Four Possible Reasons To Refinance

A mortgage is generally the largest debt most homeowners have to manage.  It’s a good idea to give your personal real estate finance portfolio a check-up at least once a year.

Since there are many reasons a homeowner may choose to refinance, we’ll take a look at the four most common.

1.  Mortgage Rates Drop:

Typically, the most common reason that homeowners refinance their mortgage is to secure a lower interest rate. Interest rate and loan amount determines the total cost that a borrower will pay. The lower the interest rate, the less the overall cost will be. Interest is calculated on a daily basis and usually paid back to the lender on a monthly basis.

2.  Lower Payments:

Lowering a mortgage payment can be achieved by lowering the mortgage rate, lengthening the loan term, combining two or more loans or removing mortgage insurance.

3.  New Mortgage Program:

Refinancing an Adjustable Rate Mortgage (ARM) to a new Fixed Rate Mortgage (FRM), combining a first and second mortgage or paying off a balloon loan are three possible reasons to explore a refinance.

4.  Debt Consolidation:

If there is sufficient equity, sometimes paying off consumer debt by combining all debts into one lower monthly mortgage payment can significantly reduce the short-term deficits in a budget.  However, it’s important to keep in mind the total cost of that debt by adding it into a 30 year mortgage payment.

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Frequently Asked Refinance Questions:

Q:  Do I have to refinance with my current mortgage company?

No, you may choose any company to refinance your mortgage since the new loan will replace the existing mortgage.

Q:  Is it easier to refinance with my current mortgage company?

It is possible your current mortgage company may require less documentation, but this could add additional cost or a higher interest rate. Do your homework and shop around to make sure you’re getting the best deal.

Q:  Will I automatically qualify if I’ve never made any late payments?

No, you will have to qualify for your new refinance. However, certain programs will allow for reduced documentation like a FHA to FHA Streamline Refinance.

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How Much Can I Afford?

How much mortgage money can I qualify to borrow?

This is typically the number one question mortgage professionals are asked by new clients.

Of critical importance when considering mortgage financing: There is sometimes a difference between what a client ***can*** borrow and what they ***should*** borrow.

In other words, what makes for a comfortable long-term mortgage payment?

The Quick Answer:

If we’re simply considering the financial math, lenders will calculate your Debt-to-Income Ratio and generally allow for 28-31% of your gross income to be used for the new house payment with up to 43% of your gross income to be used for all consumer related debts combined.

Sample Mortgage Scenario:

Let’s use a gross monthly income of $3000 and a qualifying factor of 30% Debt-to-Income Ratio:

$3000 multiplied by .3 (30%) = $900 max monthly mortgage payment

This means that your mortgage payment (Principal, Interest, Taxes, Hazard Insurance) cannot exceed $900 a month.

“Ballparking” a Qualifying Loan Amount:

Simple step:  We use a safe average of $7 per month in payment for every $1000 in purchase price so…

Step 1)  $900 a month divided by $7 = $128.50

Step 2) $128.50 multiplied by 1000 = $128,500 loan amount.

Remember, these are average ratios and guidelines set by most lenders for common mortgage programs.

Keep in mind, while most consumer debts are listed on a credit report, there are some additional monthly liabilities that may contribute to the overall qualifying percentages as well.

Regardless of how your personal income and credit scenarios factor in, it is important to consider your overall budget when trying to determine how much of a mortgage you should qualify for.

Other items to consider in your monthly budget:

1. Confirm all debts are taken into account
2. Any private notes or family loans
3. Short-term expenses – medical, auto repairs, travel, emergencies
4. Plan on additional expenses for the home such as water, electric, maintenance, etc…
5. Keep a cushion for savings and financial planning

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Understanding the FHA Mortgage Insurance Premium (MIP)

* Disclaimer – all information in this article is accurate as of the date this article was written *

The FHA Mortgage Insurance Premium is an important part of every FHA loan.

