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The Complete Guide to FHA Loans

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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Saving up for a big down payment on a home can be a financial obstacle that prevents first-time homebuyers with little savings from ever becoming homeowners. Fortunately, government-backed Federal Housing Administration (FHA) loans can help potential homebuyers who want a home but struggle to pull together a large down payment. In 2018, more than 80% of FHA loans made were to first-time homebuyers, according to the U.S. Department of Housing and Urban Development.

This guide will cover the pros and cons of using an FHA loan to purchase a home and how homebuyers can begin the process of shopping and getting approved for these loans.

Part I: Understanding FHA Loans

What is an FHA loan?

FHA loans are insured by the Federal Housing Administration, which means that the federal government makes a guarantee to the bank that the government will repay the borrower’s loan if the borrower stops making payments. This guarantee means banks are willing to provide funding to borrowers who may not otherwise be able to qualify for a home loan.

FHA loans are not funded or underwritten directly by the FHA, but rather by FHA-approved lenders. These lenders can be found using the Lender Search tool. Interest rates and fees vary by lender, even for the same type of loan, so it’s important to shop around.

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Benefits of FHA loans

FHA loans are designed to promote homeownership and make it easier for people to qualify for mortgages. For that reason, they typically have more flexible lending requirements than conventional loans, including:

Lower minimum credit scores

Many loan programs require a credit score of at least 620 or 640, but FHA loans are available to borrowers with scores as low as 500.

Lower down payments

Borrowers can get FHA loans with as little as 3.5% down. However, borrowers with credit scores between 500 and 579 will need at least 10% down.

Not just for first-time homebuyers

Although their flexible terms and low down payments make FHA loans appealing to first-time homebuyers, they’re also available to repeat buyers as long as the proceeds are used to purchase a primary residence.

Seller assistance with closing costs

Yael Ishakis, the vice president of FM Home Loans in Brooklyn, N.Y., says another benefit of FHA loans is that they allow sellers to pay up to 6% of the sales price toward buyer closing costs, including origination fees, points and other closing costs. This helps borrowers struggling to come up with a down payment cover some of the additional costs involved in closing on a home loan. Sellers may not be willing to pay closing costs in a hot housing market, but in a down market, helping with closing costs can mean a faster sale. For conventional loans, the seller can contribute no more than 3% toward closing costs unless the buyer has a down payment greater than 10%.

Drawbacks of FHA loans

FHA loans are appealing to many borrowers, but they’re not always the best choice. Here are a few reasons you may want to look into alternatives.

Mortgage insurance

FHA loans require mortgage insurance, which protects the lender against losses from defaults on home mortgages. FHA loans require both upfront and monthly mortgage insurance from all borrowers, regardless of the amount of the down payment.

On a 30-year mortgage with a base loan amount of less than $625,500 with a 3.5% down payment, the annual mortgage insurance premium would be 0.85% of the base loan amount, and the upfront mortgage insurance premium would be 1.75% of the base loan amount, as of this writing.

With a conventional loan, the borrower can avoid mortgage insurance by putting at least 20 percent down. They can also request to have their mortgage insurance premiums removed from their monthly payment once the loan is at 78% of the home’s current value, as long as the borrower has been making on-time payments for at least one year. With an FHA loan, mortgage insurance is required for the life of the loan.

Ishakis says this aspect of FHA loans causes her to hesitate before offering FHA loan options to buyers. If an FHA borrower’s home goes up in value, the only way to have the mortgage insurance removed is to refinance to a conventional loan.

The refi would require more paperwork, closing costs, and a potential increase to their interest rate if rates have increased. With a conventional loan, getting mortgage insurance removed simply requires sending a written request to the lender once you’ve met the requirements.

Documentation requirements

  • Most recent two months of bank statements
  • Most recent 30 days of pay stubs
  • Most recent two years of W-2s
  • Two years of tax returns
  • Gift letter (if using gifted funds for the down payment or closing costs)
  • Paper trail of gift funds, including a bank statement from the donor showing the funds were available at the time of gift, and verification of the funds being deposited into your account.

If you have been divorced in the past, declared bankruptcy, are self-employed, or earn income based on commissions, you may be required to provide even more documentation.

FHA Loan

Conventional Loan

Minimum credit score

500

620

Minimum down
payment

3.5%

3%

Maximum seller-
assisted closing costs

6%

  • 3% with down payments
    less than 10%

  • 6% with down payments
    between 10% and 25%

  • 9% with down payments
    greater than 25%

Upfront mortgage
insurance

1.75%

None

Monthly mortgage
insurance

0.85%

Varies based on credit score
and loan-to-value ratio

Borrowers who are able to qualify for a conventional loan may be better off choosing a conventional loan rather than an FHA loan. Conventional loans programs like Fannie Mae Home Ready® and Freddie Mac Home Possible® require a slightly lower down payment and do not require any upfront mortgage insurance.

