Other Important Things You Need to Know About Loans

In considering any mortgage loan there are other key points to keep in mind. The loan interest rate will determine the maximum amount you can qualify for. All other things being equal, you will qualify to take a bigger loan amount at 7 percent than you would if the loan were going for 8 percent.

In the case of the Browns, based on the 28 percent qualifying ratio, each month they could put $1,045 from their combined incomes to their P+I payment. Consequently, with an 8 percent interest rate, they qualified for a loan of $142,000. But, had they found a similar loan with an interest rate of 7 percent, they would have qualified for a loan of $157,000.

Hard Facts About Shorter-Term and Longer-Term Loans

Another factor determining the maximum loan amount available to you is the term of the loan. A 30-year loan is the most affordable fixed-rate mortgage (FRM), and it is right for many buyers. However, that does not mean this loan is the best value for money. It takes a very long time before the buyer builds up equity (percentageof ownership in the property), because just a tiny part of everymonth's payment goes to paying off the principal. Believe it or not—incredible as it might seem—after 10 years of paying off a 30- year FRM, the buyer, typically, will still owe around 90 percent of the original amount borrowed! At that stage, 90 percent of the dollars that have been paid have gone to the lender in interest charges.

For that reason, my advice is simple: Compare different length loans carefully. With shorter loans, equity in the home builds up faster and the benefit of that comes back to the homeowner no matter when the property is sold. Shorter-term loans also mean that you can be out of mortgage debt sooner, possibly in half the time. You'll also own your property free and clear at a younger age. Then the monthly dollars that once went for mortgage payments will be yours to spend however you wish (kids' college, vacation home,travel, retirement, etc).

Of course, a shorter-term loan also means higher repayments, but when the extra expense is manageable, a shorter loan makes good sense. Even better news: A 15-year loan is not twice as expensive as a 30-year loan, as you might have suspected. To illustrate this point, let's return to the Browns. Here is their situation:

Their monthly payment of $1,045 at 8 percent over 30 years will pay for a loan of just over $142,000. For extra clarity, and to be precise with the figures, let's state that same information another way:

Loan of $142,000 at 8% over 30 years will cost the Browns $1,041.95 per month (P+I). (After 30 years they'll have paid backa total of $375,096.)

Loan of $142,000 at 8% over 15 years will cost the Browns $1,357.03 per month (P+I). (After 15 years they'll have paid backa total of $244,264.)

As you can see, shortening the loan term to 15 years added only about $300 to the monthly payment ($1,041.95 to $1,357.03). But the15-year loan builds their equity in the home much more rapidly, and is almost like paying the extra $300 every month directly off the principal.

In these examples you may also have detected another advantage of the shorter loan. Here's a closer look. Note the huge difference between payback costs for the two identical loan amounts:

$142/000 at 8% for 30 years. Total payback amount: $375,096

$142/000 at 8% for 15 years. Total payback amount: $244/264

Difference: $130,832

Over the full term, this 15-year loan will save you $130,832! In fact, any time you select a shorter term fixed rate mortgage (FRM) you'll save money, typically thousands of dollars, often tens of thou-sands, sometimes more. And, even if you sell and move on after 5,7, or 10 years, a bigger chunk of the sales price always goes intoyour pocket—not into the banker's! So, instead of opting automati-cally for a 30-year loan, have your lender also run the monthlyrepayment figures and the full payback figures for a 15-year FRM,and compare carefully.

One More Option for Borrowers

To illustrate our final point in this section, let's stay with theBrowns. Here's a brief recap of their position: They could afford topay $1,045 P+I per month. And, with that size payment they could borrow $142,000 for 30 years at 8 percent.

But, at the last minute, they have a change of mind. A 30-year financial commitment suddenly seems too long. Instead, they decide they'll go for a 15-year FRM. How will this affect their situation, and what they can do?

Well, they already know that their income limits them to a maximum P+I payment of $1045 per month, and that's not alterable.And they also realize that the same loan amount ($142,000) over 15 years will carry higher monthly payments than they can afford. Consequently, to stay within their budget, the 15-year loan will have to be for a smaller amount, which means they'll have to settle for a less expensive home.

They now must answer this question: Without exceeding the $1,045 monthly P+I payment they're already qualified for, howmuch can they borrow if they go for a 15-year FRM at 8 percent?

Here's what they discover: Over 15 years at 8 percent, their $1,045 (approximate) monthly P+I payment will qualify them for asmaller loan of $110,000. Let's see what has changed (figures arerounded off very slightly):

Term of loan 30 years 15 years

Monthly payment $1045 $1045

Interest Rate 8% 8%

Size of loan obtainable $142,000 $110,000

As you have seen, there are real advantages to 15-year loans. If you are sure your household budget will be able to handle the higher monthly payments, this loan is worth your serious consideration. However, if you are strongly set on the shorter-term mortgage but cannot afford its higher monthly payments, consider doing what the Browns did in this situation: Scale down and buy a less expensive home (with the same monthly payments), which you'llown in half the time.

But hold on. You still have another attractive option, perhaps the best one of all—a wealth-building "trick of the trade." This is a way to get all the benefits of a 15-year loan, without committing yourself to the higher monthly payments that go with it. Sounds almost too good to be true. But, unlike most things that sound that way, this one is true. And it's easy to do on your own, without paying anyone for assistance. It's called accelerated payments, or pre-paying your loan.

