Introduction
When it comes to debt, Home Mortgage is the biggest debt in your portfolio and stays there for several years. This is precisely the reason you need to be cognizant as it has the capacity to significantly impact your future investments and several other expenses. By its very nature, home mortgages need you to commit to pay a fixed amount of money for an extended period (usually 15 to 30 years). Hence, it is imperative that you do a thorough reality check to determine if you have that kind of capacity to sustain. Another important aspect of home mortgage is that your equal installments are split into 2 components – principal repayment and interest. Towards the earlier years, you are required to pay substantial amount of interest on the mortgage and as the outstanding principal reduces, the principal payments increase and interest on the balance principal deceases.
Mortgage Types
There are several options to choose from when it comes to Home Mortgages. Most of the options are permutation and combination of the term of mortgage and fixed/ variable nature of the mortgage. There is a down payment expected to be made as your contribution to the home. Usually this is about 20% of the appraised home value. At times it may be higher depending on the state of the economy, the location of purchase, volatility of the housing market and most importantly your repayment paying capability. So, for a home that is worth $500,000, you would need to pay about $100,000 down payment plus closing costs minus builder and financer discounts.
Having said that, there are situations where you can close a home for much lesser than that amount if you do not have the down payment amount. The mortgage company will have to add a PMI which will be an insurance to ensure that in the event of a default the bank will be able to recoup their money by selling the property through an insurance company. So, assume that you purchased a property appraised at $500,000 by paying just $25,000 down payment. After a year of payments, you default on the loan and the appraised value of the property is $450,000. Your principal repayment in the initial years would be about $10,000 (validate). So, if the Bank sells the property (a.k.a. foreclosure) then they would be at a loss of $15,000. PMI comes in handy at such a time.
Another important aspect to note is that the mortgage is given as a % of the appraised value and not the sale value. These numbers can be different depending on who was more desperate to complete the transaction. If the seller were desperate then the sale value would be less than the appraised value.
How is EMI Calculated
It is important to understand how the mortgage lender calculates the EMI and what constitutes your monthly payments and more importantly, what does not constitute your mortgage payments.
There are 3 main components in your mortgage – Principal, Interest and Escrow account. You should have figured out the first 2 either intuitively or by reading the introduction. Here is how each component is calculated:
Let us say that your outstanding principal is $500,000 and your EMI is $3,500 per month. Interest rate is 2.4% per annum (or 0.5% per month) and your annual escrow is $6,000. The component interest will be $2,500 per month (0.5% * $500,000) and escrow will be $500 per month ($6,000/ 12 months). The Principal will be Monthly EMI minus your interest minus the escrow. So, your principal payment would be $500 (i.e., $3,500 – $2,500 – $500). In the following month, your principal gets reduced by $500 so the outstanding loan will become $499,500. Escrow remains constant. So, your interest component will become $2,497.50 and Principal repayment will be $502.50 ($3,500 – $2,497.50 – $500).
Fast forward to several months later when you are paying regularly and there are no changes to the term of your loan, your outstanding principal reduces to $100,000 in each month. EMI remains the same at $3,500. The principal payment for that month would be $2,500 ($3,500 – $500 Interest – $500 Escrow). The subsequent month outstanding balance will be $97,500.
I wanted to use this illustration to point out the fact how during the initial years of the loan, your principal reduces slowly, and a larger component is the interest payment on the outstanding loan and in later years the loan starts reducing much quicker.
Escrow
I had introduced this term in my earlier example. I will explain it here. Escrow is the sum of your annual property taxes (city + county taxes) and home insurance. It does not include your HOA payments. These taxes are due to the various providers at different points in time during the year. The Mortgage lender either knows the exact amount of taxes (or estimates it based on past data) and they are aware of your payments for home mortgage for a year. They would add these components and divide the number by 12. This will be charged to you as part of your EMI and billed monthly. When these payments are due, the lender makes them on your behalf and the amount of escrow gets reduced by that amount. Technically at the end of the year, they would have a zero balance in the escrow account as all receipts that they got from you have been paid off. During the subsequent year, you will start funding your escrow again and this cycle repeats.
If there is an increase in taxes of home insurance values in the subsequent years, then the escrow is recalculated, and your EMI will increase accordingly to adjust to the new reality. If there is a reduction in any of the values, then you may get a refund of the excess amounts from your escrow account or you may choose to make the excess escrow payment towards your principal and the escrow amount (and EMI) for the subsequent year will also be reduced.
The reason why lenders like to keep an escrow for property taxes and home insurance as these payments are mandated by law in each state and must be made by the homeowner. If there is a default on these payments, then the county/ city can have several options that they can exercise. The lender is protecting your home on your behalf by paying the mandatory taxes and insurance. Also, the reason why the lender takes monthly payments from you and adds to your escrow rather than a lump sum payment just prior to the payments is to lessen the impact of a large outflow from your account and moreover to ensure that you end up paying equal amounts every month.
Illustration for home loan calculation
Assumptions:
- Home loan requested is $425,928.
- There is no PMI required as borrower will be making a 20% down payment when closing the loan.