There are actually two types of Mortgage Insurance Premiums associated with FHA loans:

1.  Up Front Mortgage Insurance Premium (UFMIP) – financed into the total loan amount at the initial time of funding

2.  Monthly Mortgage Insurance Premium – paid monthly along with Principal, Interest, Taxes and Insurance

Conventional loans that are higher than 80% Loan-to-Value also require mortgage insurance, but at a relatively higher rate than FHA Mortgage Insurance Premiums.

Mortgage Insurance is a very important part of every FHA loan since a loan that only requires a 3.5% down payment is generally viewed by lenders as a risky proposition.

Without FHA around to insure the lender against a loss if a default occurs, high LTV loan programs such as FHA would not exist.

Calculating FHA Mortgage Insurance Premiums:

Up Front Mortgage Insurance Premium (UFMIP)

UFMIP varies based on the term of the loan and Loan-to-Value.

For most FHA loans, the UFMIP is equal to 2.25%  of the Base FHA Loan amount (effective April 5, 2010).

For Example:

>> If John purchases a home for $100,000 with 3.5% down, his base FHA loan amount would be $96,500

>> The UFMIP of 2.25% is multiplied by $96,500, equaling $2,171

>> This amount is added to the base loan, for a total FHA loan of $98,671

Monthly Mortgage Insurance (MMI):

  • Equal to .55% of the loan amount divided by 12 – when the Loan-to-Value is greater than 95% and the term is greater than 15 years
  • Equal to .50% of the loan amount divided by 12 – when the Loan-to-Value is less than or equal to 95%, and the term is greater than 15 years
  • Equal to .25% of the loan amount divided by 12 – when the Loan-to-Value is between 80% – 90%, and the term is greater than 15 years
  • No MMI when the loan to value is less than 90% on a 15 year term

The Monthly Mortgage Insurance Premium is not a permanent part of the loan, and it will drop off over time.

For mortgages with terms greater than 15 years, the MMI will be canceled when the Loan-to-Value reaches 78%, as long as the borrower has been making payments for at least 5 years.

For mortgages with terms 15 years or less and a Loan -to-Value loan to value ratios 90% or greater, the MMI will be canceled when the loan to value reaches 78%.  *There is not a 5 year requirement like there is for longer term loans.

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Calculating The Net Benefit Of A Refinance Transaction

Calculating the net benefit of refinancing can be a challenging task if you do not understand what to calculate. We are going to focus on the net benefits of refinancing from the standpoint of lowering your interest rate.

Although there are several reasons to refinance, lowering your mortgage rate to save on interest payments over the term of the loan is the most popular.

Calculating the actual savings can be a tricky chore unless you know the difference between cash flow savings and interest savings. If your refinance objective is to only save on the interest by lowering your rate, then the interest savings should be done with the calculations below.

Calculating Interest Savings:

(Loan Amount x Interest Rate) / Months in year = Interest paid per month

($200,000 x 6% or .06) / 12 = $1,000.00

*Remember to do the calculation in the parentheses first*

We now know that you are paying $1,000.00 per month in interest. You should take the new interest rate you are getting with your refinance and calculate what your new interest payment will be.

($200,000 x 5% or .05) / 12 = $833.34

Now we need to find out the difference between the two interest rates.

Current Interest Payment – Proposed Interest Payment = Interest Savings

$1,000.00 – $833.34 = $166.66

Now you have figured out that by dropping your interest rate 1% on $200,000 you will be saving $166.66 per month or about $2,000 per year.

Awesome!

Anyone would want to save $2,000 per year, where do I sign… right? Not so fast, you’ll want to calculate the break-even point to find out how you will benefit after your closing costs.

Net Benefit Formula (Break-Even):

(Closing Costs – Escrows) / Interest Savings = Month of Break-Even

($6,000 – $1,000) / $166.66 = 30 Months

In other words, it will take 30 months for you to recoup the cost of your refinance. If you plan to keep your mortgage for at least 30 months then you might want to consider this deal.

