How Interest Rates Work On A Mortgage

Man and woman standing in kitchen reading document

Man and woman standing in kitchen reading document

Buying a home with a mortgage is probably the largest financial transaction you will enter into. Typically a bank or mortgage lender will finance 80% of the price of the home, and you agree to pay it back – with interest – over a specific period of time. As you are comparing lenders, rates and options, it’s helpful to understand how interest accrues each month and is paid.

How Your Monthly Mortgage Payment Is Calculated

Simply put, every month you pay back a portion of the principal (the amount you’ve borrowed) plus the interest accrued for the month. Your lender will use an amortization formula to create a payment schedule that breaks down each payment into paying off principal and interest. The length or life of your loan also determines how much you’ll pay each month.

Stretching out payments over more years (up to 30) will generally result in lower monthly payments. The longer you take to pay off your mortgage, the higher the overall purchase cost for your home will be because you’ll be paying interest for a longer time period. In the beginning of the loan, the principal gets paid off slowly as most of the payment is applied toward paying interest. Toward the end of your loan, very little of the payment will be applied toward interest, and most of it will go toward paying the principal down. Online, you can use an amortization calculator to get an understanding of how interest is more expensive at the beginning of a loan.

Learning the Terms: Fixed Rate vs. Adjustable Rate

Banks and lenders generally offer two types of loans:

Fixed Rate: interest rate does not change.

Adjustable Rate: interest rate will change under defined conditions. Sometimes referred to as a variable-rate or hybrid loan.

Here’s how these work in a home mortgage:

* fixed-rate mortgage: The monthly payment remains the same for the life of this loan. The interest rate is locked in and does not change. Loans have a repayment life span of 30 years; shorter lengths of 10, 15, 20 years are also commonly available. Shorter loans will have larger monthly payments that are offset by lower interest rates and lower overall cost.

Example: A $200,000 fixed-rate mortgage for 30 years (360 monthly payments) at an annual interest rate of 4.5%, will have a monthly payment of approximately $1,013. (Taxes, insurance, escrow are additional and not included in this figure.) The annual interest rate is broken down into a monthly rate as follows: an annual rate of, say, 4.5% divided by 12 equals a monthly interest rate of 0.375%. Every month you’ll pay 0.375% interest on the amount you actually owe on the house.

Your first payment of $1,013 (1 of 360) applies $750 toward interest and $263 toward the principal. The second monthly payment, since the principal is a little smaller, will accrue a little less interest and slightly more of the principal will be paid off. By payment 359, most of the monthly payment will be applied toward principal.

* adjustable-rate mortgage (ARM): Because the interest rate is not locked in, the monthly payment for this type of loan will change across the life of the loan. Most ARMs have a limit or cap on how much the interest rate may fluctuate, as well as how often the interest rate can be changed. When the rate goes up or down, the lender recalculates your monthly payment so that you’ll make equal payments until the next rate adjustment occurs. As interest rates rise, so does your monthly payment; each payment applies to interest and principal in the same manner as a fixed-rate mortgage, over a set number of years. Lenders often offer lower interest rates for the first few years of an ARM, but then rates change frequently after that – as often as once a year.

* The initial interest rate on an ARM is significantly lower than a fixed-rate mortgage.

* ARMs can be attractive if you are planning on staying in your home for only a few years.

* Consider how often the interest rate will adjust. Example: 5/1 year ARM has a fixed rate for five years, then every year the interest rate will adjust for the remainder of the loan period.

* ARMs specify how interest rates are determined – they can be tied to different financial indexes such as one-year U.S. Treasury bills. Ask your financial planner for advice on selecting an ARM with the most stable interest rate.

Example: A $200,000 5/1 adjustable-rate mortgage for 30 years (360 monthly payments) starts with an annual interest rate of 4% for 5 years, and then the rate is allowed to change by .25% every year. This ARM has an interest cap of 12%. Payment amount for months 1 through 60 is $955 each. Payment for 61 through 72 is $980. Payment for 73 through 84 is $1,005. (Taxes, insurance, escrow are additional and not included in these figures.) You can calculate your costs online for an ARM.

