How a Mortgage is Calculated
So, you’ve been pre-approved for a mortgage, and the next step is to calculate monthly payments for a new house. Your lender will use several factors to calculate your mortgage. In this section, we will describe each piece of information and how it applies to the mortgage calculation process.
Down payment is a payment made as part of a large purchase in the early stages of a financing arrangement. The down payment represents a percentage of the full purchase price. For a conventional loan, 20% of the house price will be needed as a down payment. That would mean a $60,000 down payment for a home price of $300,000.
Loan to Value (LTV) is a critical ratio used by the lender to determine how much risk they will be taking to loan you money. LTV is calculated by dividing the loan amount by the appraised value of the property. So using our $300,000 home price with a $60,000 down payment the loan amount will be $240,000 and the LTV will be 80% ($240k / $300k = 80%). Most banks look for an LTV of 80% or less while other lenders such as the Federal Housing Administration or the Veterans Administration may allow higher percentages. One way to reduce the LTV would be to increase the amount of the down payment.
Private Mortgage Insurance (PMI) protects the lender from the risk of you defaulting on your loan. Generally, loans that require less than a 20% down payment will add Private Mortgage Insurance (PMI) to your mortgage payment. The PMI cost can be charged as an upfront premium paid at closing, but it is most commonly factored into your new monthly mortgage payment as an additional cost.
There are other loan programs available for an owner-occupied home loan, where less than 20% down is required. These include special first-time homebuyer loans, Federal Housing Administration (FHA) loans, Veterans Administration (VA) loans, and United States Department of Agriculture (USDA) loans.
- First-time Homebuyer Loans – you’ll need at least a 620 credit score and a debt-to-income ratio below 50%. The higher your credit score or the lower your debt, the better your chances are for loan approval from most lenders.
- FHA Loans – are insured by the Federal Housing Administration. If you want a down payment as low as 3.5%, you’ll need a 580 credit score or higher. With 10% down, your required credit score may go as low as 500.
- VA Loans – are a benefit for active-duty and veteran military service members and some surviving spouses. Generally, down payments are not required for loans backed by the VA, and while VA-backed loans don’t have a minimum FICO score as a part of their official requirements, many lenders look for a score of 580 to 620 or better.
USDA Loans – are zero down payment mortgages for eligible rural homebuyers. USDA loans are issued through the USDA loan program, also known as the USDA Rural
- Development Guaranteed Housing Loan Program, by the United States Department of Agriculture.
Loan Amount is calculated by adding the price of the house to the closing costs and then subtracting the down payment:
- (house price + closing costs) – (down payment + earnest money deposit + credits) = Loan Amount.
The two pieces of this equation that the homebuyer has some control over are the house price and the down payment.
- House Price – Based on your S.M.A.R.T. goal, have a conversation with your realtor about the offer you should be making based on the current housing market. You control the cost of the house by the offer you make and you don’t want to overpay on the price of the house.
- Down Payment – The more you can save towards the down payment, the less money you will have to loan and pay interest on over time.
TIP: Speak with a professional around what makes sense for your financial situation and future goals . Factoring in the loan amount you can comfortably carry, how much would be best for you to put down for the down payment.
Interest Rate is what you pay to borrow money. There are several factors a lender will evaluate when offering an interest rate to you, such as:
- Your credit score
- Down payment amount
- Type of loan
- Term of loan
Loan Term refers to the length of time you will pay off the loan. Mortgages are generally set up in 5 year increments, such:
- 30-year term
- 25-year term
- 20-year term
- 15-year term
- 10-year term
The 30-year term is most popular, as it spreads your principal and interest payment out the most to get you a lower payment. All mortgages from a bank/lender have no prepayment penalty, meaning you can pay any additional amount towards your loan without penalty. Remember that the interest has already been calculated over the term of the loan, so if you do pay additional amounts on the loan you will still be paying the same amount of interest.
The longer you hold the loan, the more interest you will pay on the borrowed money which adds to the cost of the house. You may want to consider a shorter term loan that will:
- increase the monthly amount your pay
- reduce the amount of interest you’ll pay over the term of the loan
Speak with your lender to determine what makes sense for your financial situation and future goals.
Loan Payment or monthly mortgage is also called a Principal Interest Taxes Insurance (PITI) payment. This is calculated by inputting the following core factors into a mortgage calculator.
- Principal – is the loan amount that equals the price of the house less the down payment.
- Interest – is the amount you will pay to borrow the money to pay for the house.
- Taxes – on the house will be held in an escrow account and paid when due.
- Insurance – on the house is required by the lender on the home.
Escrow is a legal concept where money is held by a third party on behalf of others. The homebuying process uses the word ‘Escrow’ multiple times. Here are a few examples of how you may hear escrow used during a real estate transaction:
- Earnest Money Deposit is typically stored in an escrow account until the transaction is completed. Earnest money lets the seller know that you are serious about buying the house, and is typically between 1% to 5% of purchase price. Your real estate agent will guide you on how much earnest money to offer. The earnest money will be credited towards your down payment at the time of closing.
- Lender Escrow Account is a separate account set aside with your lender for additional items to be paid on your behalf. Some lenders will require an escrow account; for others, it is optional. The main items that are paid out of this account are:
- Private Mortgage Insurance
Your monthly payment will include a portion that is set aside and deposited into your escrow account to pay these as they come due.
Offer and Purchase & Sale Agreement is a written contract setting out the terms under which you, the buyer, agree to buy the home. The contract includes how much Earnest Money you are willing to put down along with any terms and conditions that you and your real estate agent decide are necessary. At the Closing, the earnest money deposit is factored into the transaction as a credit.
When making an offer on a property, you are actually filling out a purchase and sales agreement with your information. It does not become a binding contract until the seller accepts the offer by signing the agreement. The seller can also edit the terms and respond with a counter-offer which is a new offer to the prospective buyer.
Title Office/Attorney facilitates the real estate transaction and makes sure everyone receives what they are promised. In order to do this, the title office/attorney will receive funds in their escrow account and process funds out to the respective parties. Your down payment and lender’s funds are actually sent to the Title Office/Attorney to pay all the parties involved in the transaction: the seller, the town for taxes, the Insurance company, the Real Estate Agent Commissions, etc.
Closing costs generally range from 1% – 5% of the loan amount for your new house. Closing costs can include such things as:
- Origination or processing charges from your lender
- Payment for credit reports
- Appraisal fee
- Title charges
- Prepaid interest
- Transfer taxes
- Any associated Home-Owner Association (HOA) dues
These charges will be added to your loan amount if you do not pay for them out of pocket.
Credits that are deducted from the purchase price and closing costs include things you have already paid for including appraisal fees, insurance, and earnest money.
We have covered a lot of terms in this section, and these are things you need to talk about with your lender, real estate agent, or attorney to make sure that you understand what you are paying for and why. For example, you may only have earnest money that needs to be credited at the time of closing because you were not required or responsible to pay for an appraisal or additional insurance. Also, a conversation with your lender, real estate agent, or attorney will help you to make the best offer on the house, and stay within your budget for buying a house.
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