- Loan term is 30 years (360 months), and Interest Rate is 2.75%.
- Initial Home Insurance amount is $1,200 per year ($100 per month) and Current Property Tax payable is $5,324 per year ($444 per month). Both Home Insurance and Property Tax values will change every year and based on that the Mortgage Lender will adjust the Escrow amount which will in turn impact the EMI. For the below example, these values are assumed to be constant throughout the loan.
Table 6: Home Loan cAlculation
| Month | Date | Residue | Interest | Principal | Insurance | Property Tax | EMI | EMI (Incl. Escrow) |
| 0 | 1-Mar-21 | (425,928) | (425,928) | (425,928) | ||||
| 1 | 1-Apr-21 | 425,165 | 976 | 763 | 100 | 444 | 1,738 | 2,282 |
| 2 | 1-May-21 | 424,401 | 974 | 764 | 100 | 444 | 1,738 | 2,282 |
| 3 | 1-Jun-21 | 423,635 | 973 | 766 | 100 | 444 | 1,738 | 2,282 |
| 4 | 1-Jul-21 | 422,867 | 971 | 768 | 100 | 444 | 1,738 | 2,282 |
| 5 | 1-Aug-21 | 422,097 | 969 | 770 | 100 | 444 | 1,738 | 2,282 |
| 6 | 1-Sep-21 | 421,325 | 967 | 772 | 100 | 444 | 1,738 | 2,282 |
| 7 | 1-Oct-21 | 420,552 | 966 | 773 | 100 | 444 | 1,738 | 2,282 |
| 8 | 1-Nov-21 | 419,777 | 964 | 775 | 100 | 444 | 1,738 | 2,282 |
| 9 | 1-Dec-21 | 419,000 | 962 | 777 | 100 | 444 | 1,738 | 2,282 |
| 10 | 1-Jan-22 | 418,222 | 960 | 779 | 100 | 444 | 1,738 | 2,282 |
| 11 | 1-Feb-22 | 417,441 | 958 | 780 | 100 | 444 | 1,738 | 2,282 |
| 12 | 1-Mar-22 | 416,659 | 957 | 782 | 100 | 444 | 1,738 | 2,282 |
| … | … | … | … | … | … | … | … | … |
| 24 | 1-Mar-23 | 407,132 | 935 | 804 | 100 | 444 | 1,738 | 2,282 |
| … | … | … | … | … | … | … | … | … |
| 36 | 1-Mar-24 | 397,339 | 912 | 826 | 100 | 444 | 1,738 | 2,282 |
| … | … | … | … | … | … | … | … | … |
| 60 | 1-Mar-26 | 376,929 | 866 | 873 | 100 | 444 | 1,738 | 2,282 |
| … | … | … | … | … | … | … | … | … |
| 100 | 1-Jul-29 | 340,318 | 782 | 957 | 100 | 444 | 1,738 | 2,282 |
| … | … | … | … | … | … | … | … | … |
| 180 | 1-Mar-36 | 256,227 | 590 | 1,149 | 100 | 444 | 1,738 | 2,282 |
| … | … | … | … | … | … | … | … | … |
| 270 | 1-Sep-43 | 141,264 | 327 | 1,412 | 100 | 444 | 1,738 | 2,282 |
| … | … | … | … | … | … | … | … | … |
| 300 | 1-Mar-46 | 97,370 | 227 | 1,512 | 100 | 444 | 1,738 | 2,282 |
| … | … | … | … | … | … | … | … | … |
| 348 | 1-Mar-50 | 20,558 | 51 | 1,688 | 100 | 444 | 1,738 | 2,282 |
| 349 | 1-Apr-50 | 18,867 | 47 | 1,692 | 100 | 444 | 1,738 | 2,282 |
| 350 | 1-May-50 | 17,171 | 43 | 1,696 | 100 | 444 | 1,738 | 2,282 |
| 351 | 1-Jun-50 | 15,472 | 39 | 1,699 | 100 | 444 | 1,738 | 2,282 |
| 352 | 1-Jul-50 | 13,768 | 35 | 1,703 | 100 | 444 | 1,738 | 2,282 |
| 353 | 1-Aug-50 | 12,061 | 32 | 1,707 | 100 | 444 | 1,738 | 2,282 |
| 354 | 1-Sep-50 | 10,350 | 28 | 1,711 | 100 | 444 | 1,738 | 2,282 |
| 355 | 1-Oct-50 | 8,635 | 24 | 1,715 | 100 | 444 | 1,738 | 2,282 |
| 356 | 1-Nov-50 | 6,916 | 20 | 1,719 | 100 | 444 | 1,738 | 2,282 |
| 357 | 1-Dec-50 | 5,193 | 16 | 1,723 | 100 | 444 | 1,738 | 2,282 |
| 358 | 1-Jan-51 | 3,466 | 12 | 1,727 | 100 | 444 | 1,738 | 2,282 |
| 359 | 1-Feb-51 | 1,735 | 8 | 1,731 | 100 | 444 | 1,738 | 2,282 |
| 360 | 1-Mar-51 | 0 | 4 | 1,735 | 100 | 444 | 1,738 | 2,282 |
