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Column: What size of mortgage can I afford?

Dale Lewis

Even if you are not a first-time home buyer, you’d be wise to understand the elements that make up a mortgage. It will help you understand why payments look like they do and what you can do to make your payment affordable.

Here are the components:

Principal: The overall loan principal represents the amount you borrow.

It is the starting point, though not the only factor, in determining your monthly mortgage ­payment.

The principal portion of your monthly mortgage payment works to reduce your loan obligation each month. In general, the larger your loan, the larger your monthly payment. But the length of your loan repayment period also plays a big role in determining how much you pay each month.

Interest: This is your cost of borrowing. The interest rate is the fee, expressed as a percentage, to use a lender’s money to buy your home. Each month, it translates into the interest portion of your loan payment, which usually makes up a larger portion of the payment at the beginning of the loan and a smaller portion at the end.

Home buyers are fortunate to be in a period of historically low interest rates. There’s always much discussion about where interest rates are headed, but the general feeling is they eventually will rise. Right now, however, they remain low, making the cost of a loan a good deal.

The other good news with your interest payment is that it becomes a deduction on your income taxes at the end of the year. This is a significant benefit of buying a home instead of renting. You not only are building your equity, or ownership stake, in the place you call home, but you also get a tax deduction on your cost of borrowing to achieve that goal.

Escrow: When you buy property, you also start paying another kind of tax: property tax. It comes with the territory, and your lender wants to make sure that it is paid.

Many monthly mortgage payments, and especially those for owners with less than 20 percent equity, include a portion set aside to go to the local property tax collector.

But when the tax bill comes due, you have contributed your funds to an escrow account managed by your lender, and the lender ensures that the property tax is paid.

In addition, lenders often require a portion of your monthly mortgage payment to go into a similar escrow account to pay for homeowner’s insurance coverage. Compared with principal and interest, the property-tax and insurance escrow portions usually don’t make up a huge portion of your monthly payment. But both are worthwhile services that protect you as the homeowner.

Other payments: Mortgage payments can include other fees as well. If you have less than 20 percent equity, most lenders also will require you to purchase private mortgage insurance, or PMI. PMI is a cost you pay to insure the lender in case you default. In most cases, you can avoid PMI with an initial down payment of 20 percent or more.

It’s wonderful that we have many mortgage options these days, from conventional 30-year loans with fixed rates to shorter term loans with adjustable rates and features such as “balloon” payments. But that complexity makes it even more important to develop a relationship with a lender who can walk through all of the details to help you understand what’s best for you.

Start that relationship now, before you look at homes or as you are looking. Understand what makes up a mortgage payment and how you can adjust the variables. That’s the best way to make sure you can buy the house you want when you find it.

Dale Lewis is president and CEO of Park State Bank in Duluth. You can reach her at president@parkstatebank.com or 218-722-3500.

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