Okay, now we can calculate your net benefit for refinancing with one more calculation.

(Monthly Savings * Months you plan to keep mortgage) – (Closing Costs –Escrows) = Net Savings

($166.66 * 120 months) – ($6,000 – $1,000) = $14,999.20

If you kept the mortgage for 120 months (10 years) you would save $15,000.

Okay, now you can find out where to sign.

Calculating the net benefits of a refinance is crucial in determining if it is strategic for you to refinance. Keep in mind that each mortgage is slightly different and you may need to adjust calculations accordingly.

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Frequently Asked Questions:

Q:  I heard that I should only refinance if I drop 1% on my mortgage is that true?

Some people say ½% , 1% to never. Every mortgage is different.

For Example: A no cost loan can have a 1 month break-even point with only a .25% drop in interest rate. Now that you know how to calculate your net benefit, you are able to figure out what may be best for your situation.

Q:  Why can’t I just compare my current payment to the proposed payment and figure out my net benefit?

You could just compare just the two payments if you wanted to find out your cash flow savings, but the current and proposed loans may have two different amortizations.

Let’s assume you currently have a 15 year mortgage and you’re comparing it to a 30 year mortgage. If both loans have the same interest rate and loan amount but the amortization is different, your interest savings per month would be $0. However, you are going to show a cash flow savings with the 30 year mortgage because of the longer amortization.

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Top Five Market Factors That Influence Mortgage Rates

Timing the market for the best possible opportunity to lock a mortgage rate on a new loan is certainly a challenge, even for the professionals.

While there are several generic interest rate trend indicators online, the difference between what’s advertised and actually attainable can be influenced at any given moment by at least 50 different variables in the market, and with each individual loan approval scenario.

Outside of the borrower’s control, the mortgage rate marketplace is a dynamic, volatile, living and breathing animal.

Lenders set their rates every day based on the market activities of Mortgage Bonds, also known as Mortgage Backed Securities (MBS).

On volatile days, a lender might adjust their pricing anywhere from one to five times, depending on what’s taking place in the market.

Factors That Influence Mortgage Backed Securities:

1.  Inflation –

According to Wikipedia:

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, annual inflation is also an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy.

A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.

As inflation increases, or as the expectation of future inflation increases, rates will push higher.

The contrary is also true; when inflation declines, rates decrease.

Famous economist Milton Friedman said “inflation is always and everywhere a monetary phenomenon.”

Public enemy #1 of all fixed income investments, inflation and the expectation of future inflation is a key indicator of how much investors will pay for mortgage bonds, and therefore how high or low current mortgage rates will be in the open market.

When an investor buys a bond, they receive a fixed percentage of the value of that bond as ‘coupon’ payments.

With MBS, an investor might buy a bond that pays 5%, which means for every $100 invested, they receive $5 in interest per year, usually divided up over 12 payments. For the buyer of a mortgage bond, that $5 coupon payment is worth more in the first year, because it can buy more today than it can in the future, due to inflation. When the markets read signals of increasing inflation, it tells bond investors that their future coupon payments will be less valuable by the time they receive them. So basically, this causes investors to demand higher rates for any new bonds they invest in.

2. The Federal Reserve

As part of its 2008-2010 stimulus effort, the NY Fed spent almost all of its $1.25 trillion budget buying mortgage bonds. Many believe this strategy kept mortgage rates lower over a 15 month period.

The lending environment significantly changed between 2008, when the Fed began its mortgage bond purchasing program, and early 2010 when the market was left to survive on its own.

When the MBS purchase program was announced in November 2008, mortgage bonds reacted immediately and dramatically.

But at that time, there weren’t any investors willing to take a risk in buying mortgage bonds. The meltdown in the mortgage market and world economies lead many investors to shy away from the risks associated with MBS, which is why the Fed had to step in and basically assume the role as the sole investor of mortgage bonds.

