Understanding Mortgages

Real Estate

If you’re planning to buy a new house, you’ll most likely need a mortgage to help finance it. Mortgages have been an integral part of the American dream of homeownership for decades. However, before the 1930s, only a minority of Americans could afford to pay for a home in cash. The introduction of mortgages changed that, making homeownership accessible to more people.

In simple terms, a mortgage is a loan that uses your home as collateral. The lender, typically a bank or a mortgage lender, loans you a substantial amount of money, usually up to 80% of the cost of the home. You must pay back the loan, with interest, over a fixed period. Failure to repay the loan may lead to foreclosure, where the lender takes possession of your home.

For many years, fixed-interest mortgages with a 30-year repayment period were the only type of mortgage available. They offered stability, with regular and relatively low monthly payments. However, adjustable-rate mortgages (ARMs) were introduced in the 1980s. ARMs have a lower initial interest rate that adjusts or “resets” every year throughout the life of the mortgage. Some lenders started offering “creative” ARMs with teaser rates, shorter reset periods, and no limits on interest rate increases.

The combination of bad loans and a weak economy led to a rise in foreclosures. Since 2007, over 250,000 Americans have entered foreclosure proceedings each month. Foreclosures are expected to reach one million homes in 2010. Many borrowers did not fully understand the terms of the mortgages they signed, leading to confusion and financial difficulty.

It’s crucial to understand the terms of your mortgage, especially if you’re taking out nontraditional loans. This article will explore the different types of mortgages available, explain confusing terms like escrow and amortization, and highlight hidden costs, taxes, and fees that can add up each month. Let’s begin by answering the most basic question: What is a mortgage?

What Are Mortgages?

In legal terms, a mortgage is “the pledging of property to a creditor as security for the payment of a debt.” In simpler terms, a mortgage is a loan. It’s often the largest loan a person will ever borrow. Unlike a regular loan, a mortgage uses the house as collateral. The lender assesses your credit history, income, and savings to determine the risk of lending you money. If you don’t repay the loan, the lender can take possession of your home.

Mortgages are commonly provided by banks, who offer different interest rates and terms for customers to choose from. Alternatively, mortgage brokers can be hired to find the best deal from various lenders. Credit unions, some pension funds, and government agencies also offer mortgages. Mortgages have a fixed or adjustable interest rate and loan term from five to 30 years. Additional fees and costs are associated with mortgages, some only occurring once while others are added to the monthly payment. Mortgages date back to the 1930s, when insurance companies were the first to offer them in the hopes of gaining ownership of properties if borrowers failed to make payments. The Federal Housing Administration (FHA) played a critical role in modernizing mortgages in 1934, offering new programs aimed at helping those who couldn’t get mortgages under the existing programs. FHA lowered down payment requirements and set quality standards for homes to qualify for loans. The FHA also extended loan terms from five to seven years to 15 years and eventually 30 years.

Before the establishment of the Federal Housing Administration (FHA), traditional mortgages were structured as interest-only payments, with the entire principal of the loan due at the end. This led to high rates of foreclosure. FHA introduced loan amortization, which allowed borrowers to gradually pay off the loan’s principal with each interest payment, reducing the loan over time until it was fully paid off.

The down payment on a mortgage is a lump sum paid upfront that reduces the amount borrowed. The traditional amount is 20 percent of the purchase price, but mortgages that require as little as 3 to 5 percent down are available. The monthly mortgage payment consists of principal, interest, taxes, and insurance (known as PITI).

With a fixed-rate mortgage, the monthly payment remains relatively constant, but the portion of the payment that goes towards the principal and interest changes over time. This gradual repayment of the loan and accumulated interest is known as amortization. In the early years of a 30-year mortgage, the borrower pays more towards interest than principal.

While amortization allows for gradual repayment of the loan’s interest, it also means the borrower pays more in interest over time and builds equity in the home at a slower pace. Despite this, fixed-rate, 30-year mortgages are still a popular and viable option.

