Since monthly payments spread the cost of a mortgage loan over an extended period, it’s easy to forget the total expense. For example, if you borrow $200,000 for 30 years at 6% interest, your total repayment will be around $431,680, more than two times the original loan.
What seems like minor differences in the interest rate can add up to a lot of money over 30 years. For example, if you move that same $200,000 loan up to a 7% rate, the total repaid would be $478,160, which is about $47,480 more than at the 6% rate.
Key Vocab Terms
Principal: The amount of money that you initially borrow and will need to repay.
Interest: Interest is the percentage of the principal that you pay for borrowing money. The interest rate is the primary component of your APR. Your interest rate is determined in large part by the current cost of borrowing in the economy and your creditworthiness.
APR (Annual Percentage Rate): The APR is a representation of the annual percentage you will need to pay back on top of the principal. It includes your interest rate, points, fees, and other costs.
Points (Prepaid Interest): Interest that you prepay at the closing. Each point is 1% of the loan amount. For example, on a $90,000 loan with two points, you’d prepay $1,800.
Fees: Fees include application fees, loan origination fees, and other initial costs imposed by the lender.
Term:The total length of the loan. A longer term means lower monthly payments, but higher overall costs as it results in more interest being accumulated. Similarly, a shorter term means higher monthly payments but a lower overall cost.
Multiple factors can change the overall cost of a mortgage, but the interest rate and term length will often have the largest impact.
Paying Off Your Loan
You repay a mortgage loan in a series of monthly installments over the term, a process known as amortization. Over the first few years, most of each payment is allocated to interest and only a small portion to paying off the principal. By year 20 of a 30-year mortgage, the amounts allocated to each equal out. And, by the last few years, you’re paying mostly principal and very little interest.
Cutting Mortgage Expenses
The amount you borrow, the finance charges—which combine interest and fees—and the time it takes you to repay are the factors that make buying a home expensive. So finding a way to reduce one or more of them can save you money.
Make a larger down payment. The less you borrow, the less interest you’ll pay. Since the interest is calculated on a smaller base, your payments will be lower. And if your down payment is at least 20% of the purchase price, you won’t be required to purchase private mortgage insurance (PMI), which adds to your borrowing costs. The primary drawback to a larger down payment may be cutting too deeply into your savings, making it difficult to cover other expenses.
Consider a shorter loan. With a shorter term, you pay less interest overall on the same principal. You may also qualify for a somewhat lower APR, which would reduce your total cost even more. But your monthly payments will be higher than if you chose a longer term, so you run the risk of committing yourself to larger payments than you can afford.
Make more payments. You can pay more than the amount required by your contract, either by making more payments or paying an extra amount with each regular payment. If you do the latter, be sure to make it clear that the extra amount should be used to reduce principal, not prepay interest. Lenders may offer a bi-weekly payment plan, but managing the extra payments yourself gives you more flexibility and may reduce the loan faster. Be aware that taking this strategy may cause you to pay off before you reach the full term. While that can be a good thing, some mortgages have prepayment penalties, which will charge you a fee for paying your loan off early. Talk to your lender to be sure that you understand all of the terms of your mortgage and the associated fees.
A Point Well Taken
Lenders might be willing to raise a loan’s interest rate by a fraction (say 1/8 or 1/4 of a percent) and lower the number of points—or the reverse. The advantages of fewer points are lower closing costs and laying out less money when you’re apt to need it most. But if you plan to keep the house longer than five to seven years, paying more points to get a lower interest rate will reduce your long-term cost.
Other Costs of Owning
Principal and interest are major components of the cost of buying a home, but they aren’t the only ones. You’ll also owe real estate taxes, which can vary dramatically from state to state and from region to region within a state.
The taxes, which are based on the assessed value of your property and the municipality’s tax rate, typically pay for public schools, police and fire protection, highways, and other government services. Assessed value, which is determined by an assessor working for a particular municipality, usually differs, at least to some extent, from both the market value and the appraised value.
There is also the cost of homeowners insurance, which your lender will require to protect its investment and which you should have to protect your equity. You may also be required to have flood insurance, which is separate.
In most cases, your monthly mortgage payment includes all four costs, typically shortened to PITI, for principal, interest, taxes, and insurance.