Did you know that a 30-year $100,000 mortgage at 4% interest would cost over $171,000 to pay off if you just made the minimum monthly payments?
Let's take a quick look at the payments on this loan. The loan payment itself is $478 per month. Remember, this doesn't include taxes or insurance, which will be included in your mortgage and may fluctuate a little year-to-year. The first month you make a payment of $478, let's see where that goes. Would you believe that a whopping $144 goes to principal? Where does the other $334 go? Well, it goes to interest. In your first 5 years of your mortgage, you will pay over $19,000 in interest and a little less than $10,000 in principal. The difference is significantly more if you have a higher interest rate.
This may be daunting, but don't be discouraged. There are a lot of ways to pay off that debt faster and maximize your home investment.
By far, if you can afford to do so, getting a 15-year mortgage is the way to go! The biggest benefit to 15-year mortgages is that you usually save on the interest rate. For this example, we will reduce the interest rate by 0.5%. The same $100,000 mortgage at 3.5% interest but for 15-years would cost just over $128,000 to pay off, saving you about $43,000 in interest. The down side to a 15-year mortgage is that the monthly loan payment goes from $478 to $715. But, you can imagine the great financial footing you put yourself and your family in by having your home paid off in 15 years. If you can sacrifice and make it happen, this is the way to go.
Total savings: 15 years and $43,000
Most people get paid every other week and not on a monthly basis, so for most people, this option makes a lot of sense. Instead of paying $478 per month, you pay $239 bi-weekly. It sounds like you are paying the same amount, but let's look at the math. If you pay $478 per month on the first, you will make 12 payments, for a total of $5,736 per year. If you pay $239 every other week, you will make 26 payments per year, or $6,214 per year, which is an extra payment of $478 every year. That amount goes straight to the principal. Also, if you are paying it bi-weekly, you are actually paying additional principal every payment, which is reducing the amount of interest that compounds. In other words, you save additional interest compared to if you just added an additional payment every year. Paying bi-weekly reduces the same 30-year $100,0000 mortgage from above to 25 years and reduces interest payments by over $11,000.
Note: When paying bi-weekly, it is best to contact your mortgage company to tell them what you are doing. While it may seem like common sense that any extra payment would go to principal, that's not the case. Additional payments may be intended to go to escrow for use on taxes and insurance or may be held over for the next month's payment. Be sure to specify!
Total savings: 5 years and $11,000
Let's look back at our standard payment. Remember, the first five years of your loan, you made only $10,000 in principal payments. What if you added $100 per month in principal only payments to that? 5 years is 60 months, so you would add $6,000 to that number with payments alone, even if we don't figure in the interest savings, which is about $500 extra. By adding $100 per month to your $100,000 mortgage, your loan would be paid off in 21 years with a little less than $50,000 in interest. Remember, if you want to use this method, the amount it will reduce your mortgage will depend on the total value of your mortgage and the interest rate. With higher interest rates on the same loan, you will save more time. The same interest rates with a higher principal will take more time to pay off. Add what you can afford to add each month to your mortgage payment. Every little bit makes a difference.
Total savings: 9 years and $21,000
According to IRS Filing Statistics from 2011, over 75% of people filing taxes in the US received a refund. For those receiving a refund, that refund averaged $2,913. The IRS doesn't have 2011 statistics for refunds by filing type (single, married, etc), but we will assume $2,913 for married couples and half of that ($1,456) for single people.
Let's look at the married couple first. If we add the full $2,913 as a yearly payment to the mortgage, the mortgage would be paid off in less than 15 years with about $34,000 paid in interest!
For a single person, if we add $1,456 as a yearly payment, the mortgage would be paid off in about 20 years with about $46,000 paid in interest. Still an amazing difference from the full 30 year loan!
Total savings: 10-15 years and $25,000-$37,000
Note: This section applies to those who already have a credit history. If you have no credit history, please visit How Can I Buy a Home if I Have No Credit History?
This one is a little different, but greatly impacts your mortgage! Mortgage companies want to make loans to people more likely to pay on-time and less likely to stop paying the loan. Most mortgage companies look at your credit scores when making this determination. Fair Isaac, the company that generates the FICO score, publishes average interest rates that banks have given people in various FICO score ranges. In January 2013, the rate for a score of 620-639 was 4.812% versus 3.229% for a score of 760-850, for loans made in Missouri. The difference is 1.583%. Using our 30-year $100,000 mortgage, the total interest charged over the life of the loan for someone with a score of 620-639 would be a little more than $89,000. In contrast, the same loan for a person with a score of 760-850 would only pay just over $56,000 in interest.
Increasing your credit score from 620 to 850 takes years, but there may be ways to improve your score by a significant amount within a few months. While big blemishes, such as extremely late payments and accounts in collection take years to drop off of your report, other things like credit-to-debt ratio are still a big part of your score and can be changed within months, instead of years. Decrease debt and your ratio will improve and have an impact on your score. This may sound like common sense and you may say it isn't feasible, but that all depends on how much debt you have. If you have a credit card with a $1,000 limit and have $700 on it, your credit score may increase if you only got the balance down to $300. Of course, you will have the most impact by eliminating this debt altogether. Second, check your credit report and credit score. Make sure that everything is reported properly. If it isn't, report it to the credit bureau.
Before starting your home search, take a moment to get your credit reports. The three major credit bureaus are required to provide you a free credit report every year. To request this report, visit https://www.annualcreditreport.com, the official free credit report site. Other sites may charge or require you to sign up for services to get your reports. This site was mandated by the US Government to provide your free annual reports.
While there is no site to view all of your credit scores for free (only your credit reports), you can view your TranRisk score, which is your score as calculated by TransUnion (one of the three major bureaus), for free. Credit Karma provides you an opportunity to view this information for free, with no fees...ever. Credit Karma is an advertising-based web site to keep the service free to users. One of Credit Karma's best features is its Credit Simulator. You can put in various scenarios and judge how it will affect your credit score. Credit Karma will also show you areas of your credit that need improvement.
As you can see, a good credit score can have a huge impact on your mortgage. It can reduce your interest rate as well as potentially reduce your insurance rates. Please take note, though. I am not advocating you get more debt accounts or increased credit limits to improve your credit scores. I am advocating paying down debt and correcting any credit report mistakes to improve your score. The less bad debt you have, the better off you are going to be financially.
Total savings: up to $33,000
As shown here, there are a lot of ways to pay down your mortgage, especially if you get into a home that is below your maximum budget. I make it my personal goal to help you find a home that meets your needs and strive to do so under your budget. With the tips above, I hope you can live a happier, lower stress life and that your home purchase can be a true investment in your future.