Borrowers can request to have their monthly mortgage insurance payments removed once they have at least 20% equity in the home and make on-time payments for one year. The lender will probably require you pay for an appraisal to verify the value supports you having 20% equity, but is worth it because removing mortgage insurance can add up to significant savings over the life of the loan.

Part II: FHA Loan Requirements

With their flexible requirements and low barriers to approval, FHA loans are some of the easiest loans to qualify for. Here’s a look at FHA loan requirements.

Minimum credit score requirements

The minimum credit score for an FHA loan with a 3.5% down payment is typically 580. If your credit score is between 500 and 579, you may be approved for an FHA loan, but you will need to put at least 10 percent down.

These are FHA guidelines, but individual lenders may have their own requirements, referred to as lender overlays. A particular lender may require a minimum credit score of 640 or higher, so if you are turned down for an FHA loan by one bank, it’s a good idea to try others.

Income requirements

The FHA does not have minimum or maximum income requirements. However, borrowers must have sufficient income to be able to afford the mortgage payments and their other obligations. Part of the approval process involves verifying your employment and income, but the amount you earn is not as important as the amount of income you have left over after paying your other monthly bills.

The only time you might run into income maximums is if you are applying for down payment assistance to help with the down payment on an FHA loan. In that case, your income will need to be below the program limit to be eligible for the down payment help.

Debt-to-income ratio requirements

Debt-to-income (DTI) ratio is another key metric FHA-approved lenders consider when determining whether you can afford a mortgage. DTI measures the amount of debt you have compared to your income, and it is expressed as a percentage.

Lenders look at two debt-to-income ratios when determining your eligibility:

  • Housing ratio or front-end ratio. What percentage of your income would it take to cover your total monthly mortgage payment? According to Kevin Miller, Director of Growth at Open Listings, lenders like to see a front-end ratio below 31% of your gross income, although approval with a percentage up to 40% is possible depending on the circumstance.
  • Total debt or back-end ratio. Shows how much of your income is needed to pay for your total monthly debts plus your future monthly mortgage payment. Miller says lenders prefer a back-end ratio of less than 43% of your gross income, although approval with a percentage of up to 50% is possible.

Down payment requirements

FHA loans require a down payment of at least 3.5% of the purchase price, or 10% if your credit score is below 580. In addition to the down payment, the borrower may have to pay other upfront costs including appraisal and inspection fees, upfront mortgage insurance, real estate taxes, homeowners insurance, homeowners association dues, and more.

However, the FHA allows sellers to cover up to 6% of closing costs and closing costs can be gifted from friends or family members.

Clear CAIVRS report

Any federal debt that hasn’t been repaid and has entered default status can prevent you from getting an FHA loan. The government keeps track of people who default on all types of federal debts, like government-backed mortgage loans, SBA loans, and even federal student loans.

The system they use to track defaults is called the Credit Alert Verification Reporting System (CAIVRS). Borrowers do not have access to CAIVRS, so you’ll have to consult an FHA-approved lender to learn whether you are in the system.

If the delinquency was for a prior FHA-backed loan, you’ll have to wait three years from the time that the Department of Housing and Urban Development (HUD) paid the mortgage lender’s insurance claim.

FHA loan limits

The FHA puts a cap on the size of a mortgage that it will insure. These loan limits are calculated and updated annually and announced by HUD near the end of each calendar year.

Because the cost of living can vary widely throughout the country, FHA loan limits differ from one county to the next. The national maximum for an FHA loan is currently $726,525, but in low-cost areas, the maximum can be as low as $314,827 for a single-family home. You can look up the limit in your area using HUD’s FHA Mortgage Limits lookup tool.

FHA mortgage limits are calculated based on 115 percent of the median home price in the county, as determined by the Federal Housing Finance Agency.

Property requirements

FHA loans are only available when the borrower intends to use the property as a primary residence — investment properties are not eligible.

In addition, the property you intend to purchase must meet certain requirements to qualify for an FHA mortgage. Every FHA loan a property appraisal and inspection by a HUD-approved home appraiser to verify the current market value and ensure it meets HUD’s minimum property standards.

The appraiser will look at the roof, foundation, lot grade, ventilation, mechanical systems, heating, electricity, and crawl space in the home. Their detailed standards are outlined in HUD’s Single Family Housing Policy Handbook, but essentially, the property must not be hazardous or threaten the health and safety of the buyer who will live in the home.

