principal balance |
Payment amount |
Interest paid |
Principal applied |
New balance |
1 |
$150,000 |
$1,048.82 |
$937.50 |
$111.32 |
$149,888.68 |
60 |
$142,086.93 |
$1,048.82 |
$888.04 |
$160.78 |
$141,926.15 |
120 |
$130,426.14 |
$1,048.82 |
$815.16 |
$233.66 |
$130,192.48 |
240 |
$88,851.22 |
$1,048.82 |
$555.32 |
$493.50 |
$88,357.72 |
359
(next to last) |
$2,078.14 |
$1,048.82 |
$12.99 |
$1,035.83 |
$1,042.3 |
Source: Bankrate.com |
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On a 30-year, $150,000 mortgage with a fixed interest rate of 7.5 percent, a homeowner who keeps the loan for the full term will pay $227,575.83 in interest.
The lender can't possibly expect that person to pay all that interest in just a couple of years so the interest is spread over the full 30-year term. That keeps the monthly payment at $1,048.82.
But the only way to keep the payments stable is to have the majority of each month's payment go toward interest during the early years of the loan
Of the first month's payment, for instance, only $111.32 goes toward principal. The other $937.50 goes toward interest. That ratio gradually improves over time, and by the second-to-last payment $1,035.83 of the borrower's payment will apply to principal while just $12.99 will go toward interest.
HOME EQUITY BASICS
Homeowners are increasingly relying on their homes and rising property values to increase their purchasing power. They are borrowing against the equity in their homes to pay down credit card debt and auto loans or even to finance vacations or renovations. These loans are more attractive than other forms of credit because, in many cases, you gain some tax breaks on interest. Additionally, because the loan is secured by your home, it will likely have a lower APR. However, home equity loans aren't right for everyone, so make sure you carefully consider the pros and cons before signing on. Before you go loan shopping, it may be worth while to see what lenders will see and order your own free credit report!
There are two basic types of home equity loans: lump sum loans, which work like second mortgages, or home equity credit lines, which work more like credit cards. In both cases, the amount you can borrow is, of course, limited by your actual equity. Equity is calculated by subtracting the unpaid balance of your mortgage from the fair market value of your home.
Up-Front Loans Can Cover Big-Ticket Purchases
With an up-front home equity loan, or second mortgage, you receive the full amount of the loan when it is opened, and pay it back in fixed monthly installments over the life of the loan. Up-front loans can be good for debt consolidation, buying a car, education, major home improvements, or paying large, unexpected bills, such as emergency medical expenses.
Home Equity Lines Allow You to Borrow Only What You Need
More and more lenders are offering home equity lines of credit, which allow you to draw off your loan as you need it, usually by writing a check. Your monthly payment is usually a percentage of the total outstanding principle.
The particular benefit of home equity lines of credit, as opposed to up-front loans, is their flexibility. A credit line like this can be a good way to help pay for a child's education, for example, because you can borrow and pay interest on each year's costs only as they arise. With an up-front loan, you would pay interest on all the money from the very beginning.
Because this flexibility is the key benefit, try to avoid a home equity line that specifies a certain minimum be borrowed every time you draw on the line or that requires an initial cash advance you do not need. Also, unless you have very strong willpower, don't take the "credit card" that some lenders may offer with a home equity line. Carrying it around in your wallet may make drawing on the line too easy and encourage you to borrow more freely than you should.
Examine All Your Options Before Borrowing Against Your Home
With interest rates that are typically lower than many credit cards, a home equity loan can be the best way to finance a large purchase or cover an unexpected expense. But home equity loans and credit lines are more expensive than first mortgages, and may be more expensive than other financing options, such as an auto loan or subsidized student loan. When you consider a home equity loan, think through these issues:
Does this home equity loan offer the lowest interest I can find to finance this purchase?
Am I attracted by an introductory rate that is much better than the long-term rate of the loan?
Will my interest be tax deductible? (The only way to be sure is by consulting a tax advisor.)
Is the risk of putting my home on the line a worthwhile tradeoff to achieve this financial goal?
Finally, when considering between an up-front loan and line of credit, ask your lender to help you compare the interest rates. Matching up the Annual Percentage Rates alone won't give you an accurate picture, since the APR for a home equity line of credit is based on the periodic interest rate alone. It does not include points or other charges associated with an up-front loan.
A Final Caution
When you borrow against your home, you are securing the loan with collateral, your house. If you can't repay, the lender has the right to force foreclosure to receive repayment. That means you'll lose your home and have a foreclosure on your credit report. If you think you may not be able to make the payments when faced with a drop in income, then a home equity loan probably isn't for you. Additionally, if you're consolidating credit card debt, then make sure to keep your credit-card spending under control. If you charge those cards back up, you'll be in a worse financial position than before.
Whether a home equity loan is in your future or you've decided to pursue another form of credit, it's important to check interest rates and fees with a variety of lenders. To protect your credit rating, minimize inquiries on your report by only authorizing credit checks with the one or two lenders you're serious about. CREDIT BASICS
For years, the entire credit scoring process was shrouded in mystery. Fair Isaac and other scoring firms said that if they revealed the scoring system -- and the exact criteria to determine that score -- their services wouldn't be needed anymore.
In June 2000, Fair, Isaac surrendered to increasing pressure from Congress and consumer groups and released a list of the criteria it uses to determine credit scores. In addition, the company plans to develop a web feature so you can check your own score.
The five main criteria are:
- Your payment history payment history on credit cards, retail accounts at stores, installment loans, and mortgages. 35% of total score
- Amounts owed. What is important is how many accounts have balances and how much of the total credit line is being used on credit cards and other "revolving credit" accounts. 30% of total score.
- Length of credit history. That's why parents should help children establish credit histories before they go out on their own. 15% of total score.
- New credit. Applying for too much new credit is one of the easiest ways for people to inadvertently harm their credit score. (10% of total score)
- Types of credit. This takes into account your mix of installment loans, mortgages, retail accounts, credit cards and finance company accounts. (10% of total score)
The question is often asked when looking for a mortgage how can I raise my score. By looking at the criteria above you'll see the only factor you can immediately impact is Amounts Owed and specifically amounts owed to revolving, credit card debt. The single greatest impact you can make to your credit score is to lower the ratio of your balance to limit on any outstanding revolving debts. This can be done in two ways: • Ask the creditor to raise your credit limit on each account. • Pay down the balances on your cards. To attain the highest possible score your balance to limit ratio needs to be at 30% or less. DO NOT CLOSE ANY OF THESE ACCOUNTS. Many uninformed so called credit experts will tell you to pay off your accounts and close them, and while it may be in your financial best interest to close revolving accounts it is absolutely not only going to raise your credit score it will actually lower your score. For example a Borrower A could be carrying a $30,000.00 balance on their credit cards but have a $100,000.00 total credit limit and Borrower B could be carrying a $1,000.00 balance on their credit cards with a $1,000.00 limit. Which borrower has the higher score with all other things being equal
Borrower A by a large margin. To the average consumer this seems illogical but you must realize that the scoring system can not factor in totals as they would relate to your income, it can only factor in percentages. The scoring model does not know if Borrower A has an income of $10,000.00 per year or $200,000.00 per year, only that Borrower A has plenty of available credit and Borrower B is at their limit. Your scores will be updated immediately upon each credit repository updating your balance and limit on each account. |
