When it comes to budgeting your monthly finances, your mortgage payment is likely to be your highest expense. If you are considering to purchase a home, then this article is for you because you are going to learn the following:
• Fees & Expenses during a Home Purchase • What is in the Mortgage Payment • Tips to Reduce Your Mortgage Payment • Avoiding Common Pitfalls
1. Fees & Expenses during a Home Purchase
Buying a home is both exciting and nerve-wracking. The stressors of home shopping can take over the joy and excitement while the thrill of visioning your home to look like something from HGTV’s dream home fills your imagination while walking the aisles of a local hardware store.
Private Mortgage Insurance
The first most common expense and a monthly fee that you’ll pay with your mortgage are the Private Mortgage Insurance, as known as PMI. This insurance provides protection but this protects the mortgage company, not you. So why is PMI relevant? Well, put yourself in the lender’s shoes. You loan funds for $200,000 to a couple who purchases a home. The couple puts $0 towards a down payment and the home’s value is appraised at $205,000. Fast forward three months, the couple loses one of their jobs and miss a mortgage payment. As the couple continues missing payments, the housing market drops in value. The home is no longer worth $205,000 but $165,000.
The couple filed for bankruptcy leaving the bank to sell the home at a loss. The company selling the PMI will deliver a payment to the bank making up the difference. Remember-banks will do everything possible NOT to lose money.
According to The Truth About Mortgage, a “mortgage with no down payment is more likely to default than one with a large down payment”.
This is why it is highly recommended for home buyers to put 20% down towards a home purchase. A 20% down payment will remove PMI and will decrease your mortgage payments.
Here are several reasons why you should avoid Private Mortgage Insurance.
a. It’s an additional expense. PMI usually costs between 0.5% to 1.0% of the loan amount annually. With the $200,00 loan, your PMI may cost $2,000 annually, or $166.67 per month that is added to your monthly mortgage payment.
b. PMI may not be tax-deductible. The PMI tax deductible was supposed to expire last year but the Trump Administration extended this deductible. I write “may not” because future Presidential Administrations may allow this deduction to expire. As with most finances and taxes, PMI does have an AGI limit and according to TurboTax for 2018, once your Adjusted Gross Income (AGI) exceeds $109,000 if married filing separately, your mortgage insurance deduction is eliminated.
c. It’s not insurance that pays upon your death. Just because it has the word insurance, tell your family this isn’t a payable benefit. The only beneficiary on this policy will be the lending institution.
d. You may pay PMI for years. Because this insurance must be paid until your equity in your home reaches 20%, it could take before you reach this level. That’s where understanding your mortgage payment comes into play which you will read about shortly below. The bottom line is your mortgage payment in the early years is mostly paid towards the interest and rarely gets paid towards the principal amount. It can also be very challenging when trying to cancel your PMI once you reach 20% so that’s an additional factor because the PMI signed may have been a contract requiring payments for a determined amount of months.
If you’re a military veteran, you have a benefit highly regarded by many. This benefit is the PMI waiver in which you are not required a down payment (my thoughts below). The Veterans of Affairs claims that “only about 6 percent of them [vets] bought a home using a VA home loan in the past five years.”
Also, veterans can use this benefit more than once. According to Ellie Mae, VA loan rates are lower than conventional loans, approximately 0.25% and private banks, credit unions, financial institutions, and mortgage companies recognize this benefit. I have found contradictory statements claiming VA Loans actually have more fees and can be more expensive than Conventional Loans. So be sure to research your area of interest thoroughly before you decide on VA vs Conventional.
As a vet, I definitely appreciate the benefit of being able to use the VA loan option, but there is a risk involved. If you are a vet and considering using your VA benefit to remove being pushed in putting a down payment onto your purchase, consider this. Imagine you just bought your $200,000 home. Having used your VA benefit, you put nothing down. The housing market drops and now the value of your home is $165,000. As long as you never plan to leave during the life of the loan, you have nothing to worry about, but who can predict the future?
Fast forward two years where the market hasn’t improved and your home appraises at $145,000. Because most of the mortgage payments applied to the interest only and you have changed jobs, you must sell your home but your upside down. This means before you sell the house, you need to come up with $55,000 to cover the difference before the bank will look at you. This can create significant pressure and stress.
But the opposite can be true too! You could purchase this home and should you sell, the house may be valued at $230,000, you could leave with $30,000 profit.
Determine your Mortgage down payment with this Free Down Payment Calculator from The Mortgage Reports.
Most home buyers are concerned with closing costs. With my last home purchase in San Antonio, Texas, the closing cost was roughly 3.25% of the purchase price. This fell in between the nation’s average of 2 to 5 percent of the purchase price of their home. Using our example above of the $200,000 home, closing costs due at signing would be $4,000 to $10,000.
According to Zillow.com, “buyers pay roughly $3,700 in closing fees”. This is also misleading if you choose to roll up the $3,700 into your mortgage because then you are paying interest on this $3,700 over a 15 to 30-year period.
One great tip that I learned later is some fees are negotiable. Once you receive the Loan Estimate, review fees such as High Administrative, Mailing, or Courier Costs as these are sometimes visible on the estimate. Request these be removed or lowered and if not, mention you will consider shopping around with other lenders. Remember you have the freedom to shop around and are not restricted to one lender or realtor.
It is recommended that you do not finance the closing costs because typically, lenders will charge you a higher interest rate if these fees are not paid up front. This is because the lender will roll-up the charges and fees into the mortgage.