Safety hazards noted during the appraisal will not automatically disqualify the property from an FHA loan. If the issue can be corrected before final inspection — such as the seller repairing a leaking roof — the loan can move forward.

Part III: Types of FHA Loans

There are several types of FHA loans to meet the needs of different homeowners. Here’s a look at the options available.

Fixed-rate mortgages

Fixed-rate mortgages are the most common type of FHA loans. The borrower chooses a loan term between 10 and 30 years, and the interest rate will not change over the life of the loan.

Adjustable-rate mortgages

Adjustable-rate mortgages (ARMs) also have terms between 10 and 30 years, but as the name implies, the interest rate can change periodically, so the payments can go up or down. The initial interest rate on an ARM is lower than that of a fixed-rate mortgage, so this can be a good option for a borrower who plans to own their home for only a few years.

Many ARMs are hybrids, meaning there is an initial period during which the rate is fixed. After that, the rate changes at regular intervals. FHA ARMs are required by law to have caps that limit how much the rate can change at any one time and throughout the life of the loan.

FHA loans offer the following interest rate cap structures for ARMs:

  • One- and three-year ARM rates may increase by 1% annually after the initial fixed-rate period and 5% over the life of the loan.
  • Five-year ARM rates may either allow for increases of 1% annually and 5% points over the life of the loan, or increases of 2% annually and 6% over the life of the loan.
  • Seven- and 10-year ARMs may only increase by 2% annually after the initial fixed-interest rate period, and 6% over the life of the loan.

FHA reverse mortgages

Seniors with a paid-off mortgage or significant equity in their home may be able to access a portion of their home’s equity with an FHA Home Equity Conversion Mortgage (HECM), commonly referred to as a reverse mortgage.

The loan is called a reverse mortgage because instead of the borrower making monthly payments to the lender, as with a traditional mortgage, the lender makes payments to the borrower. The borrower is not required to pay back the loan unless the home is sold or otherwise vacated.

Many seniors use reverse mortgages to supplement Social Security income, meet unexpected medical expenses, make home improvements, or a combination of all of these. A meeting with a HUD financial counselor is needed before applying for a reverse mortgage to ensure that the borrower clearly understands the pros and cons of this complex mortgage.

Energy Efficient Mortgages

The FHA’s Energy Efficient Mortgage (EEM) program is designed to help homeowners save on utility bills by financing energy-efficient improvements with an FHA loan. The program is available as part of a home purchase or by refinancing the current mortgage.

To qualify for an EEM, the borrower must first get a Home Energy Rating Systems Report performed by a professional rater. The rater inspects everything in the home, from insulation to appliances and windows. Once the property’s current energy efficiency is calculated, the inspector makes recommendations for energy-efficient upgrades.

EEMs are available for $4,000 or 5% of the property value up to $8,000. If the EEM is included in the initial home purchase, you do not need to come up with a larger down payment.

FHA 203(k) loans

Homebuyers looking to buy a fixer-upper may be interested in an FHA 203(k) mortgage. This program allows homeowners and homebuyers to finance up to $35,000 into their mortgage for repairs and improvements.

These loans often make it possible for buyers to purchase and rehabilitate properties that other lenders won’t touch because the property is in such bad shape. The loan includes money to purchase the property, enough to make necessary improvements, and, in certain cases, enough to cover rent or the borrower’s existing mortgage for up to six months so the buyer has another place to live while the home is being renovated.

Part IV: Shopping for FHA Loans

As mentioned previously, FHA loans are notorious for requiring a lot of documentation. Here’s a list to get you started:

  • Addresses of your residences for the last two years
  • Social Security number(s)
  • Names and locations of your employer(s) for the last two years
  • Gross monthly salary at your current job(s)
  • Two years of completed tax returns (three if you are self-employed)
  • Two years of W-2s, 1099s, or other income statements
  • Most recent month of pay stubs
  • Recent statements for all open loans (such as student loans or car loans)
  • A year-to-date profit-and-loss statement for self-employed individuals
  • Most recent three months of bank, retirement, stocks, and/or mutual fund statements
  • Contact information for your landlord or current mortgage lender
  • Bankruptcy and discharge papers (if applicable)
  • Copies of driver’s license(s)
  • Social Security card(s)
  • Copy of divorce decree (if applicable)
  • Letters of explanation for any past credit issues, bankruptcies, or foreclosures (if applicable)
  • Gift letter if your down payment or closing funds are a gift from friends or family members
  • If you are refinancing or you own another property, you will also need:
  • Note and deed from current loan
  • Property tax bill
  • Homeowners insurance policy

Your lender will also have you sign multiple disclosure documents, including authorization to pull your credit report, verify your employment, and obtain a transcript of your tax return from the Internal Revenue Service.

