The Beginner’s Guide to Financing

This is a very basic explanation of what financing is in the housing world.

When someone doesn’t have enough money to purchase a good or service, such as a home, they typically look to someone who does who is willing to lend that money to them.

In exchange for the use of someone else’s money, the borrower pays a small premium in the form of an annual interest rate.

For example, at the time this was written, interest rates were found to be around 4% to 5% annually. In other words, if you borrow $100,000 at 4% per year, that means that you will pay your lender approximately $4,000 in interest for the first year.

Your payments each month consist of up to 4 parts which are paid to either the bank you borrowed the money from, or the company that your lender hired to collect your payments (servicer.)

(1) One part is called the principal which represents the amount that you owe, and (2) one part is the interest, which is paid to the lender in exchange for borrowing the money. The (3) third payment is a semi-annual (that’s twice per year) property tax payment. The home owner is responsible for paying those taxes, but in most cases, the lender requires that your payment include enough to cover the semi-annual tax payment, and they end up paying the tax bill for you out of what’s known as an impound account. Sometimes there’s a (4) fourth part, and that’s called Mortgage Insurance. If you purchase home with less than 20% down (in other words, $20,000 in this example), then the lender will require that you pay an insurance premium every month. They do this to ensure that they get paid if you fail to make your payments.

At the beginning, MORE of the payment is interest, and less is principle. As time goes on, the interest paid every month decreases, because it is calculated based on the amount you still owe, which is also decreasing. By the time you reach the half way point, usually 15 years, the amount you pay in interest and the amount you pay towards the loan is nearly the same. Later in the life of the loan, you will be paying much more on the loan, and much less in interest.

This is called amortization (the death of a loan) and lenders do this to ensure that they get most of their investment back at the beginning, rather than at the end.

I can’t stress enough how beneficial it will be to you and your family to only consider 15-year fixed rate loans. Anything else will cost you much more and be much more of a risk to your financial well being.

The Consequences Of Holding Out

15-year90at585

There are three compelling reasons to get a move on when it comes to buying a home.  1) You may be eligible for that $8000.00 first time home buyer tax credit, 2) homes are on sale, 3) most importantly, interest rates will probably increase.

The $8000.00 Tax Credit

First time home buyers have been given a gift from our all knowing, all powerful federal government, provided they close escrow on a home before December 1st, 2009.  For more information about this program, and whether or not you qualify, please visit this page.

Homes are on Sale

As you’ve already heard over and over again, due to foreclosures and short sales, homes are at incredible prices, but that won’t last forever.  Real estate, over time, is bound to increase in value, especially in Scottsdale.

Interest Rates Increasing

This is the overlooked component by many.  So many people look at the price of a home and forget that borrowing money costs money, and waiting for the price of a home to decrease even more could very well be offset by an increase in the interest rate on your loan.  At the same time, if you wait too long, you’ll miss out on an additional $8000.00 tax credit from the government.

A $100,000.00 home financed for 15-years on a fixed interest rate of 4.85% will cost you a total of $140,940.00.  The same home at 5.85% will cost you $150,940.00.  If my math is correct, that’s $10,000.00 more.  Divide $10,000 by 15 years and you need to recover $667.00 per month in property value appreciation to offset the loss.

If you wait thinking that $100,000 home may sell for $90,000 in a few months, at 5.85%, which is what the interest rate may be in a few months, you’re paying $145,395.00 for a home that you could have purchsed at 4.85% for $140,940.00.  That means that waiting around only saved you $5545.00, not $10,000.  AND, you missed the tax credit, so you’re out a potential additional $8000.00.

15-yearat485

Shown above, your 15-year fixed mortgage at 4.85% will cost you a total of $140,940 over the course of 15 years with a monthly payment of only $783.00.

The following shows that the same mortgage at 5.85% increases your payment by about $50.00/month and costs you an additional $10,000 over the term of the loan.

15-yearat585

The graphic below illustrates that waiting for a $10,000 decrease in price puts you at risk of getting a loan at a higher interest rate, assuming interest rates increase, which most of us expect to happen.  Your savings would be determined by subtracting the cost of your $100,000 home at 4.85% from the cost of the same home at $90,000 at 5.85%.  The difference is $5545.00.  Not as much of a savings as you would have liked.

15-year90at585

Why It’s a Good Time to Buy a House

The Wall Street Journal published a chart that shows how lower interest rates on 30 Year fixed mortgages would affect the monthly payment which I’ve republished here in the table below.

Good news this week brings us lower interest rates down from 6% to 5.5%. When you consider that this is the largest single week drop in interest rates in 27 years then you may see that now is the time to buy.

Loan Amount Rate Monthly Payment
$200,000 5.50% $1,135.58
5.00% $1,073.64
4.50% $1,013.37
$400,000 5.50% $2,271.16
5.00% $2,147.29
4.50% $2,026.74
$600,000 5.50% $3,406.73
5.50% $3,220.93
4.50% $3,040.11

According to the table, the savings on a lower mortgage rate will outpace the difference in price down the road. In other words, if you wait for the prices of homes to continue to fall at the same time the interest rate increases, the savings you think you’ll realize will be wiped out by the additional interest you’ll pay over time. It makes perfect sense to give more credence to your rate of interest than your potential loss, one of which is known and the other not.

Month after month we’re amazed at how low the rates are.  There’s even a buzz about rates going even lower!  Can you imagine being able to buy your first home for as much as you’re paying in rent now?

Stay away from the fence and jump to ownership, but remember, only if you are qualified to buy.  Don’t try to buy something you can’t afford.

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Data last updated 5/21/12 11:08 AM PDT.

This IDX solution is (c) Diverse Solutions 2012.