Other fees that are usually included in purchasing a home are usually found in closing costs. While you may not see all of the below fees, you are likely to see many of these: Application Fee, Appraisal, Attorney Fee, Closing/Escrow, Courier, Escrow Deposit for Property Taxes & Mortgage Insurance, FHA Up-Front Mortgage Insurance Premium, Flood Determination or Life of Loan Coverage, Home Inspection, Home Owners Association Transfer Fees, Lender’s Policy Title Insurance, Lead-Based Paint Inspection, Loan Discount Points, Owner’s Policy Title Insurance, Origination Fee, Pest Inspection, Prepaid Interest, Property Tax, Recording Fees, Survey Fee, Title Company Title Search, Transfer Tax, Underwriting Fee, and VA Funding Fee.
3% versus 20%
In 2016, Wells Fargo announced that it launched 3% down payment mortgage. Bank of America has been offering this option for quite some time; however, capital markets didn’t find these products popular. This wasn’t anything new because 3% was historically the industry’s standard to help first-time home buyers and low-to-moderate income buyers since Fannie Mae and Freddie Mac made its announcement in 2014 that “3%-down conventional mortgage loan products designed to make homeownership accessible to otherwise qualified buyers who didn’t have the cash available for a large down payment.”
2. What is in the Mortgage Payment
Before we dive into listing several ways in reducing your mortgage payment, let's break down the several components of a mortgage payment. The most common components include principal, interest, taxes, and insurance (PMI which is mentioned above).
The principal of a home is the amount borrowed less interest. For example, if you borrowed from a lender to purchase a $200,000 home, then the principal is $200,000. When paying your mortgage payment every month, the amount applied to the principal portion gradually increases with each payment as the interest slowly decreases. See the example below.
Any loan or amount borrowed from a financial institution will charge you interest. This is the amount you pay to the bank for allowing you to use their money to buy a home. In the above example, you will see the interest amount decreases every month. This is because the bank ALWAYS gets paid first. The bank coins this term as risk-reduction.
According to Credit.com, “Everyone who owns or occupies property pays property taxes, but the rules and amount vary widely from state to state. In fact, this is usually the main source of local government funding and is generally based on the home’s value.” So it literally pays to review which state has the highest property taxes and it is helpful for you to know what percentage your state charges.
3. Tips to Reduce Your Mortgage Payment
Now that you understand the components of a mortgage payment, there are several ways to reduce your mortgage payment.
a. The obvious strategy is to refinance. This is the most common but only encouraged when you can obtain a lower interest rate. By getting a lower interest rate, you can save thousands on interest over the course of the loan period.
b. Recast your mortgage. Working with lenders to recast your payments is a difficult task sometimes. This can usually be done when you’ve paid more on the principal over time and the bank will recalculate your principal and interest payments over the remaining life of the loan.
c. Petition your tax assessment. My home is based on taxes and my property tax would usually average around $10,000 annually. Each year the state/county would reassess and there became a growing trend of property values. Some years we experienced double-digit growth so the community got together and petitioned our property taxes. The following year, we saw a correction which did help the payments.
d. Avoid PMI. As mentioned earlier in the article, looks for ways to remove or avoid PMI altogether.
4. Avoid Common Pitfalls
a. More Home than You Can Afford
When shopping for a home, buyers are usually more persuaded with how much they can afford monthly versus the total cost of the home. It can be enticing to believe such a notion but this is also one factor that caused the Financial Recession in 2007/2008.
Mortgage Officers will determine your approval based on the Debt-to-Income ratio which paints a partial financial snapshot. It fails to consider other factors into your financial situation such as you saving for retirement, building your emergency fund, saving for your children’s college, extra payments being paid towards debt, entertainment and travel expenses, etc.
Dave Ramsey says “limit your monthly payment to 25% or less of your monthly take-home pay” which means if you are budgeting your finances correctly, you will need to determine if the mortgage exceeds or fits in this 25% or less budget category. Paying more towards a mortgage will reduce income that can go towards regular house maintenance and repairs, furniture purchases (if you’re paying cash), throwing holiday parties and backyard events, etc).
b. Don’t Rush to Buy
Realtors are sellers! While there are some really great realtors, some bad ones exist too. If they are like typical sellers, they will sell you the idea of excitement and to hurry up with an offer to get you in making a rash decision. To help you with this, MortgageHippo.com has several recommendations such as:
- Write down your deal breakers and home features you need - Ensure you visit the home during different times of the day and weather - Get a home inspection first - Keep a Journal
c. Mortgage Rates
While it is true that mortgage rates may fluctuate quickly, lenders will try to entice you to lock in a rate immediately or pay a premium to lock a rate. This means you pay an additional fee to be guaranteed a rate for a certain period of time determined by the lender. Historically, rates have seen a continual decline, as seen by the Federal Reserve Economic Data below. There is a slight risk that rates may change overnight by a few tenths or hundredths of a percentage point but to see rates jump from 4% to 6% overnight is very rare and this means there are serious problems in the economy and you probably shouldn’t buy a mortgage. To avoid locking in a rate unless you are 100% that rates will rise during your house hunt.
If you are shopping for a mortgage it is important to understand your needs for a home. These needs include, what can you comfortably afford (not just monthly), can you get a good rate, do you have a down payment, and do you understand the risks. While owning a home is rewarding, there can be pitfalls if you do not understand the risks. Be sure to conduct adequate research ahead of time, have money saved for emergencies, and always ensure it is a fixed-rate loan and never an adjustable rate mortgage!
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