As you get closer to your closing date, you may need to update many of these documents. For instance, if you provided a January bank statement and pay stubs when you started your loan process and your loan doesn’t close until March, your loan officer will likely need a copy of your February bank statement and pay stubs to finalize your loan.

Where can you compare FHA loan rates?

As mentioned above, FHA loans are not provided directly by the FHA, but by FHA-approved lenders, so rates can vary depending on which bank you work with. For that reason, it’s a good idea to shop around for the best rate.

Fortunately, some resources allow you to do a lot of your initial mortgage rate shopping online.

Check out LendingTree’s FHA loan rates here. By filling out an online form with questions about the type of property you’re purchasing, city, state, and a few other details, you can compare personalized rates from several lenders. Note: LendingTree is the parent company of MagnifyMoney.

Be sure you match up your quotes based on the same date, since interest rates
can vary daily. Double check to make sure you’re getting quotes on the same loan amount, loan term and loan type for each lender you get a loan estimate from.

Part V: The FHA Closing Process

The HUD Handbook 4155.2 explains the FHA loan process in detail, from identifying a lender to the lender’s responsibilities after the loan is closed. The time it takes to close on an FHA loan is pretty comparable to other types of loans. According to a recent Origination Insight Report from Ellie Mae, in October 2018, FHA loans for new purchases took an average of 45 days to close.

Here are the steps that apply to borrowers:

  1. Lender identification. Contact a HUD-approved lender to find out if you are eligible for an FHA loan. All of the major banks and many smaller, regional lenders participate in the FHA loan program.
  2. Loan application. The lender will help you complete a loan application and request a variety of financial documents, or you may be able to fill one out online.
  3. Lock in your interest rate. Your interest rate should be locked in soon as possible to prevent any changes to the payment or fees before closing. Be sure to get the lock confirmation in writing, and keep track of the expiration date.
  4. Case number assigned. Every FHA mortgage is assigned a case number that identifies the individual loan and borrower.
  5. Property appraisal. The lender will order a property appraisal from a HUD-approved appraiser to verify the market value of the home and that it meets all of HUD’s property requirements.
  6. Mortgage underwriting. The underwriter reviews your file in accordance with HUD’s guidelines to determine whether you have the ability to repay the loan. They’ll take a close look at your credit history, employment situation, income stability, debt-to-income ratio, and other factors.
  7. Underwriting decision. If your application is approved, you may need to provide a few more approval conditions, and once you meet those conditions, you are “clear to close” and will move on to the closing process. If your file is rejected for some reason, the lender will notify you and will likely tell you why the underwriter came to that decision — or make a counter-offer that may involve you making an additional down payment or paying off debt to qualify.
  8. Closing process. The lender “closes” the loan by having all documents signed, wiring the loan proceeds to the escrow account, and ensuring that all money is distributed to the appropriate parties. Borrowers should review all loan documents carefully to ensure accuracy. This is also the time when you’ll need to present a cashier’s check or wire funds from your bank to cover closing costs.

One warning about wires worth noting: always confirm wiring instructions directly with the title company handling your closing, using a phone number that you can verify with your purchase contract, or through the company’s directory. Wire fraud reached epidemic levels in 2018, and the scheme usually involve hackers gaining access to realtor, escrow officer, or attorney emails in order to defraud homebuyers into wiring closing funds into an account detailed in the email.

Institutional bank insurance does not cover losses due to wire fraud since you initiate and verify the accuracy of the information when you hit the send button. Extra care is well worth it to avoid losing hard earned down payment funds to a wire fraud scheme.

Before you sign

The closing process can be a ceremonious event. It will likely take place at the title company, or at the lender or attorney’s office. You’ll be handed a pen and a big stack of documents that require your signature.

A notary will likely be present to witness your signature. But don’t let the pomp and circumstance distract you from the task at hand: making one of the largest financial transactions of your life.

Before you get to closing, you should receive a loan estimate that lays out the important information about your loan, including the loan amount, projected interest rate, estimated monthly payment, and estimated funds required to close. Your interest should be locked in. This means your rate won’t change between the offer and closing date, as long as there are no changes to your application and you close within the specified time frame.

At least three business days before closing, by law you should receive a Closing Disclosure form listing all final terms of the loan you’ve selected and final closing costs. When you sit down to sign the loan documents at closing, double-check the details to ensure your final documents agree with the Closing Disclosure. The Consumer Financial Protection Bureau has an excellent interactive tool explaining all of the parts of your Closing Disclosure and the details you should review.

Your lender or realtor should give you a list of items to bring with you to the closing. This will likely include a cashier’s check or proof of wire transfer for the funds you need to close and your driver’s license.

