A home loan that is structured according to your goals and objectives can make home ownership a financially rewarding experience. Understanding the components of a loan will empower you in selecting your options and provide you with peace of mind that you are clear on what the actual terms mean.
FACTORS THAT YOU CONTROL
The overall condition of the economy sets the benchmark for interest rates, your specific rate will be determined by the lender’s overall assessment of your credit risk. Lenders calculate your credit risk based in part your income, employment history, credit history, and credit rating. Lowering your interest rate by raising your credit score can save borrowers hundreds, if not thousands of dollars, over the life of a loan. Another factor is how much you are borrowing and what type of loan you are getting. For example, interest rates on a home equity loan are generally higher than that of a primary loan. Also, conforming loan amounts have lower interest rates then non-conforming loan amounts.
ANNUAL PERCENTAGE RATE (APR) – The total cost of credit.APR is the easiest way to compare loans with different features because it factors all the cost of the loan regardless of how they are presented. As loan programs become available, APR becomes more important to understand and use as a loan-shopping tool.
APR would be the same as the interest rate on the loan if the loan were free. The following example highlights the difference. Let’s go through an example:
Loan Amount: $500,000
Total Cost of Loan (points, processing fee, doc fees, etc.): $5,000
Amount Borrowed (the amount you get in hand): $495,000
Interest Rate (based on the $500,000): 4%
Term of the loan: 30 years
Monthly Payment: $2,387
The monthly payment at 4% is based on $500,000 even though the borrower only received $495,000. So, what would cause the payment of $2,387 on a loan amount of $495,000? The answer is 4.08, which is the APR. This is what the loan is really costing you.
INTEREST RATES AND BONDS – THE RELATIONSHIP
Mortgage interest rates closely track the 10-year Treasury Bond. Interest rates and bonds are inversely related. When bonds go up, rates go down, when bonds go down, rates go up. In general (1) as the economy shows signs of strengthening, bond prices go down as the bonds that have been purchased are worth less (2) Economic uncertainty means interest rates will tend to stay flat (3) A weakening economy will push interest rates down as bond prices rise.
Another factor that determines interest rates on home loans is the actions taken by the Fed (Federal Reserve Bank). The Fed is where banks borrow money when they are not borrowing from each other. The discount rate is the interest rate the Fed charges banks to borrow from them. The Fed uses this discount rate to control the supply of available funds in the economy, which in turn influences inflation and overall interest rates. When the discount rate is low, there is more money in the economy as money is cheap. The more money available, the more people spend and the higher prices become. In contrast, raising the discount rate makes it more expensive to borrow money, lowering the money supply and in turn slows down the economy.
LOAN TO VALUE (LTV)
Determines how much a lender will lend given a specific property value amount and is expressed as a percentage.
For Example: If a house is worth $100,000 and the lender is willing to lend up to $80,000 toward the purchase price of that house, the LTV for that loan is 80%.
LTV is a reflection of the lender’s perception of risk. The lower the LTV, the more secure a lender is on lending towards that property, and vice versa
The lender’s way of comparing a borrowers debt to their income and is one of the most important tools used by the lending industry to qualify a prospective borrower. If the borrower’s debt exceeds a certain percentage to their income, the loan will be declined.
For Example: If a borrower’s gross income is $6,000 and her total monthly expenses are $3,000, the DTI would be 50%. If lenders are lending at a 40% DTI, this borrower would be declined. This borrower would have to earn more, or lower their expenses to qualify.
Finance Charge (origination fee) – The amount charged for the credit
Amount Financed – The loan amount minus all of the finance charges that were included in the loan. The amount the borrower gets in hand, even though they pay interest on the entire loan balance.
Schedule of Payments – Total payments due over the life of the loan including any adjustments in the amount of the payment.
Total Payments – Total all payments made over the life of the loan, which reveals how much the borrower really paid for the loan by the tine they have completed all payments.