However, loan underwriting guidelines drastically tightened up by 2010, which may create a little more confidence in the mortgage bond market.

3. Unemployment –

Decreasing unemployment will suggest that mortgage rates will rise.

Typically, higher unemployment levels tend to result in lower inflation, which makes bonds safer and permits higher bond prices. For example, the unemployment rate in March 2010 was at 9.7%, just slightly below its highest mark in the current economic cycle.

Every month, the BLS releases the Nonfarm Payrolls (aka The Jobs Report) which tallies the number of jobs created or lost in the preceding month.

The previous report indicated a loss of 36,000 jobs. Not necessarily a number that will move the needle on the unemployment gauge, but some economists suggest we need about 125,000 new jobs each month just to keep pace with population growth. So that negative 36,000 is more like negative 161,000 jobs short of an improving unemployment picture.

One flaw to pay attention to with unemployment rates is that the method of surveying fails to capture part-time workers who desire full-time employment, discouraged job seekers who have taken time off from searching and other would-be workers who are not considered to be part of the labor force.

4. GDP –

GDP, or Gross Domestic Product, is a measure of the economic output of the country.

High levels of GDP growth may signal increasing mortgage rates.

The Federal Reserve slashes short-term rates when GDP slows to encourage people and businesses to borrow money. When GDP gets too hot, there might be too much money floating around, and inflation usually picks up. So high GDP ratings warn the market that interest rates will rise to keep inflation concerns in balance.

Spiking GDP with flat/increasing unemployment begs some questions.

There are two major indicators that help provide more context:

1. Increases to worker productivity – employers are getting more work out of their current employees to avoid hiring new ones

2. Surges in inventory cycles – when the economy first started contracting, manufacturing slowed down to cut costs, and sales were made by liquidating inventory.

This is like a roller coaster cresting a hill, where one part of the train is going up, the other down. Eventually, the other side catches up, inventories are rebuilt by manufacturing more than is being sold. Both surges can throw off periodic reports of GDP.

5. Geopolitics –

Unforeseen events related to global conflict, political events, and natural disasters will tend to lower mortgage rates.

Anything that the markets didn’t see coming causes uncertainty and panic. And when markets panic, money generally moves to stable investments (bonds), which brings rates lower. Mortgage bonds pick up some of that momentum.

Acts of terrorism, tsunamis, earthquakes, and recent sovereign debt crises (Dubai, Greece) are all examples.

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Putting It All Together:

Economic data is reported daily, and some items have a greater tendency to be of concern to the market for mortgage rates. If you are involved in a real estate financing transaction, it’s helpful to be aware of these influences, or to rely upon the advice of a mortgage professional who is already dialed in.

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What's The Difference Between Interest Rate and Annual Percentage Rate (APR)?

The difference between APR and actual note rate is very confusing, especially for First-Time Home Buyers who haven’t been through the entire closing process before.

When shopping for a new mortgage loan, you may notice an Annual Percentage Rate (APR) advertised next to the note rate.  The inclusion of an APR is actually mandated by federal law in order to help give borrowers a standard rule of measurement for comparing the total cost of each loan.

The APR is designed to represent the “true cost of a loan” to the borrower, expressed in the form of a yearly rate to prevent lenders from “hiding” fees and up-front costs behind low advertised rates.

According to Wikipedia:

The terms annual percentage of rate (APR) and nominal APR describe the interest rate for a whole year (annualized), rather than just a monthly fee/rate, as applied on a loan, mortgage, credit card, etc. It is a finance charge expressed as an annual rate. 

  • The nominal APR is the simple-interest rate (for a year).
  • The effective APR is the fee+compound interest rate (calculated across a year)

The nominal APR is calculated as: the rate, for a payment period, multiplied by the number of payment periods in a year.

However, the exact legal definition of “effective APR” can vary greatly, depending on the type of fees included, such as participation fees, loan origination fees, monthly service charges, or late fees.