Ask questions to ensure you feel comfortable with everything you’re signing and make sure you know when and where to send your first mortgage payment and when it will be due.

Closing costs to consider

Your Closing Disclosure will show all of the closing costs required to finalize your loan. Some of them may be financed into your loan, some may be paid by the seller, and some are your responsibility. Closing costs vary based on where you live and the property you buy. Here’s a list of some common ones:

  • Application fee. Covers the cost of the lender to process your application.
  • Appraisal. Paid to the appraisal company to confirm the value of your home.
  • Attorney fee. Paid to an attorney to review the closing documents on behalf of the buyer or lender.
  • Escrow fee. Paid to the title company or escrow company that oversees the closing of your home purchase.
  • Credit report. The cost of pulling your credit report and credit score.
  • Escrow deposits. You may be required to put down two months or more of property taxes and mortgage insurance payments at closing to set up your escrow account so the lender pays your property taxes and insurance when they come due.
  • Upfront mortgage insurance premium. FHA loans require an upfront mortgage insurance premium of 1.75% of the loan amount.
  • Homeowners insurance. Homeowners insurance covers possible damage to your home. The lender may require that you pay the first year’s premium at closing.
  • Origination fee. Covers the lender’s administrative costs.
  • Prepaid interest. The lender may require you to prepay any interest that will accrue between your closing date and the date your first mortgage payment is due.
  • Recording fees. Charges by your local city or county for recording public records.
  • Title company search. A fee paid to the title company for doing a thorough search of the property’s records to ensure that no one else has a legal claim to the property.

Closing costs typically run 3% to 5% of the loan amount.

This article contains links to LendingTree, our parent company.

FAQ

Still wondering whether an FHA loan is right for you? The following are some frequently asked questions about FHA loans that may help you decide.

Yes! FHA guidelines require borrowers to wait two years from the discharge of a Chapter 7 bankruptcy or one year from the discharge of a Chapter 13 bankruptcy before applying for an FHA loan. In addition to meeting the waiting period, borrowers with bankruptcies should be able to demonstrate that they’ve worked to re-establish good credit or chosen not to incur any new debts since the bankruptcy. Borrowers will also have to submit a letter of explanation detailing the circumstances that lead to the bankruptcy with their loan application.

Yes. Having a co-signer may improve your chances of getting approved for the loan, especially if it’s a high debt-to-income ratio holding you back from getting approved. The co-signer must also submit to an underwriter review of their income and credit as they will be liable for repayment of the loan if the borrower fails to meet their obligation.

The FHA does require that the co-signer be a family member, and the co-signer will likely be required to write a letter confirming the relationship. In rare cases, an underwriter may ask for some sort of proof of the relationship such as birth certificates of co-borrowing siblings.

Yes. You can refinance an existing mortgage to a new FHA loan in a streamline refinance as long as you’ve made at least six monthly payments on your current mortgage and it’s been at least 210 days since the closing of that loan. You cannot have any payments overdue by more than 30 days and no late payments in the past 90 days. If you qualify, the streamline refinance does not require an appraisal, credit qualification, or employment verification.

FHA loans allow you to take more cash out than a conventional loan, which can come in handy if you are trying to consolidate some debt, or need to do some upgrades and improvements to your home. The maximum amount you can borrow is 85% of your home’s value, which is higher than the 80% cap on a conventional cash-out refinance.

You can also refinance an FHA loan into a conventional loan. This is often a good option for borrowers whose home has increased in value substantially. Since some FHA loans require mortgage insurance be paid during the entire life of the loan, refinancing to a conventional loan can eliminate mortgage insurance.

No. While FHA loans are popular among first-time homebuyers due to their low down payments and flexible requirements, they are available to repeat buyers as long as the loan is being used to purchase a primary residence.

No. FHA loans are only available for purchasing a buyer’s primary residence. However, you can use an FHA loan to buy a property with up to four units, as long as you will live in one unit while renting out the others.

The FHA allows 100% of the down payment and closing cost funds to be gifted, as long as the donor signs a gift letter stating that the money is a gift and does not have to be repaid.

You will need to establish your relationship with the donor. The FHA only allows a gift to be provided by a family member, an employer or labor union, or a close friend with a clearly defined and documented interest in the borrower.

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Denny Ceizyk
Denny Ceizyk |

Denny Ceizyk is a writer at MagnifyMoney. You can email Denny here

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Mortgage

Should You Save for Retirement or Pay Down Your Mortgage?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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On the list of financial priorities, which comes first — paying off your mortgage or saving for retirement? The answer isn’t simple. On one hand, owning a home with no mortgage attached to it provides long term security knowing you’ll have a place to live with no monthly payment except property taxes and insurance. However, you’ll also need income to live on if you plan to retire, and how much you save now will have a big impact on your quality of retirement life.

