Mortgage Basics: Amortization, Debt-to-Income Ratio, and Closing Costs

Published on December 16, 2016

– 9 min read

Here is your essential primer on mortgage basics.

Learn how amortization works, how to calculate debt-to-income ratio (DTI), and what’s included in closing costs.

Amortization: Do I really have to pay for 30 years?

The short answer is yes, and that’s not a bad thing. The alternative is buying only when you have cash, or making incredibly steep short-term payments. A long payment period makes homeownership accessible. Otherwise only the privileged few could afford to buy, leaving the rest of us to rent.

A 30-year loan is not your only option, though. There are many different options to choose from. For instance, here at Clara, we offer 15-, 20-, 25-, 30-Fixed Year mortgages as well as Adjustable Rate Mortgages (ARMs).

The shorter the loan term, the lower your interest rate is going to be. This is because the investor’s money is at risk for a shorter period of time. The relationship between time and interest rate is always in flux, but as you can see in the chart below, they tend to move together.

15
 

With a shorter loan term, you will end up saving a lot of money over the life of the loan. This is due to the lower interest rate, plus the fact that you pay interest for a shorter time period. The trade-off is that your monthly payment will be higher. To see the effects, let’s compare 15- and 30-year loans.

15
 

As you can see, the shorter term loans have a larger payment per month. However, they can save you an incredible amount over the life of the loan. When it comes to choosing your amortization term, there is no right answer. You need to decide what’s right for you. There’s nothing wrong with a 30-year loan — they’re by far the most common choice among borrowers.

If you plan to be in the home for only a few years, the payment on a 30-year loan is less of a burden. However, if you can afford the larger payment, want to pay your home off faster, and save money in the long run, a 15-year loan is a great option.

Debt-to-Income Ratio

Many people don’t know that lenders care more about your monthly debt payments than your total amount of debt. Your debt-to-income (DTI) ratio is a monthly analysis of how much of your income goes towards paying your debts.

There are two types of DTI calculations: front end and back end.

1. Front-End Debt-to-Income – Your housing expenses (mortgage, property tax, home insurance, etc.) divided by your gross income.

2. Back-End Debt-to-Income – All of your monthly debt obligations (auto loans, student loans, credit card payments, housing expenses, etc.) divided by your gross income.

The back-end DTI is the important number here. Most lenders won’t originate a loan if the back-end DTI is over 43%. Said another way, all of your monthly debt payments combined shouldn’t be more than 43% of your gross income.

Even then, most lenders want to see you well below 43%. The Consumer Finance Protection Bureau has a pretty good explanation why.

Good Debt-to-Income

Prevailing wisdom recommends keeping your back-end DTI ratio below 36%. This will give you more flexibility when shopping for a home — if you find a home in this range, a 36% DTI ratio will put you well below the maximum limit and make getting a home loan much easier. And if you fall in love with a home at the top end of your range, you will have some wiggle room to move up towards the limit if you feel it’s worth it.

 

Cash to Close

Many first-time home buyers focus only on saving for their down payment. It’s often the largest chunk of money you’ll need to save, but it’s not the only cash you’re going to need to get a loan.

The total amount of money you’ll need can be called your “Cash to Close.” It includes a few things:

Down Payment – This is the big one. This can be anywhere from 0% to 25%+ of the home value.

Taxes, Insurance, Fees & Closing Costs – There are a number of things you’ll need to pay for during the process, and they add up quickly. These fees can be anywhere from 2% to 5% of the total home value.

Closing Costs & Fees

These fees vary considerably. The list below is by no means exhaustive. Whether or not you are responsible for certain things depends on the type of loan you choose and where you are purchasing, but you can expect to pay some of the items listed below.

Appraisal – This is generally paid to the appraisal company to estimate the value of the home. It’s required by the lender. You can’t get far without this. Appraisals are required to close your loan — it’s a cost of doing business.
Credit Report – Some lenders charge you for this; others do not. It’s usually less than $20, but another cost of doing business.
Closing / Escrow Fee – This can fluctuate based on the state you are buying in, but it’s the fee paid to the title company, escrow company, or attorney who is the independent third party completing the transaction.
Title Search Fee & Title Insurance – These fees pay for the title company to search historical records and ensure the person selling you the property actually owns it. After the search is complete, lenders require the purchase of insurance in case the search is inaccurate. This protects them from any liens that may not have been discovered, or if someone manages to sell a house they don’t own. As the buyer, you will have the option to purchase owner’s title insurance as well. The loan is secured by the property itself — if you don’t own the property, that’s a problem! Thankfully, this is a one-time cost.
Homeowners Insurance – In the same vein of title insurance, you need to insure the property itself. Accidents happen, and if your home is uninsured, you suddenly have a mortgage payment, no place to live, and no cash to rebuild. Unlike title insurance, homeowners insurance is paid annually. In many cases, it is included in your monthly mortgage payment.
Property Taxes – Property taxes are a complex. They are paid in varying ways: sometimes quarterly, bi-annually, or annually. Because of this, the person selling the home may have paid property taxes in advance, in which case you have to repay them. Other times, they may not have taxes paid yet, in which case you’ll have to split the bill. All of this will be settled during escrow. Generally, after the transaction, your property taxes will be added to your monthly payment.

Pre-paid Interest – Loans can close on any calendar day. Sometimes there’s a small interest payment due to shore up any interest accrued before your first full payment.

Lender Fees – Also known as “Origination Fees” or “Lender Costs.” Outside of your down payment, this is probably the biggest fee in your closing costs. At some lenders, this fee could be a percentage of your loan amount, which can add up to thousands of dollars. Thankfully, with the new Loan Estimate form, it’s easy to see these fees in a way that is clear and transparent (under “Closing Costs Details” in Section A). The Loan Estimate allows you to easily compare your loan quotes from different lenders.

At Clara, we charge a flat origination fee as a lender, regardless of your loan amount. We feel that this helps keep our pricing transparent, and can help some of our customers reduce their closing costs.

If you have a question about your particular scenario, you can chat with one of Clara’s licensed Loan Specialists. To see what rates you might be able to qualify for, click here.

Andrew Kilburn
Andrew Kilburn is a licensed Loan Specialist at Clara. He likes to live an active lifestyle outside the office, where you’ll find him sailing with his wife and 3-year-old, hiking around the Bay Area, doing yoga, or rock climbing.
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