Part 2: How Exactly Does a Mortgage Work
In our previous post, we provided an overview of the basic concept of a mortgage and defined key terms often associated with the home buying process. Now we will take an even deeper dive into the mechanics of a mortgage and how it compares to the Divvy program.
The first step in getting a mortgage is the approval process. To many, this can be one of the most challenging and time-consuming steps. That’s why we broke down each step in our recent Mortgage Readiness Guide. You can refer to that guide in tandem with this series as you work your way through the mortgage approval process.
The offer on your dream home may have been accepted, but that doesn’t mean you’re move in ready just yet! As you’ll recall from your Divvy experience, there are a number of steps that need to occur between getting an offer accepted and closing on your home — things like getting insurance in place, scheduling an inspection and an appraisal, and finalizing all the mortgage documentation, among other things. In a future blog post, we’ll walk through the closing process in detail and provide a checklist for reference.
It may seem daunting, but don’t worry — as a Divvy customer, we’ll be there to help you each step of the way, along with your mortgage provider (whether a bank or a broker).
The Payment Schedule and Structure of your Mortgage
Once you’ve closed on your mortgage and settled into your home, it’ll be time to start paying off that loan. Let’s spend a few minutes on the schedule and structure of your payments to help you get a fuller picture of how your mortgage works.
Your mortgage payment will always be due and payable on the first of each month, just like your Divvy payment. You may hear mortgage payments described as being “paid in arrears”. That’s just a fancy way of saying that when you make your payment, you’re paying interest on the balance during the prior period — so your May 1st mortgage payment is interest that “accrued” (or “built up”) during April.
Your monthly mortgage payment is determined through something called “amortization”. “Amortization” is a mathematical calculation that figures out how much principal you need to pay off each month in order to fully pay back the loan, with interest, over a set period of equal payments (that is, the term of your loan). We encourage you to dig into the math to understand it, but all you really need to know for this discussion is that your monthly payment will be the same every month, and each time you make a payment a portion of it will be interest on the loan and the rest will go to reduce the principal. As you pay down your principal, the amount of interest goes down as well, meaning every month an increasingly larger portion of your payment will go towards the principal. Here is an example:
Let’s say you buy a home for $150,000. You use $15,000 of your own money as your down payment (10%), and you borrow the remaining $135,000 (90%) with a 30-year fixed-rate mortgage and a 5% interest rate. Your monthly mortgage payment would come out to about $725 ($724.70, to be precise). Each month, the amount of interest you owe is calculated based on your current principal balance — for your first payment, you won’t have made any payments yet, and so you pay interest on the full amount of the loan (in this example, $135,000 multiplied by 5% and divided by 12, or $562.50), plus an amount of principal. The next month, however, you only pay interest on the outstanding principal ($135,000 – $162 = $134,838), and so your interest is now slightly less ($561.83). The total amount of your payment will be the same each month ($725), but how it is applied will change — take a look at the following:
As you can see, the amount of interest you’re paying decreases slightly over time: from $563 in the first month, to $559 in the 6th month, and so on.
At first, the differences look pretty insignificant: less than a dollar each month! However, over time, the power of amortization becomes clearer, and things accelerate: The longer you make payments, the more of each payment goes towards paying down the principal. Take a look:
More importantly, each one of those principal payments is increasing your ownership stake in your home! In our example, you start out with 10% equity ($15,000 divided by $150,000). Even assuming that the value of your home doesn’t increase (also known as “appreciation”), by the end of the first year, your ownership interest is 11.2%; at the end of year 3, more than 14%:
…and if you build in some appreciation (let’s say an average of 2% per year), the value of your equity grows a lot faster:
Of course, predicting home prices isn’t an exact science — sometimes prices go down, sometimes they go up, sometimes they stay the same. Over the long term, though, prices tend to appreciate. And because you’re paying down the principal of the mortgage, your ownership stake in your house will increase over time in any case.
What happens if I pay early or extra?
Paying extra on your mortgage can be a terrific idea as it can help you reach your goal of outright owning the home more quickly. The more you pay, the more you save on interest, which means more of your monthly payment goes towards paying down principal and increasing your ownership stake. By way of example, even paying as little as an extra $12 per month towards your principal would mean you paid off your mortgage more than a year early.
What happens if I miss a payment?
It is vital that you do all that you can to ensure that you make your mortgage payments on time. However, if you are forced to miss a payment, you should be sure to communicate with your lender: many lenders are happy to help you restructure mortgage payments to account for a missed payment.
That being said, missed payments can lead to late fees, often up to 5-10% of your monthly mortgage payment, and can result in a drop in your credit score. If you are a month behind on your payments, you will likely receive a call or a letter from your lender concerning the payment. Take this correspondence seriously! By accounting for missed payments, you can save yourself future headaches and heartaches. If you miss a payment for 90 days, you may be considered in default of your loan and risk losing your home.
In all cases concerning late or missed payments, communication is critical to ensure that you and your lender are on the same page.
How Do Traditional Mortgage Payments Compare to Divvy?
To put this all in context, we thought it would be helpful to compare the home costs as a Divvy customer with those of homeownership. At first glance, your monthly payments as an owner will seem significantly less than your payments with Divvy. However comparing Divvy to ownership isn’t a simple apples-to-apples comparison — homeowners bear the responsibility for every cost of the home, including costs currently covered by Divvy such as:
- Homeowner’s Insurance (approx. 1% of the value of the home per year)
- Taxes (jurisdiction dependent but generally 1 – 2% of the value of the home per year)
- Maintenance (on average 0.5 – 1.0% of the value of the home per year)
- While a portion of your Divvy payment goes towards maintenance, any amount above your budget, including in an emergency, is covered by Divvy; as the owner, you’ll be responsible.
- Personal Mortgage Insurance, or PMI (required by most lenders until your LTV reaches a certain threshold – generally 0.5 – 1.0% of the loan amount per year)
By way of example, here’s what those costs might look like for our theoretical $150,000 home:
|Base monthly payment
(Divvy pmt. or Mortgage pmt.)
How Do I Get Started?
If you are ready to begin, take a good look at our Mortgage Readiness Guide and consider taking our free credit counseling course to ensure that everything is prepared for you to begin your homeownership journey.
We know that buying a new home is more than just a purchase, it’s a dream. That’s why we created Divvy, to help more people access home ownership, all at their own pace. If you have any questions, please do not hesitate to reach out to the Divvy team at firstname.lastname@example.org.
We are here for you every step of the way.