We’ll discuss the pros and cons of whether you should save for retirement or pay down your mortgage, or maybe a combination of both.

Pros of paying down your mortgage vs. saving for retirement

The faster you pay your mortgage off, the sooner you own the home outright. However, there are other benefits you’ll realize if you take extra measures to pay your loan balance off faster.

You could save thousands in long-term interest charges

Most homeowners take out a 30-year mortgage to keep their monthly payments as low as possible. The price for that affordable payment is a big bill for interest charged over the 360 payments you’ll make if you’re in your “forever” home.

For example, a 30-year fixed $200,000 loan at 4.375% comes with a lifetime interest charge of $159,485.39. That’s if you never pay a penny more than your fixed mortgage payment for that 30-year period. Using additional funds to pay down your mortgage faster can significantly reduce this.

Even one extra payment a year results in $27,216.79 in interest savings on the loan we mentioned above. An added bonus is that you’ll be able to throw your mortgage-free party four years and five months sooner.

You’ll build equity much faster

Thanks to a beautiful thing called amortization, lenders make sure the majority of your monthly mortgage payment goes toward interest rather than principal in the beginning of your loan term. Because of that, it’s difficult to make a real dent in your loan principal for many years. You can, however, counteract this by making additional payments on your mortgage and telling the lender to specifically put those payments toward your principal balance instead of interest.

Not only do you pay less interest over the long haul with this strategy, but you build the amount of equity you have in your home much faster. And to homeowners, equity is gold — you’re closer to owning your home outright, and equity can also be a resource if you need funds for a home improvement project or another big expense.

You can access that equity as your financial needs change by doing a cash-out refinance or by taking out a home equity loan or home equity line of credit (HEL or HELOC).

You won’t lose your home if values drop

When you contribute extra money into a retirement account, there is always the risk that you’ll lose some or all of the money you invested. When you contribute money to paying off your mortgage, even if the values drop, you still have the security of a place to live, and are increasing the equity in the home, no matter how much it’s ultimately worth.

Making extra payments ensures you’ll eventually have a debt-free asset that provides shelter to you and your family, regardless of what happens to the housing market in your neighborhood.

Cons of paying down your mortgage vs. saving for retirement

There are some cases where paying down your mortgage faster might actually hurt you financially. Before adding extra principal to your mortgage payments, you’ll want to make sure you aren’t doing damage to your financial outlook with an extra contribution toward your mortgage payoff.

You might end up paying more in taxes

The higher interest payments you make during the early years of your mortgage can act as a tax benefit, so paying the balance down faster could actually result in you owning more in federal taxes. If you are in a higher tax bracket in the early (first 10 years) of your mortgage repayment schedule, it may make sense to focus extra funds on retirement savings, and let your mortgage interest deduction work for you. Of course, everyone’s tax situation is different, so you’ll have to decide (with help from an accountant ideally) if it makes sense to itemize your taxes in order to claim mortgage interest payments as a deduction.

You won’t get to enjoy the return on your paydown dollars until you sell

The only real benchmark for figuring out the value of paying down your mortgage is to look at how much equity you’re gaining over time. However, the equity doesn’t become a tangible profit until you actually sell your home. And the costs of a sale can take a big bite out of your equity because sellers usually pay the real estate agent fees.

Home equity is harder to access

The only way to access the equity you’ve built up is to borrow against it, or sell your home. Borrowing against equity often requires proof of income, assets and credit to confirm you meet the approval requirements for each equity loan option. If you fall on hard financial times due to a job loss, or are unable to pay your bills and your credit scores drop substantially, you may not be able to access your equity.

Pros of saving for retirement vs. paying down your mortgage

Depending on your financial situation and savings habits, it may be better to add extra funds monthly to your retirement account than to pay down your mortgage. Here are a few reasons why.

You may earn a higher return on dollars invested in retirement funds

The growth rate for a stock portfolio has consistently returned more than housing price returns. The average return in the benchmark S&P stock fund is 6.595% for funds invested from the beginning of 1900 to present, while home values have increased just 0.1% per year after accounting for inflation during that same time period.

Assuming your portfolio at least earns 7%, if you consistently invest your money into a balanced investment portfolio, you can expect to double your money every 10 years. There aren’t many housing markets that can promise that kind of growth.

Retirement funds are generally easier to access than home equity

Retirement funds often give you a variety of options for each access, with no income or credit verification requirements, and only sufficient proof of enough funds in your account to pay it back over time. For example, a 401k loan through the company you work for will just require you to have enough vested to support the loan request, and sufficient funds left over to pay it off over a reasonable time.

