amortization

House Loan 101 – Part 2

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How To Get A House Loan

If you come from ‘House Loan 101 – Part 1‘, that contains the basics about a house loan: Great! You’re comfortable with the basics about a house loan, let’s dive deeper into how monthly payments are calculated and the nuances of interest rates, focusing on making these complex financial principles accessible.  (If you have not read House Loan 101 – Part , I suggest you start there and then read on here.

Here are the links to this 5 part house loan explainer:

House Loan 101 – Part 1
House Loan 101 – Part 2 (this one here)
House Loan 101 – Part 3
House Loan 101 – Part 4
House Loan 101 – Part 5

 Calculating Monthly Payments for a House Loan

The monthly mortgage payment is primarily determined by four factors: the loan amount, the interest rate, the term of the loan, and the type of loan (such as fixed or adjustable). The formula to calculate monthly payments for a fixed-rate mortgage is based on the concept of present value and involves amortization, the process by which the loan balance decreases over the loan term.

Amortization Explained with an Analogy

Think of amortization like cutting a log (the loan) into equal segments (monthly payments) over time. Each chop (payment) has two components: one part cuts into the wood (principal), reducing the size of the log, and the other part is the energy or effort (interest) needed to make the chop. Early on, more energy (interest) is needed, but as the log gets smaller, less energy (interest) and more actual chopping (principal repayment) occurs.

Monthly Payment Calculation

To calculate the monthly payment, banks use an equation that accounts for the compounding nature of interest, ensuring that each payment covers the interest for the period while also reducing the principal owed. This calculation ensures that by the end of the term, the loan is fully repaid.

Fixed vs. Adjustable Rates for a House Loan

– Fixed-Rate Mortgages: The interest rate remains the same for the entire loan term. This means monthly payments are also fixed. Using our analogy, it’s like knowing exactly how much effort each chop will take, no matter how long you’re chopping.

– Adjustable-Rate Mortgages (ARMs): The interest rate can change over time based on market conditions. Initially, ARMs often offer a lower rate (making the initial chops easier), but the effort required can increase or decrease over time. This can affect the size of your monthly payment, making budgeting a bit more like weather forecasting.

Understanding Interest Rates

Interest rates are determined by a combination of factors including the Federal Reserve’s policies, inflation, and the lender’s assessment of risk. Lower risk borrowers (high credit scores, stable income) generally receive lower rates.

Risk-Based Pricing Analogy

Imagine you’re lending out bicycles. Lending to someone with a history of taking good care of bikes and returning them on time is less risky, so you might do it for a small favor in return. But lending to someone with a history of returning bikes late or damaged is riskier, so you might ask for a bigger favor to compensate for that risk. Similarly, banks adjust interest rates based on how risky they perceive the loan to be.

Practical Implications for You

Understanding these principles can help you:
– Shop for the best mortgage rates: Knowing how rates are set can help you improve your credit score and lower your DTI ratio to qualify for better rates.
– Choose the right loan term: Shorter terms mean higher monthly payments but less interest paid over the life of the loan. Longer terms lower monthly payments but increase total interest paid.
– Decide between fixed and adjustable-rate mortgages: Consider your future income stability, how long you plan to stay in the home, and your tolerance for the risk of rising payments.

Checking Your Understanding

To ensure you’ve got a solid grasp of these concepts:
– Can you explain how making a larger down payment affects your loan and interest payments?
– How does the concept of amortization impact the proportion of interest to principal in your monthly payments over time?
– What are the benefits and risks of choosing an adjustable-rate mortgage over a fixed-rate mortgage?

 

All clear?  OK, then let’s move on to House Loan 101 – Part 3.

 

House Loan 101 – Part 1

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How To Get A House Loan

Understanding how banks in the USA evaluate potential homebuyers and determine house loan conditions is crucial for navigating the home-buying process. Let’s break it down into five more manageable parts, using clear explanations and analogies to make the complex financial principles involved more accessible.  This series can help you avoid mistakes many make, when looking for a cheap house loan.

Here are the links to this 5 part house loan explainer:

House Loan 101 – Part 1  (this one here)
House Loan 101 – Part 2
House Loan 101 – Part 3
House Loan 101 – Part 4
House Loan 101 – Part 5

 

1. Evaluation of a Future House Owner

Banks look at several key factors before deciding to lend money for a mortgage. Think of the bank as a meticulous chef evaluating ingredients before preparing a meal; they want to ensure everything combines well to produce a satisfactory outcome.

a. Credit Score:

– What it is: A numerical expression based on an analysis of a person’s credit files, to represent the creditworthiness of an individual.
– Analogy: Consider your credit score like a grade in school that shows how well you’ve managed your borrowing habits. Just like a report card, a higher score (grade) makes you a more appealing candidate.

b. Income:

– What it is: Regular income ensures you have the means to repay the loan.
– Analogy: Think of your income as the fuel in your car; without enough fuel, you won’t be able to complete the journey (repay the loan).

c. Employment History:

– What it is: A stable job history indicates reliability in maintaining income.
– Analogy: Like a reliable recipe that always tastes good because of consistent ingredients, a stable job history shows you’re a dependable borrower.

d. Debt-to-Income Ratio (DTI):

– What it is: A personal finance measure that compares an individual’s debt payment to his or her overall income.
– Analogy: Imagine you’re carrying a backpack. The more items (debt) you add compared to the strength you have (income), the harder it is to walk comfortably. A lower DTI means a lighter backpack.

e. Down Payment:

– What it is: The initial, upfront portion of the total amount. This affects the loan-to-value ratio.
– Analogy: Think of the down payment as the foundation of a house; a strong, larger foundation (down payment) makes for a more stable structure (loan).

2. Calculating and Evaluating the House Loan and Interest

a. Loan Amount:

The loan amount is the total sum borrowed. It’s determined by the price of the house minus the down payment.

b. Interest Rate:

– What it is: The cost of borrowing money, expressed as a percentage of the total loan amount.
– Analogy: Consider the interest rate as the rental fee for borrowing money; the higher the rate, the more you pay to use the lender’s money.

c. House Loan Term:

– What it is: The amount of time you have to repay the loan.
– Analogy: Like a library book loan period; longer terms mean more time to read (repay), but potentially more late fees (interest).

d. Amortization:

– What it is: The process of spreading out a loan into a series of fixed payments over time.
– Analogy: Imagine paying off a large meal in smaller, manageable bites until it’s all gone.

Banks use these factors to calculate monthly payments, which include both the principal (the original loan amount) and interest. The interest rate and loan term will directly affect these payments. Additionally, banks often use risk-based pricing, meaning the interest rate offered reflects the perceived risk of lending to the borrower. A higher risk (e.g., lower credit score) generally means a higher interest rate.

Understanding Prerequisites

Before diving deeper into the calculation specifics, like how exactly monthly payments are calculated or the impact of different types of interest rates (fixed vs. adjustable), let’s ensure you’re comfortable with some of the foundational concepts  we’ve just discussed:

– Do you have a basic understanding of what a credit score is and how it’s determined?
– Are you familiar with the concept of debt-to-income ratio and why it’s important?
– How comfortable are you with the idea of compound interest and amortization schedules?

All clear?  OK, then let’s move on to House Loan 101 – Part 2.