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The Real Estate Loan Formula
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A real estate loan is based on a mathematical formula which is easy to run on a financial calculator, but too
difficult to figure out on paper.
The five main elements of the loan formula are the same as the five keys on a financial calculator.
These are:
These elements mathematically interrelated. When you change
the value of one element, it automatically alters
the value of one or more other elements in surprising and unexpected ways. The time value of money is a powerful concept. It allows the borrower to go into debt just as effectively as it helps the investor build wealth.
Like, if you want to make lower monthly payments, you can do one (or all) of four things – increase the term of the loan, lower the interest rate, lower the principal amount or reserve a final payment at the end of the loan term.
Interest Rate:
The rate of interest in effect for the monthly installment
due is called mortgage interest rate. It is usually expressed as the annual percentage rate or
APR. For fixed-rate mortgages or for adjustable-rate mortgages that have an initial fixed-rate period, it is the rate in effect during that period. For adjustable-rate mortgages after any initial fixed-rate period, it is the sum of the applicable index and the mortgage margin (rounded as appropriate and subject to any per adjustment or lifetime interest rate ceilings).
When you apply for a loan, most lenders will allow you to “lock in” an interest rate for a period of time, usually 30 to 60 days.
Interest rates for 30-year home mortgages normally ride a few notches above the interest rates for 30-year treasury bonds, called “long bonds,” which serve as a national benchmark for mortgage interest rates. Bond interest rates normally rise and fall with the rate of inflation, and generally run in counterpoint to the stock market. A strong stock market, healthy economy and low inflation usually means low mortgage interest
rates.
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Term:
The term of the loan is the
length of time during which the special conditions of
the mortgage remain in force. At the end of the term,
things such as interest rate, pre-payment privileges,
etc. are renegotiated.
The standard term for a residential mortgage is 30 years, with the 15 year loan a close second in popularity. Loan terms of 10, 20, 25 and 40 year terms are less common, but not unheard of.
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Payment:
Once you know the term, interest rate, principal and final value, you can calculate the monthly payment. This is an important number because it determines whether or not you can afford to pay back the loan.
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Principal:
The principal is the original amount of a debt on
which interest is calculated or the total amount being financed. When you buy a house, this is the purchase price minus the down payment. However, the principal can also include a variety of closing costs, also called settlement costs. These include fees for loan origination, document preparation, escrow, title insurance, credit reporting, document recording, pest inspection, appraisals, surveys, commissions, legal fees, insurance and property taxes.
Closing costs are always negotiable. Lenders often use a term called points to describe the loan origination fee, which can be one of the major closing costs. One point is equal to one percent of the loan amount. Points become part of the principal which has to be repaid over the term of the loan. Borrowers can often decrease or “buy down” the interest rate by paying more points.Congress passed the Real Estate Settlement Procedures Act (RESPA) in 1974, which requires the lender to provide a good faith estimate of closing (settlement) costs within three business days from the date of the loan application. Lenders are also required to provide the borrower with a “truth-in-lending” statement which discloses the annual percentage rate (APR) of the loan.
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Final Value:
The final value at the end of a conventional mortgage term is usually zero, meaning the loan has been paid in full. However, some loans call for a balloon payment at the end, where the borrower has to pay a lump sum. When sellers finance a real estate loan, they often make it a short-term loan with a balloon payment at the end, giving the buyer time to establish good credit and refinance with a conventional loan.
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