Interest-only Loans, Regular and Jumbo

A third option – usually reserved for affluent homebuyers or those with irregular incomes – is an interest-only mortgage. As the name implies, this type of loan gives you the option to pay only interest for the first few years, and it’s attractive to first-time homeowners because of the low payments during their lower earning years. It may also be the right choice if you expect to own the home for a relatively short time, and intend to sell before the bigger payoff begins.

A jumbo mortgage is usually for amounts over the conforming loan limit, currently $417,000 for all states except Hawaii and Alaska, where it is $625,000; additionally, in certain federally designated high priced housing markets such as New York City, Los Angeles and the entire San Jose-San Francisco-Oakland area, the conforming loan limit is $625,000.

Interest-only jumbo loans are also available, though usually for the super-wealthy. Structured similarly to an ARM, the interest-only period lasts as long as 10 years. After that, the rate adjusts annually and payments go toward paying off principal. Payments can go up significantly at that point. (You may be interested in 5 Risky Mortgage Types To Avoid.)

Other Things To Consider

* Escrow and other fees. You’ll need to budget for other items that will significantly add to the amount of your monthly mortgage payment, such as taxes, insurance, and escrow costs. These costs are not fixed and can fluctuate. Your lender will itemize additional costs as part of your mortgage agreement.

* Should you pay a little extra each month? In theory, paying a little extra each month toward reducing principal is one way to own your home faster. Financial professionals recommend that outstanding debt such as from credit cards or student loans be paid off first, savings accounts be well-funded, and then consider paying extra each month. Calculate your savings online.

*Interest is a tax deduction. If you itemize deductions on your annual tax return, the IRS allows you to deduct home mortgage interest payments; for state returns, the deduction varies. Check with a tax professional for specific advice regarding the qualifying rules. For many home owners, this mortgage interest deduction is one of the largest write offs they can ever take advantage of.

The Bottom Line

National policy favors home buyers via the tax code, and for many families, the right home purchase is the best way they can build an asset as their retirement nest egg. Also, if you can refrain from cash-out refinancing, the home you buy at age 30 with a 30-year fixed rate mortgage will be fully paid off by the time you reach normal retirement age, giving you a low-cost place to live when your earnings taper off. In spite of the turmoil following the financial crash of 2008 and the subsequent collapse of the housing bubble, home ownership is something you should consider in your long-term financial planning.

A Guide to Taxes and Reverse Mortgages

If you’re thinking about taking out a reverse mortgage, you need to know whether and how it will affect your income tax situation. In this article, we’ll explain whether reverse mortgage proceeds are taxable, whether the interest on a reverse mortgage is tax deductible and more. (Learn the basics about this financial product in The Reverse Mortgage: A Retirement Tool and Steps To Retiring With A Reverse Mortgage.)
Are Reverse Mortgage Proceeds Taxable?

The money you receive when you take out a reverse mortgage is not taxable – that’s the official word from the Internal Revenue Service, which classifies the proceeds as a loan advance, not income. A reverse mortgage is, indeed, a loan, though many people don’t realize this. If you’ve ever gotten a loan to buy a car, you know that you didn’t pay taxes when the car dealership advanced you that money. You repaid it in monthly installments over five years, probably using income you earned from your job for which you’d already paid income tax.

Here’s another way of looking at why it doesn’t make sense for reverse mortgage proceeds to be taxable. With a reverse mortgage, the lender is essentially returning your home equity to you. How did you accumulate that equity? By making your monthly mortgage payments. And, as with the auto-loan example, you made those monthly mortgage payments out of your income – income you’d already paid taxes on.

A reverse mortgage essentially gives you money that’s already yours by converting equity into cash. You don’t send the IRS a check when you make a withdrawal from your savings account, and you also don’t owe the IRS anything when you unlock the equity you’ve accumulated in your home through a reverse mortgage (or through a home equity loan, for that matter – which you might consider as an alternative to a reverse mortgage).
The Reverse Mortgage Interest Tax Deduction

Because the lender is giving you money for a house that you still own, you’re basically getting a loan, and when you take out a loan, you usually have to pay interest. Unfortunately, reverse mortgages don’t have promotions like car dealerships or furniture stores where you can get 0% financing.