Mortgages with Fixed Interest Rates

Before, lenders only offered one type of mortgage, which is the 30-year fixed-rate mortgage. With this type of mortgage, the interest rate remains the same throughout the entire loan period. The monthly payment also remains constant for 15, 20, or 30 years, depending on the length of the mortgage. The only changes that can occur are the property taxes and insurance payments included in the monthly bill. The interest rates of fixed-rate mortgages fluctuate with the larger economy. Borrowers are given specific rates based on their credit history and loan term. The following are the benefits of 30, 20, and 15-year terms:

• 30-year fixed-rate – It has the lowest monthly payments, but you’ll end up paying the most interest. This type of loan allows borrowers to deduct the most interest payments from their taxes.
• 20-year fixed-rate – These loans are harder to find, but the shorter term allows borrowers to build up more equity in their home sooner. The interest rate is generally lower than a 30-year fixed-rate mortgage because of the larger monthly payments.
• 15-year fixed-rate – This loan term has the same benefits as the 20-year term, but borrowers have to make even higher monthly payments.

Many borrowers prefer fixed-rate mortgages because of their long-term stability, especially if they plan on staying in their homes for a long time. However, other borrowers prioritize getting the lowest interest rate possible, which is why adjustable-rate mortgages are attractive.

Mortgages with Adjustable Interest Rates

An adjustable-rate mortgage (ARM) has an interest rate that changes depending on market conditions, usually once a year. This change affects the monthly mortgage payment. ARMs offer lower initial rates compared to conventional 30-year fixed-rate mortgages. Even when the latter has historic low-interest rates, the ARM rate is almost a full percentage point lower. ARMs are also attractive to borrowers who plan on selling their homes within a few years.

However, borrowers who plan on getting an ARM should remember that their intentions might not always match reality. Many ARM borrowers were stuck with a “reset” mortgage they couldn’t afford when they failed to sell their homes during the real estate boom. Many of them did not fully understand the terms of their ARM agreement. When considering an ARM, these are the essential numbers to look for:

The interest rate on an adjustable rate mortgage (ARM) can adjust annually, although there are other options such as six-month, one-year, two-year, and more. A popular type of ARM is the 5/1 year ARM, which has a fixed rate for five years and then adjusts annually for the remainder of the loan. It’s important to note that there are caps on how high the interest rate can go over the life of the loan and how much it can change with each adjustment. Additionally, ARM interest rates can be tied to various indexes, such as U.S. Treasury bills or the London Inter-Bank Offer Rate (LIBOR). Other mortgage options include balloon mortgages, which have low monthly payments for a short period of time but require a large “balloon” payment at the end of the loan term, and reverse mortgages, which pay homeowners (who are 62 or older) as long as they remain in their homes. Finally, government-sponsored loans from agencies like the Federal Housing Administration (FHA), Veterans Administration (VA), and Rural Housing Service (RHS) offer discounted rates and loan terms for qualifying borrowers.

There are agencies that do not directly lend money to borrowers, but instead insure loans made by approved mortgage lenders. This includes refinancing mortgages that have become unaffordable. Borrowers with bad credit histories may find it easier to secure a loan from an FHA-approved lender since the lender knows that if the borrower fails to pay back the loan, the government will cover the cost. FHA loans only require a 3 percent down payment, all of which may come from a family member, employer, or charitable organization. Commercial mortgages do not allow this.

Like FHA loans, Veterans Administration loans are guaranteed by the agency, not lent directly to borrowers. VA-backed loans offer generous terms and relaxed requirements to qualified veterans. Veterans can pay no money down as long as the home price does not exceed the loan limits for the county.

If you live in a rural area or small town, you may qualify for a low-interest loan through the Rural Housing Service. RHS offers both guaranteed loans through approved lenders and direct loans that are government-funded. They enable low-income families to get loans for homes.