The effective APR has been called the “mathematically-true” interest rate for each year. The computation for the effective APR, as the fee+compound interest rate, can also vary depending on whether the up-front fees, such as origination or participation fees, are added to the entire amount, or treated as a short-term loan due in the first payment.

What Fees Are Typically Included In APR?

  • Origination Fee
  • Discount Points
  • Buydown funds from the buyer
  • Prepaid Mortgage Interest
  • Mortgage Insurance Premiums
  • Other lender fees (application, underwriting, tax service, etc.)

Since origination fees, discount points, mortgage insurance premiums, prepaid interest and other items may also be required to obtain a mortgage, they need to be included when calculating the APR. Fees such as title insurance, appraisal and credit are not included in calculating the APR.

The APR can vary between lenders and programs due to the fact that the federal law does not clearly define specifically what goes into the calculation.

What Does APR Not Disclose?

  • APR on a loan tied to a market index, like a 5/1 ARM, assumes the market index will never change.  But Adjustable Rate Mortgages always change over the course of 30 years.
  • Balloon Payments
  • Prepayment Penalties
  • Length of Rate Lock
  • Comparison between loan terms – EX:  A 15-year term will have a higher APR simply because the fees are amortized over a shorter period of time compared to a similar rate / cost scenario on a 30-year term.

APR Comparing Examples:

  • Bank (A) is offering a 30 year fixed mortgage at 8.00% APR
  • Bank (B) is offering a 30 year fixed mortgage at 7.00% Note Rate

Easy choice, right?

While Bank (B) is advertising the lowest Note Rate, they’re not factoring in the origination points, underwriting / processing fees and prepaid mortgage interest (first month’s mortgage payment), which could essentially make the APR much higher than the one Bank (A) is advertising. So Bank (A) may show a higher rate due to the APR, but they could actually be charging a lot less in total fees than Bank (B).

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Before lenders and mortgage brokers were required to state the APR, it was more difficult to find the truth about the total borrowing costs of one loan vs another. When comparing mortgage rates, it’s a good idea to ask your lender which fees are included in their APR quote.

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How Do Mortgage Rates Move When The Fed Lowers Rates?

Lower mortgage rates is a common misconception that is perpetuated by the mainstream media when the Fed makes an announcement of lowering rates.

However, when the Fed cuts interest rates, mortgage rates can actually increase.

Fed 101:

According to Wikipedia:

The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States.

This system was conceived by several of the world’s leading bankers in 1910 and enacted in 1913, with the passing of the Federal Reserve Act. The passing of the Federal Reserve Act was largely a response to prior financial panics and bank runs, the most severe of which being the Panic of 1907.

Over time, the roles and responsibilities of the Federal Reserve System have expanded and its structure has evolved. Events such as the Great Depression were some of the major factors leading to changes in the system.

Its duties today, according to official Federal Reserve documentation, fall into four general areas:

  1. Conducting the nation’s monetary policy by influencing monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.
  2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system, and protect the credit rights of consumers.
  3. Maintaining stability of the financial system and containing systemic risk that may arise in financial markets.

The Federal Reserve controls two key interest rates in this country:

1) The Federal Funds Rate

2) The Discount Rate

These are overnight lending rates used by banks when they lend money to each other.

When these rates are low, money is cheaper for banks to borrow, and that “cheap” money spreads throughout the economy.

The aim of the Federal Reserve in its interest rate policy is to either speed up or slow down the economy. In times of economic downturn, the Federal Reserve will cut rates to help create a boost. Conversely, in times of heavy inflation, the Fed will raise rates to help slow down the economy.

That’s it; speed up or slow down….no tricks.

When the credit crisis began to spiral in 2007, the Fed cut rates dramatically in hopes of jump-starting the economy. The Fed keeping rates near zero is an indication that the economy is moving along at a steady pace. If the economy improves to the point where inflation starts to creep up the Fed will begin hiking rates.

