Many details associated with the primary cost of mortgages—the interest rate—can be confusing, especially when you are purchasing your first house. Before you buy, here are a few things you need to know.
Mortgage Rates Are Inching Up
In October of 2016, mortgage interest rates were just under 3.5 percent. By March of 2017, they were up to 4.3 percent. This may seem like a small change, but over the life of a 30-year fixed interest loan, it makes a significant difference, impacting both the total amount of interest you will pay, as well as the size of your monthly mortgage payment.
Comparing those recent rate changes, if you had borrowed $200,000 at 3.5 percent for 30 years, your monthly payment would be $898 with a total of $123,312 in interest paid over the term of the loan.
In contrast, if you borrow that same $200,000 at 4.3 percent, your monthly payment will be $990 (over $100 a month higher) and you will pay a total of $156,307 in interest over 30 years.
If you are planning to buy a house, and you want to lock in low interest rates, start shopping right away. The experts expect rates to continue to rise throughout 2017.
How to Interpret an Amortization Schedule
Lenders use amortization schedules to indicate how much of each payment is applied to interest expense versus the principal on a loan. Typically, the monthly payment doesn’t change, but the allocation between principal and interest does. Initial payments are heavily weighted towards paying off interest costs, with less going toward the principal of a loan.
For example, for a $200,000 mortgage at 3.5 percent, the first $898 monthly mortgage payment applies $583 towards interest and $315 towards principal. In contrast, the last payment applies less than $3 towards interest and over $895 to principal.
In other words, lenders earn interest before you accrue equity in your home.
Ways to Save Money on Your Mortgage
The best way to reduce the total cost of purchasing a home is to opt for a shorter mortgage, such as 15 instead of 30 years. For example, reducing that $200,000 mortgage (at 3.5 percent) to a 15-year term will result in a $1,430 monthly payment. That’s substantially higher than $898 a month, but over the life of the loan, the total interest expense is $57,358 over 15 years, compared to $123,312 for the 30-year mortgage!
A 15-year mortgage has more money going toward the principal from the beginning, so the total cost of the loan itself is less, even though your payment is higher each month. If you can budget for a higher 15-year payment, you cut your repayment period in half (over a 30-year standard mortgage) and save on the interest paid to the bank.
Additionally, banks typically charge a lower interest rate for 15-year mortgages, because they are less risky and less expensive to issue, compared to 30-year loans. So, instead of paying 3.5 percent for a 30-year mortgage, you may be able to secure a 15-year mortgage for 3.0 percent, cutting your total costs even more.
Other Ways to Reduce Your Mortgage Expense
If you can’t afford to make the mortgage payment on a 15-year loan, you can still pay down the loan quicker and save yourself interest expenses by making “principal only” payments. (Check with your loan officer to make sure the loan you are securing will allow those extra payments without penalty.)
If allowed, there are various ways to do this. Consider the implications of each on a 30-year $200,000 mortgage at 3.5 percent interest.
1. Annual Lump-Sum Payments on Mortgage Loans
For example, if you receive a year-end bonus and apply an extra $2,000 toward the principal each year, you could shorten the life of your loan by 6 years and 8 months and reduce the total interest expense by over $32,500.
2. Monthly Principal Only Payments (Pre-Payments on Mortgage)
If you can’t make a lump sum payment once a year, you may be able to manage adding an additional $100 per month to your mortgage payment instead. This would shorten your payments by 4 years and 10 months and save over $22,000 in interest.
3. Lump Sum Prepayments AND Monthly Principal Only Payments
What if you could do both? If you budget to buy a house that would allow you to add $100 more to your mortgage payment each month (toward the principal) AND make an annual “bonus” payment of $2,000, you’d shave over 10 years off the term of your loan, while saving over $45,000 in interest!
Don’t Overestimate Savings from Mortgage Interest Tax Credits
Many homebuyers look forward to saving money on their federal taxes by deducting their mortgage interest payments. This is an attractive write-off, but it’s also important to consider a few important caveats.
Tax credits could end – The tax code is always subject to change, so it’s best not to depend on something that could disappear without warning. Your mortgage, on the other hand, will be here for many years, without question.
You have to Itemize – If you don’t currently itemize your taxes, you will have to start doing this in order to claim the tax credit for your mortgage interest. In order for it to benefit you, the interest you pay in any given year (along with any other deductions you may claim) will have to be more than the standard deduction. (Note: In 2016, the standard deduction for “married filing jointly” was $12,600, the “head of household” deduction was $9,300, and $6,300 for anyone filing “single” on federal taxes.)
The “savings” are small – Using the $200,000 30-year mortgage at 3.5 percent, and assuming you bought your house in January, you could claim 12 months of mortgage payments, which adds up to nearly $7K in interest. (Remember, the first year includes higher interest payments than future years, so this number will go down each year.)
Your interest payments, property taxes and other major deductions may not be sufficient to offset the difference between your itemized deductions and your standard deduction, especially if you are filing as a head of household or married filing jointly. Single taxpayers, on the other hand, would see a tax benefit of more than $600 over the standard deduction (for $7K in interest expense), although the net tax savings would only be about $150 for a payer in the 25 percent tax bracket.
Consult with your tax professional before buying to determine what the real savings will (or won’t) be in your particular case.
Don’t Sell Too Quickly
Buying a home is a big decision. You should find a home you love, and one where you plan to stay for a while. Make sure it suits your budget and take sensible steps to save money on your mortgage.
Selling your home too soon after buying will result in a less than ideal financial situation. With your early mortgage payments going to interest more than principal, you haven’t had much time to build equity. Unless your home’s market value has increased dramatically, selling too soon could result in closing costs and transaction fees that exceed any “profit” on the sale.
Talk with your Accredited Buyer’s Representative to get the information you need on current market values and local price trends before finalizing your decisions to buy and/or sell your next home.