Just be cautious about making a 401k withdrawal, which is treated totally differently than a loan. You aren’t expected to pay it back like you would a 401k loan, but you could get hit with taxes and penalties.

Cons of saving for retirement vs. paying down your mortgage

You’ll need to weather the ups and downs of the market

Most people who have invested money in the stock market or tracked the performance of their 401k over decades have stories about periods when the value of those investments dropped substantially. While the 7% return on investment is a reliable long term indicator how much your retirement fund might earn, the path to that return is hardly linear.

For example, if you were considering retirement between 1999 and 2002, you may have had to delay those plans when the S & P plummeted over 23% in value in 2002. If you look at each 10-year period since the 1930s, every decade has been characterized by periods of ups and downs.

Calculating the benefit of paying down your mortgage vs. saving for retirement

If you’re torn as to what to do with that extra cash or windfall, let’s look at an example of someone who has an extra $200 to put into either their nest egg or their mortgage each month for the next 30 years.

For this scenario, we’re going to assume their retirement account earns an average 7% rate of return and that their mortgage loan balance is $200,000.

Here’s how much they’d save:

Savings From Paying $200 per Month Down on Your Mortgage
Years PaidMortgage Interest SavingsExtra Equity in HomeTotal Interest Savings and Equity Built Up
10 years$6,040$30,039$36,079
20 years$28,529$76,529$105,058
22 years 6 months$50,745$200,000$250,745

One thing you may notice about the mortgage savings chart — it includes how much extra equity you’re building. Often only the mortgage interest savings is cited when people look at how much you save with extra payments, but that ignores the fact that you’re building equity in your home much faster as well. So not only do you save over $50,000 in interest with your extra contribution, you replenish $150,000 of equity that was used up by your mortgage balance.

As you can see, adding that extra $200 to their mortgage principal each month saved them about $200,000 in the long haul — but the real savings don’t stop there.

By adding an extra $200 to their mortgage payment each month, this borrower turned their 30-year loan into a 22-and-a-half year loan and became mortgage debt-free seven years faster.

That means, in addition to saving $50,000 in interest savings and gaining $200,000 of equity, they also no longer have a mortgage payment. That frees up $998.57 per month that they can now use as discretionary income. That’s an extra $89,871 they could potentially save over that 7.5 year period.

When you add that to the $250,745.41 they saved on mortgage interest and earned in home equity, they’re looking at a total savings of $340,616.

That gives the mortgage paydown a $54,000 net positive edge over saving that extra $200 for retirement, as you can see in the table below.

Savings From Contributing $200 per Month to a Retirement Fund
Years PaidRetirement Balance
10 years$34,404
20 years$102,081
30 years$235,212

The one caveat for this retirement calculation is we assumed the saver was starting at a $0 investment balance. If they already had a healthy balance in their nest egg, they might actually come out in better shape than paying down their mortgage.

There are clearly benefits to each option, and you should consider running your own calculations with your real numbers to get the best answer for yourself.

Paying down your mortgage and saving for retirement at the same time

There’s a fair case to be made for both paying down your mortgage and saving more for retirement, but why choose? If you’re somewhat on track with your retirement savings goals, and like the idea of having your mortgage paid off quicker, you could allocate a certain amount to each.

Pick a number you feel comfortable paying to your principal every month, and then to your 401k, and put it on autopilot for a year. Any time your income increases, or you get bonuses, divide up the amount between principal pay down and retirement additions.

Let’s look at what happens if you evenly divide up your $200 per month between investing your retirement and paying down your mortgage. We’ll use the same $200,000 loan at 4.375% referenced above, and look at the lifetime results.

Savings From Paying $100 Down on Your Mortgage Until Paid Off
Years PaidInterest SavingsExtra Home EquityTotal Interest Savings and Equity Built Up
10 years$3,020$15,020$18,040
20 years$14,265$38,265$52,350
25 years$30,534$200,000$230,534
Savings From Contributing $100 to a Retirement Fund for 30 Years
Years PaidRetirement Balance
10 years$17,202
20 years$51,401
30 years$117,607

Balancing the $100 investment in both strategies still yields a six-figure retirement balance after 30 decades, a debt-free house after 26 years, and shaves off $30,000 in mortgage interest expense. If you don’t like putting all your eggs into one financial basket, this may balance the risks and rewards of each option.

Final thoughts

Looking at the short term and the long term may provide you with the best framework for making a good decision about how to spend dollars on retirement versus extra mortgage payments. Be wary of any financial professional that tells you one path is absolutely better than another.