The interest rate on a reverse mortgage is either fixed, if you get the proceeds as a lump sum, or variable, if you get the proceeds as a stream of monthly payments or through a line of credit. Either way, the interest isn’t due until the loan is due, which can happen in one of several ways:

– You die, and you’re the only borrower on the loan.

– Both you and your co-borrower (who is usually your spouse) die.

– You (and your co-borrower) permanently move out. If the house has not been your primary residence for the last 12 months, you’re considered to have permanently moved out, even if you still own the home.

– You sell the home.

– You stop paying property taxes or homeowners insurance.

– You fail to maintain your home in a good state of repair.

(See Reverse Mortgage Pitfalls and The Dangers Of A Reverse Mortgage.)

How does the interest get paid when the loan is due? It gets paid the same way the principal gets paid: through selling the home, through refinancing the home or from personal assets. These are the three ways a reverse mortgage can be repaid in full. After it’s paid off, either you (if you’re still alive) or your heirs (if you’re deceased) may be able to take a tax deduction for the interest paid on the reverse mortgage.

With a forward mortgage, the kind you have when you’re paying off your house, you make monthly payments of principal and interest, and you can deduct the interest on your tax return each year. With a reverse mortgage, you don’’t actually pay any interest until the loan is due, so a mortgage-interest tax deduction only exists in that one tax year. There is an exception, however: In rare circumstances, borrowers will make payments on their reverse-mortgage loans while they’re still living in the home, and in this case, you can deduct the interest in the year you pay it.

As you might know, mortgage interest is only tax deductible if you itemize your deductions, and it only makes sense to itemize your deductions if they exceed the standard deduction. Because all of a reverse mortgage’s accrued interest is paid in the same year, there’s a decent chance it will exceed the standard deduction. (Learn more in Calculating The Mortgage Interest Tax Deduction and Tax Deductions On Mortgage Interest.)

The IRS may limit your deduction, however, because there’s another key difference between deducting mortgage interest on a forward mortgage vs. a reverse mortgage. The IRS considers forward-mortgage interest to be “acquisition debt,” while it may consider reverse-mortgage interest to be “equity debt.” It depends on how you use the loan proceeds, and this is where things get tricky and a tax professional’s advice can really help. Money used for renovations or repairs may be classified as acquisition debt, and you can deduct interest on as much as $1 million in acquisition debt. You can only deduct interest on $100,000 of equity debt, money used for non-residence-related purposes, such as paying your medical bills.
Deducting Property Taxes

In addition, the terms of a reverse mortgage require that you continue to pay property taxes for as long as you live in your home. Property taxes (which the IRS calls “real-estate taxes”) are deductible in the year you pay them. However, this tax deduction will only benefit you if you itemize, and without high amounts of mortgage interest – or medical and dental bills that exceed a certain percent of your adjusted gross income (either 7.5% or 10%, depending on your age and the tax year) – you will probably be better off taking the standard deduction. That means you won’t benefit from the property-tax deduction.
The Bottom Line

The proceeds you receive from a reverse mortgage – whether you get them as a lump sum, in monthly installments or through a line of credit – are not taxable. They’re considered a loan advance, not income. The interest you pay on a reverse mortgage may be tax deductible in the year you or your heirs pay it, depending on the details of your situation.


Economic Reports That Influence Real Estate Stocks

In a previous article for Investopedia, I cited 5 ways that one can invest in real estate through the stock market, rather than buying the actual real estate asset. But successful investing, no matter what the asset class, requires investors to carefully monitor the current economic conditions that could affect one’s portfolio in the future.

In 2007, despite the many warnings from the economic reports, many investors were clueless that the real estate market had peaked and was already turning negative. Today with real estate news constantly reported on the Internet, every investor has access to current data and future trends that affect both real estate and real estate related stocks.

