Components of Home Ownership

So it’s the model of the American dream, but is it right for you, yet? Don’t just assume it is. There exist many considerations that go into possibly becoming a homeowner. It’s a very big step from the responsibilities of a renter to an owner. Gone will be the days of short-term delights; relocating without worries, having your landlord fix your property, and the carefree attitude of equity management. However, if done properly, carefully, and thoughtfully homeownership may be one of the most rewarding experiences you may come across. Below are some broad topics of consideration for those who wish to know where they stand, the benefits and drawbacks, and the process of owning a home.

The majority of transition issues are financial, so it is a great topic to examine. Of these, mortgages may be of the least understood.

Mortgages are loans from a lending institution that purchase your home and charge you interest to pay them back. They are the most predominant form of buying a home, since most people don’t have the money to buy a home outright.

Mortgages have two (2) forms of interest, fixed and ARM (adjustable rate mortgage)

Since you know what your payment will be for the life of the loan, you can budget more easily.

No possibility that the interest rate may fluctuate up making your mortgage payment suddenly unaffordable.

No worries over interest rate fluctuations.

Disadvantages

More income needed to qualify because of higher initial mortgage rate.

If interest rates decrease appreciably, it will be necessary to refinance to get a lower payment.

ARM- the interest rate can vary--up or down--at specified times during the mortgage term.

Advantages

Lower initial interest rate and as a result a lower monthly payment.

If interest rate declines, your payment will also decline.

Easier to qualify for due to lower initial interest rate and payment amount.

Disadvantages

If interest rate increases, payment amount will also increase.

A large increase in interest rates and resultantly your payments could make your house unaffordable.

Mortgages have loan term periods usually in 15, 20, and 30 year intervals

Demonstrated below are the benefits and disadvantages to a common 15 and 30 year loan:

100,000 mortgage at 8.5%
Term	15 year	30 year
Principal and Interest Payment (monthly)	$985	$769
Total paid over term in P&I	$177,300	$276,840
Total interest over term	$77,300	$176,840

In summary:

Longer time periods usually result in lower, perhaps more comfortable monthly payments but at the expense of substantial increased interest accrued and more total amount to be paid in the end.
Shorter time periods result in higher initial payments but result in a substantial decrease in accumulated interest over term that costs you a lot less in the long-run.

Mortgage payments consist of P/I/T/I

The dollars in your monthly mortgage payment go towards P/I/T/I;

Principal- The original dollar amount borrowed.
Interest- The cost of borrowing the principal amount, variable upon the rate.
Taxes- Real Estate taxes imposed on the property
Insurance- Homeowners insurance on the home. As well as any mortgage insurance (called PMI) to protect the mortgage company.

Keep in mind, that as time progresses and the loan matures more of your dollars will go toward principal (gaining equity) than paying interest. In general, at the beginning of your loan most of your money will go towards paying off the interest.

Private Mortgage Insurance (PMI)

PMI is an insurance that the majority of lenders require of all borrowers whose down payment is less than 20%. Its purpose is to protect the lender against losses should the borrower default. At first glance it may seem that you are paying for an insurance that is for their benefit and not yours.

However, if you consider that statistically, lenders have found those who put down less than 20% are considerably riskier to default. PMI then becomes a bridge for those who don’t have 20% for down payment and gives them the ability to still be able to borrow but at a lesser down payment percentage. This is crucial, especially to first-time home buyers, where cash for down payments and closing costs may leave funds very low.

Typically, PMI monthly payments will add another $25-$100 on your mortgage for fairly priced homes. However, PMI depends on a number of factors such as; insurance carrier, and size of the loan, so it is dependant upon your unique situation.

Mortgage Ratios

A major component of the mortgage application process is the determination of how much house you can afford based on your income or better yet how much should the lender let you borrow. Mortgage companies use the front ratio and back ratio to determine interest rate and amount to be loaned.

Front Ratio

Calculates total mortgage payment INCLUDING principal, interest, taxes, fees, and insurance DIVIDED by borrower’s GROSS income.
Traditionally, the ratio must not exceed 28%, or it may be liable to higher interest rate fees.
Take the following example; Bob with a gross income of $3500, will be at his ceiling amount at $980 at a front ratio of 28% .

Back Ratio

Calculates total mortgage payments INCLUDING principal, interest, taxes, fees, PLUS any car notes, credit cards, and any other outstanding loan payments DIVIDED by the borrower’s total GROSS income
Traditionally, this ratio may not exceed 36%, or again it may be liable to higher interest rate fees.
Take the following example; Bob with his prior front ratio amount of $980 now must add his car note of $199, his credit card payment of $39 and his bank loan payment of $39 to his list of payments totaling $1257 and DIVIDE by his gross income of $3500. The result is a ratio of 36% which again would be at his limit.

Keep in mind, although your maximum ratio may be reached, it does not necessarily mean that it is your loan ceiling amount. It is a measure of risk, and as such surpassing a certain measure of risk you will be charged at a higher rate accordingly.

Points

Points are fees the borrower pays the lender at the time the loan is closed, expressed as a percent of the loan. For example, on a $100,000 loan, 4 points means a payment of $4,000. Increasing points are part of the cost of credit to the borrower, and decreasing points are part of the investment return to the lender. Naturally, the next question may be, should/do I need to pay points? Who benefits?

“Don’t pay now, pay me later”, with the growing popularity of zero point loans where you pay no money down, it might be an enticing option, no one likes to pony up if you don’t have to, right? Maybe not so much. Remember, a zero-point loan almost always brings a higher interest rate, usually a lot higher. The following chart illustrates the cost/benefit:

$200,000 Loan @ 15 year term
Lender quote combinations	6.75% and 4.50 Points	7.25% and 2.00 Points (Quoted)	7.75% and 0.00 Points
Cost(Points in dollars, Upfront)	4.5 Points = $4,500	2 Points = $2,000	0 points = $0
Cost (Yearly)	$12,892.50	$14,210	$15,500
Cost(Length of Loan Total Interest)	$193,387.50	$213,150	$232,500
Cost(In Extra Lender Revenue/ Added Borrower Total Cost)	$0(base of example)	$19,762.50	$39,112.50
Benefit	Borrower	Borrower	Lender

As demonstrated, when a lender when a lender offers a zero point loan he usually temporarily forfeits a certain amount on the closing, 4.5 points or $4,500 in this example, yet for forfeiting this amount the first year his total benefit increases to 39,112.50! That’s almost a 900% return on investment for the lender at your expense!

In general, the more points you are willing/able to acquire the less you will pay, both in interest and monthly payments, throughout the duration of the loan. The less points and the more interest and higher the payments will become. Keep in mind, that lending is a zero-sum game, one person benefits at the others detriment, as such you can expect a lender to encourage a zero or low point purchases. Zero or low point purchases aren’t inherently a bed idea, it makes sense for persons wishing only to stay less than 3 years at a property, anything lengthier you’d be better set on acquiring points.

In Summary

As Suze Orman (CNBC) so eloquently stated “A long time ago I learned a great piece of wisdom: The hardest thing to do in life is to jump a chasm in two leaps.” Buying your first home is a very big step, one that you should consider, research, and plan long in advance before ever taking the jump. Once you have given yourself the proper time and consideration, however, you will be able to take the leap and reach the other side with your finances and peace of mind intact, no regrets.