Having a stable source of affordable shelter is equally as important as having enough income to live when you retire, so a balanced approach to paying down your mortgage and savings for retirement may help you accomplish both goals.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Denny Ceizyk
Denny Ceizyk |

Denny Ceizyk is a writer at MagnifyMoney. You can email Denny here

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What Is Mortgage Amortization?

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One of the biggest advantages of homeownership versus renting is each mortgage payment gradually pays off your mortgage and builds equity in your home. The difference between your home’s value and the balance of your loan is home equity, and your equity grows with each payment because of mortgage amortization.

Understanding mortgage amortization can help you set financial goals to pay off your home faster or evaluate whether you should refinance.

What is mortgage amortization?

Mortgage amortization is the process of paying off your loan balance in equal installments over a set period. The interest you pay is based on the balance of your loan (your principal). When you begin your payment schedule, you pay much more interest than principal.

As time goes on, you eventually pay more principal than interest — until your loan is paid off.

How mortgage amortization works

Understanding mortgage amortization starts with how monthly mortgage payments are applied each month to the principal and interest owed on your mortgage. There are two calculations that occur every month.

The first involves how much interest you’ll need to pay. This is based on the amount you borrowed when you took out your loan. It is adjusted each month as your balance drops from the payments you make.

The second calculation is how much principal you are paying. It is based on the interest rate you locked in and agreed to repay over a set period (the most popular being 30 years).

If you’re a math whiz, here’s how the formula looks before you start inputting numbers.

Fortunately, mortgage calculators do all the heavy mathematical lifting for you. The graphic below shows the difference between the first year and 15th year of principal and interest payments on a 30-year fixed loan of $200,000 at a rate of 4.375%.

For the first year, the amount of interest that is paid is more than double the principal, slowly dropping as the principal balance drops. However, by the 15th year, principal payments outpace interest, and you start building equity at a much more rapid pace.

How understanding mortgage amortization can help financially

An important aspect of mortgage amortization is that you can change the total amount of interest you pay — or how fast you pay down the balance — by making extra payments over the life of the loan or refinancing to a lower rate or term. You aren’t obligated to follow the 30-year schedule laid out in your amortization schedule.

Here are some financial objectives, using LendingTree mortgage calculators, that you can accomplish with mortgage amortization. (Note that MagnifyMoney is owned by LendingTree.)

Lower rate can save thousands in interest

If mortgage rates have dropped since you purchased your home, you might consider refinancing. Some financial advisors may recommend refinancing only if you can save 1% on your rate. However, this may not be good advice if you plan on staying in your home for a long time. The example below shows the monthly savings from 5% to 4.5% on a $200,000, 30-year fixed loan, assuming you closed on your current loan in January 2019.

Assuming you took out the mortgage in January 2019 at 5%, refinancing to a rate of 4.5% only saves $69 a month. However, over 30 years, the total savings is $68,364 in interest. If you’re living in your forever home, that half-percent savings adds up significantly.

Extra payment can help build equity, pay off loan faster

The amount of interest you pay every month on a loan is a direct result of your loan balance. If you reduce your loan balance with even one extra lump-sum payment in a given month, you’ll reduce the long-term interest. The graphic below shows how much you’d save by paying an extra $50 a month on a $200,000 30-year fixed loan with an interest rate of 4.375%.

Amortization schedule tells when PMI will drop off

If you weren’t able to make a 20% down payment when you purchased your home, you may be paying mortgage insurance. Mortgage insurance protects a lender against losses if you default, and private mortgage insurance (PMI) is the most common type.

PMI automatically drops off once your total loan divided by your property’s value (also known as your loan-to-value ratio, or LTV) reaches 78%. You can multiply the price you paid for your home by 0.78 to determine where your loan balance would need to be for PMI to be canceled.

Find the balance on your amortization schedule and you’ll know when your monthly payment will drop as a result of the PMI cancellation.

Pinpoint when adjustable-rate-mortgage payment will rise

Adjustable-rate mortgages (ARMs) are a great tool to save money for a set period as long as you have a strategy to refinance or sell the home before the initial fixed period ends. However, sometimes life happens and you end up staying in a home longer than expected.

Knowing when and how much your payments could potentially increase, as well as how much extra interest you’ll be paying if the rate does increase, can help you weigh whether you really want to take a risk on an ARM loan.

The bottom line

Mortgage amortization may be a topic that you don’t talk about much before you get a mortgage, but it’s certainly worth exploring more once you become a homeowner.

The benefits of understanding how extra payments or a lower rate can save you money — both in the short term and over the life of your loan — will help you take advantage of opportunities to pay off your loan faster, save on interest charges and build equity in your home.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Denny Ceizyk
Denny Ceizyk |

Denny Ceizyk is a writer at MagnifyMoney. You can email Denny here

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