The Fed and Mortgage Rates:

Mortgage rates are tied to mortgage bonds, which are traded every day on the secondary market just like stocks.

Bonds are often considered a safer investment than stocks since they yield a constant rate of return.

During times of market turmoil, investors sell their stock holdings and move into bonds (called a “flight to safety” in financial jargon).

Conversely, when the economy is booming, investors move their money away from bonds and into stocks to take advantage of the upswing in the economy.

Remember, The Fed cuts interest rates to boost the economy.

When investors see this boost, they sell their bond holdings and move into stocks.

This movement causes the rates on those bonds to increase naturally as the bonds have to attract new investors with higher rates of return.

As a result, we see mortgage rates increase.

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So, the next time you hear the Fed cutting interest rates, don’t assume mortgage rates will simply follow suit. The rate cut is simply meant to boost the economy, which moves money from bonds to stocks, and causes mortgage rates to rise.

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Why Do I Need To Pay A VA Funding Fee?

The VA Funding Fee is an essential component of the VA home loan program, and is a requirement of any Veteran taking advantage of this zero down payment government loan program.

This fee ranges from 1.25% to 3.3% of the loan amount, depending upon the circumstances.

On a $150,000 loan that’s an additional $1,875 to almost $5,000 in cost just for the benefit of using the VA home loan.

The good news is that the VA allows borrowers to finance this cost into the home loan without having to include it as part of the closing costs.

For buyers using their VA loan guarantee for the first time on a zero down loan, the Funding Fee would be 2.15%.

For example, on a $150,000 loan amount, the VA Funding Fee could total $3,225, which would increase the monthly mortgage payment by $18 if it were financed into the new loan.

So basically, the incremental increase to a monthly payment is not very much if you choose to finance the Funding Fee.

Historical Trivia:

Under VA’s founding law in 1944 there was no Funding Fee; the guaranty VA offered lenders was limited to 50 percent of the loan, not to exceed $2,000; loans were limited to a maximum 20 years, and the interest rate was capped at 4 percent.

The VA loan was originally designed to be readjustment aid to returning veterans from WWII and they had 2 years from the war’s official end before their eligibility expired. The program was meant to help them catch up for the lost years they sacrificed.

However, the program has obviously evolved to a long term housing benefit for veterans.

The first Funding Fee was ½% and was enacted in 1966 for the sole purpose of building a reserve fund for defaults. This remained in place only until 1970. The Funding Fee of ½% was re-instituted in 1982 and has been in place ever since.

The Amount Of Funding Fee A Borrower Pays Depends On:

  • The type of transaction (refinance versus purchase)
  • Amount of equity
  • Whether this is the first use or subsequent use of the borrower’s VA loan benefit
  • Whether you are/were regular military or Reserve or National Guard

*Disabled veterans are exempt from paying a Funding Fee

The table of Funding Fees can be accessed via VA’s website – CLICK HERE

The main reason for a Veteran to select the VA home loan instead of another program is due to the zero down payment feature.

However, if the Veteran plans on making a 20% or more down payment, the VA loan might not be the best choice because a conventional loan would have a similar interest rate, but without the Funding Fee expense.

The best way to view the VA Funding Fee is that it is a small cost to pay for the benefit of not needing to part with thousands of dollars in down payment.

* Disclaimer – all information is accurate as of the time this article was written *

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Why Do I Need Mortgage Insurance?

Mortgage Insurance, sometimes referred to as Private Mortgage Insurance, is required by lenders on conventional home loans if the borrower is financing more than 80% Loan-To-Value.

According to Wikipedia:

Private Mortgage Insurance (PMI) is insurance payable to a lender or trustee for a pool of securities that may be required when taking out a mortgage loan.

It is insurance to offset losses in the case where a mortgagor is not able to repay the loan and the lender is not able to recover its costs after foreclosure and sale of the mortgaged property.