The calculation of interest is one of the most confusing things about mortgages and other loans due to variations in compounding, terms, and other factors. It is difficult to compare mortgages accurately. However, lenders are required by the Federal Truth in Lending Act to disclose the effective percentage rate, as well as the total finance charge in dollars. The annual percentage rate (APR) allows for true comparisons of the actual costs of loans. The APR is the average annual finance charge, including fees and other loan costs, divided by the amount borrowed. It is expressed as an annual percentage rate. The APR will be slightly higher than the interest rate charged by the lender because it includes all or most of the other fees that the loan carries with it, such as the origination fee, points, and PMI premiums.

The interest rate is not always the only factor to consider when choosing a mortgage lender. The origination fee, which lenders charge upfront, can also affect the overall cost of the loan. This fee is usually a percentage of the total loan amount and can range from 0.5 to 1 percent. For example, if a lender charges a 3 percent origination fee on a $100,000 loan, the new loan amount would be $96,180, resulting in a higher APR. When comparing lenders, it’s important to ask for the APR and understand which fees are included in the calculation. The lender will provide the APR in the Federal Truth in Lending Disclosure. Other factors to consider include the total loan amount and the length of time you plan to stay in the home. Most lenders require a debt-to-income ratio of 28/36 to qualify for a mortgage. This means that no more than 28 percent of your monthly income can go toward housing, and no more than 36 percent can go toward your total monthly debt.

The debt-to-income ratio can be demonstrated through an example. If you make $35,000 annually and are considering a house that requires an $800 monthly mortgage payment, according to the 28 percent limit for housing expenses, you could afford a payment of $816 per month, so the $800 per month this house will cost is acceptable (27 percent of your gross income). However, if you have other monthly payments, such as $200 for a car and $115 for student loans, you must add these to the $800 mortgage payment to determine your total debt. The total is $1,115, which is approximately 38 percent of your gross income. Lenders usually use the lower of the two numbers, in this case, the 28 percent $816 limit, but you may have to negotiate with the lender or make a larger down payment. It’s also important to consider your regular expenses and any future expenses that may arise when determining what you can afford.

To qualify for a mortgage, lenders will look at your employment and credit history. They want to see stability, so they will examine any late payments during the last two years of your credit history, particularly for rent or mortgage payments that were more than 30 days past due, as well as late payments for credit cards during the last six months. A stable income is also crucial, and lenders prefer to see steady employment with one employer for the past two years or at least employment in the same field. Other income such as part-time or freelance work, overtime, bonuses, or self-employment is acceptable if it has a two-year history. If you don’t meet the minimum requirements, you may need to talk to more lenders or accept a higher interest rate. The credit market has been tight for several years, and mortgage lenders offer the best interest rates to borrowers with high credit scores (760 to 850) who can make a significant down payment (10 to 20 percent). When applying for a mortgage, you typically need to provide certain documents.

This is a list of documents and information that you will need when applying for a home loan. This includes money for closing costs, a completed sales contract signed by both the buyer and seller, the Social Security numbers of all applicants, and a complete address for the past two years (including the name and address of landlords for the past 24 months). Additionally, you will need the names, addresses, and income earned from all employers for the past 24 months, W-2 forms for the two years prior to the loan application, the most recent pay stub showing year-to-date earnings, and names, addresses, account numbers, monthly payments, and current balances for all loans and charge accounts. You will also need names, addresses, account numbers, and balances for all deposit accounts, such as checking accounts, savings accounts, stocks, and bonds. The last three statements for deposit accounts, stocks, and bonds are also required. If you choose to include income from child support and/or alimony, bring copies of court records of cancelled checks showing receipt of payment. Your lender and closing attorney will give you a more detailed list and tell you what other paperwork and documents you need to present at the loan closing. It is important to note the difference between prequalification and preapproval. Prequalification means that you have told a lender your income level and your debt and credit information, and the lender has estimated what you can afford. Preapproval means that the lender has done the legwork of pulling your credit report, checking your debt-to-income ratio, and more in-depth analyzing of your potential situation. Closing costs include the total cost of a home mortgage, which is much more than just the monthly mortgage payments. The amount of money you’ll have to pay in closing costs varies depending on the region. Typically, you will pay anywhere from 3 to 6 percent of your total loan amount in closing costs. However, you can negotiate the fees and ask the seller to pay some of the closing costs.