So today I want to summarize five important economic reports that investors should monitor every month to keep them informed of where real estate and its related stocks are heading. Investors can view the original sources of data by putting these report names into the Google browser, or they can be accessed through many of the large financial websites, such as, yahoo finance, etc. along with more detailed information about each report. The five reports are:

1) U.S. Department of Labor Monthly Unemployment Rate.

On the first Friday of every month, the U.S. Department of Labor reports on the National Unemployment statistics. This is an extremely important report because employment numbers, more than any other facet of the economy, influence the number of home sales.

People without jobs seldom qualify to get a home mortgage. Therefore, rising or falling unemployment numbers impact heavily on home sales. The impact forms an inverse ratio, so when unemployment numbers fall, home purchases should rise, and when unemployment numbers rise, sales should fall.

However, you can’t just look at the change in unemployment data to determine the direction of home sales. The type and quality of jobs is also important. If more jobs are created but a large portion are minimum wage or part time, that is not a positive for real estate. In order to boost home sales, a good percentage of the new jobs created must be decent paying, full time jobs.

When the unemployment rate drops, and the quality of the jobs created is good, look for a rally in the home builders, home retailers, mortgage companies, and bank stocks.

2) S&P/ Case-Shiller Home Price Indices of 10 and 20 Composite Cities

The Case-Shiller home price indices of 10 and 20 composite cities are measures of price appreciation, as well as the momentum of price changes in 10 and 20 of the largest cities across the United States. Increased prices are a sign of strength in real estate, and will be reflected in related stock prices, but before we celebrate a rise in the median prices of homes across the U.S., we must also look at the rate of the increase.

If a year ago, prices were rising .6% per month (7.2% annualized), and now they are only rising .4% a month (4.8% annualized), that means that even though home prices are rising, the overall appreciation level is slowing down.

Often when this occurs, as it did in early 2006, it signifies the peak of the real estate market is approaching. Those who saw the warnings in the Case-Shiller index (see chart below) as the market peaked and then turned lower, had ample time to sell their shares of real estate related stocks before the subsequent crash of 2007-2009.

1) New Home Sales

Once a month, the U.S. Census Bureau reports on the number of new construction sales that have closed over the past 30 days. When the number is rising, it has a beneficial effect upon all of the real estate stocks. Conversely, when the numbers of closed sales fall, those same stocks usually decline.

Due to the nature of real estate sales to rise or fall during various parts of the year, it’s important to compare the current month’s sales with the same month from a year ago, and not simply from the previous month.

2) Existing Home Closing Sales and Pending Home Sales

Once a month, the National Association of Realtors (NAR) puts out two separate reports for existing home sales. The first report is on closed sales (homes that have completed the sale transfer from sellers to buyers), and the second is the pending sales (homes that are under contract but have yet to close).

The existing closed and pending home sales show not only the present state of the real estate market, but also where it’s heading. A strong pending report suggests that closed sales will rise in future months as well.

However, keep in mind that pending sales do not always close. Tougher regulations in the mortgage industry can reduce the number of successful closings. So of the two reports, the closed sales report is always the more important one to follow.

Existing home closed and pending sales numbers often affect the prices of related stocks such as Zillow (NASDAQ:Z), Trulia (NYSE:TRLA), as well as retailers like Home Depot (NYSE:HD) and Lowes (NYSE:LOW). When sales are strong, those stocks will perform very well because it means that more consumers are utilizing their services.

3) Housing Permits and Housing Starts

Once a month, the U.S. Census Bureau also reports on the number of housing permits and housing starts. A permit is simply the filing of paper work with the local municipality for future starts (the beginning of construction), but many permits never become starts for one reason or another. So the more important measure is always the starts, and that number will affect the performance of the homebuilders and some mortgage company stocks.

As the housing market crashed in 2007, many builders either drastically reduced their planned starts or went out of business all together, and so many of the permits pulled in 2005-2006 were never utilized.

So remember, it’s not enough to just invest in real estate stocks. You have to also follow the various monthly housing reports I have outlined here, to achieve maximum performance from your investments.

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