PMI isn’t necessarily a bad thing since it allows borrowers to purchase a property by qualifying for conventional financing with a lower down payment.

Private Mortgage Insurance (PMI) simply protects your lender against non-payment should you default on your loan. It’s important to understand that the primary and only real purpose for mortgage insurance is to protect your lender—not you. As the buyer of this coverage, you’re paying the premiums so that your lender is protected. PMI is often required by lenders due to the higher level of default risk that’s associated with low down payment loans. Consequently, its sole and only benefit to you is a lower down payment mortgage

Private Mortgage Insurance and Mortgage Protection Insurance

Private mortgage insurance and mortgage protection insurance are often confused.

Though they sound similar, they’re two totally different types of insurance products that should never be construed as substitutes for each other.

  • Mortgage protection insurance is essentially a life insurance policy designed to pay off your mortgage in the event of your death.
  • Private mortgage insurance protects your lender, allowing you to finance a home with a smaller down-payment.

Automatic Termination

Thanks to The Homeowner’s Protection Act (HPA) of 1998, borrowers have the right to request private mortgage insurance cancellation when they reach a 20 percent equity in their mortgage. What’s more, lenders are required to automatically cancel PMI coverage when a 78 percent Loan-to-Value is reached.

Some exceptions to these provisions, such as liens on property or not keeping up with payments, may require further PMI coverage.

Also, in many instances your PMI premium is often tax deductible in a similar fashion as the interest paid each year on your mortgage is tax deductible. Please, check with a tax expert to learn your tax options.

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Understanding An Amortization Schedule

By committing to a mortgage loan, the borrower is entering into a financial agreement with a lender to pay back the mortgage money, with interest, over a set period of time.

The borrower’s monthly mortgage payment may change over time depending on the type of loan program, however, we’re going to address the typical 30 year fixed Principal and Interest loan program for the sake of breaking down the individual payment components for this particular article about an amortization schedule.

On each payment that is made, a certain amount of interest is taken out to pay the lender back for the opportunity to borrow the money, and the remaining balance is applied to the principal balance.

It’s common to hear industry professionals and homeowners talk about a mortgage payment being front-loaded with interest, especially if they’re referencing an amortization chart to show the numbers. Since there is more interest being paid at the beginning of a mortgage payment term the amount of money applied to interest decreases over time, while the money applied to the principal increases.

We can better understand mortgage payments by looking at a loan amortization chart, which shows the specific payments associated with a loan.

The details will include the interest and principal component of each periodic payment.

For example, let’s look at a scenario where you borrowed a $100,000 loan at 7.5% interest rate, fixed for 30 year term. To ensure full repayment of principal by the end of the 30 years, your payment would need to be $699.21 per month. In the first month, you owe $100,000, which means the interest would be calculated on the full loan amount. To calculate this, we start with $100,000 and multiply it by 7.5% interest rate. This will give you $7,500 of annual interest. However, we only need a monthly amount. So we divide by 12 months to find that the interest equals $625. Now remember, you are paying $699.21. If you only owe interest of $625, then the remainder of the payment, $74.21, will go towards the principal. Thus, your new outstanding balance is now $99,925.79.

In month #2, you make the same payment of $699.21. However, this time, you now owe $99,925.79. Therefore, you will only pay interest on $99,925.79. When running through the calculator in the same process detailed above, you will find that your interest component is $624.54. (It is decreasing!) The remaining $74.68 will be applied towards principal. (This amount is increasing!)

Each month, the same simple mathematic calculation will be made. Because the payments are remaining the same, each month the interest will continue to be reduced and the remainder going towards principal will continue to increase.

An amortization chart runs chronologically through your series of payments until you get to the final payment. The chart can also be a useful tool to determine interest paid to date, principal paid to date, or remaining principal.

Another frequent use of amortization charts is to determine how extra payments toward principal can affect and accelerate the month of final payment of the loan, as well as reduce your total interest payments.

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