Accelerated Payments

Over the past few years the idea of pre-paying your mortgage has gained press and popularity. Almost always though, it seems that someone else wants to do it for you—your bank or mortgage company, or an Internet service—for a fee! In fact, it is simple to arrange, and you can do it yourself! All you need do is send in extra dollars with your monthly payment. The extra dollars go off your loan principal, reducing your debt to the lender. But why should you do this? To answer that, let's continue with the Browns. (Note: If you work out the math yourself you'll find slight variations from these figures due to rounding off of cents and fractions of cents):

We'll assume the couple are still considering the $142,000 30-year FRM at 8 percent. This loan, as we saw, would cost them close to $1,045 per month (actually, $1,041.95). Now they ask: How much extra would they have to send in each month to pay off the loan in20 years instead of 30?

Here's what they discover: By sending in an extra $147.05 along with their $1041.95 monthly payment (total $1189), they'll pay off the loan in 20 years. But that's not all, not by a long shot! They will also save $90,475 in interest. Here's how:

$142,000 at 8%. Per month $1041.95.

Loan paid off after 30 years: Total paid: $375,096

$142,000 at 8%. Per month $1189.00

Loan paid off after 20 years: Total paid: $284.621

Interest saved: $90,475

But perhaps paying an extra $147.05 per month is too steep. What if they sent in just an extra $57.05 each month, making a total payment of $1,099 ($1,041.95 plus $57.05)? Here's what they find:

$142,000 at 8%. Per month $1041.95.

Loan paid off after 30 years: Total paid: $375,096

$142,000 at 8%. Per month $1099.00

Loan paid off after 25 years: Total paid: $326.843

Interest saved: $ 48,253

As you can see, the extra payment of $147.05 per month saved the Browns 10 years of payments in the first example, plus $90,475in costs.

And in the second example, an extra payment of just $57.05 per month shortened the loan by 5 years and saved them $48,253. This is the miracle of pre-payment!

The Advantages of Bi-Weekly Payments

Similar savings can be gained by making what is known as bi-weeklypayments. Here's an example:

Suppose you have a $100,000 30-year FRM at 8 percent. Your monthly payment will be $733.77. Now divide $733.77 by 2 and youget $366.89. If you simply send in this amount bi-weekly (every two weeks) you'll make 26 such payments every year. This will save you $46,300.86 in interest charges, and will pay off this loan in just under23 years (over seven years early). Yet your bi-weekly payments willcost you only $733.77 extra per year: that is $366.89 x 26 instead of$733.77 x 12 (figures are rounded off slightly).

If your lender does not offer a bi-weekly program (few do), or tells you they cannot accommodate your suggestion (most say theycan't), you have yet another equally attractive alternative. Simply divide your regular payment of $733.77 by 12 and you get $61.15.Now add this $61.15 to the $733.77 to get $794.92. This will be your new monthly payment (twelve per year) and will bring you virtually the same saving as the bi-weekly method. Just send in your check for $794.92 each month. That's it! Note: With this option you'llbe paying exactly the same amount each year as with the bi-weekly method ($794.92 x 12 versus $366.89 x 26).

Some More Pre-Payment Options

Now, we'll look at some practical pre-payment variations using aloan at the historical average interest rate of 10%. We'll assume youare borrowing $100,000 on a 30-year FRM. Monthly payments willbe $877.58. But you want to know what you can save by pre-paying $25, $50, $100, and $200 per month, and how each will reduce the 30year term:

To each monthly P+I Payment of $877.58, if you add a pre-payment of:

$25, you will save $36,659 and reduce the loan term by 4 yearsand 3 months

$50, you will save $60,323 and reduce the loan term by 7 years

$100, you will save $90/497 and reduce the loan term by 10 yearsand 9 months

$200, you will save $123,178 and reduce the loan term by 15years and 1 month

Clearly, the figures make a very good case for pre-paying what-ever extra monthly amount you can afford. Of course it doesn't have to be a consistent amount every month. You can pre-pay irregularly too, whenever your budget allows. There are no fees, costs, or applications involved. And you do not need anyone's permission. Your bank will simply credit the extra payment against the outstanding loan principal (which is exactly what you want them to do). If you feel more comfortable talking with your lender first, go ahead, but make sure you speak with the manager, or someone else who can understand what you are planning.

Even if your mortgage contract contains a pre-payment penalty clause (few do) this can often be waived if you request it. And even when you don't, the lender typically does not impose the penalty,which is usually too small anyway, and shouldn't cause you any worry.

It is worth restating here that it makes the most sense to pay off highest interest debts first. If, for example, you have credit card debt at, say, 15 percent interest, this should be paid off before you pre-pay a lower-interest-rate home loan. The same applies to higher-interest-rate car loans and college loans.

Remember, too, that you do not need anyone to set up a pre-payment program for you, nor need you pay anyone to do so. If your lender asks for a fee, as some do, request that it be waived.Most lenders will comply. Generally borrowers who pre-pay need do nothing more than write in the pre-payment amount on the extra payment line of the coupon from the mortgage payment book. For extra peace of mind, you might check to make sure your full pay-ment is credited on the date it is received by your lender, not held until the end of the month (very unlikely).