When closing a mortgage, the expenses for services can be divided into three categories: the actual cost of obtaining the loan, the fees for property ownership transfer, and the taxes that are paid to the state and local governments. The following three pages will provide a detailed breakdown of every fee that may be included in closing on a home purchase.

Part I of the list of closing costs includes the following major fees: the processing fee, which covers the initial loan processing costs and includes application and credit report access fees; the appraisal fee, which is required by the lender to ensure that the property is worth what you are paying for it; the origination fee, which covers additional work that the lender needs to do when preparing your mortgage and can be a flat fee or a percentage of the mortgage; the discount points, which allow you to buy down the interest rate you’ll be paying and can be paid when the loan is approved or at closing; and the document preparation fee, which pays for the preparation of the documents required for closing.

Part II of the list of closing costs shows that there may be more fees to consider.

The closing process involves various expenses that both the buyer and the lender must pay. These charges are necessary to ensure that all the required documents are prepared correctly and that the closing goes smoothly. One of these expenses is attorney fees, which cover the cost of the buyer’s and the lender’s attorneys. The closing attorney’s job is to represent the buyer’s interests, transfer the deed to the buyer, pay all closing costs, outstanding taxes, and utility bills, and give the remaining money to the seller. The attorney fees vary depending on the property’s purchase price and the sale’s complexity, ranging from $500 to $1,000 or more.

Another expense is the home and pest inspections, which are usually required by the lender to ensure that the property is structurally sound and free of termites and other destructive insects. If the property uses well water, the water may also need to be tested. The homeowner’s and hazard insurance policies must also be in place and prepaid at the time of closing to protect the buyer’s and lender’s investment if the house is destroyed.

Private mortgage insurance (PMI) may also be required if the down payment is less than 20 percent of the property’s value. This insurance protects the lender in case the buyer fails to make mortgage payments. PMI premiums are usually part of the monthly mortgage payment and must be paid until the buyer reaches the 20 or 25 percent requirement or for the loan’s life.

Finally, some lenders may require an independent survey to ensure no changes have been made to the property since the last survey. These surveys usually cost between $250 to $500.

There are still more closing costs to consider, which are listed in the next section.

When closing the sale on your new home, there are several additional fees and expenses you should be aware of. Prepaid interest is calculated from the day you close the sale, which could add up significantly if your closing date is at the beginning of the month. Deed recording fees and title search fees are also required, with the latter ensuring that there are no outstanding claims against the property. Title insurance protects you from potential issues that may arise in the future and is a one-time fee that covers the property for as long as you or your heirs own it. Closing taxes may also be required, which could include prorated school and municipal taxes. Private Mortgage Insurance (PMI) can be helpful for those with a down payment of less than 20%, as it provides insurance for the lender in case of default. The more equity you have in the home, the lower the rate of default.

The process of buying a house can be complex and confusing, especially when it comes to down payments and private mortgage insurance (PMI). If a couple has $10,000 in the bank, they can buy a $50,000 home with a 20 percent down payment. If they choose a more expensive house, they will need to pay for PMI, which is based on the loan amount. However, if they reach 20 or 22 percent equity in the home, PMI can be automatically terminated or requested to be dropped depending on the date the mortgage was signed. There are exceptions to this rule, such as if payments are not current or if the loan is high-risk or has other liens on the property.

Mortgage lenders make their money by selling mortgages on the secondary investment market to entities like Fannie Mae and Freddie Mac, which were created by Congress to make mortgages available to more people with low and moderate incomes. These GSEs purchase mortgages from lenders and sell them as securities in the bond market to provide lenders with liquidity to fund more mortgages. However, when the mortgage default rates in the U.S. rose, the securities plummeted in value, causing shockwaves throughout the global economy.

The Federal Housing Finance Agency took over Fannie and Freddie in 2008, and they received $145 billion in bailout funds from the US Treasury to inject emergency liquidity into the credit market by June 2010. Even after the government takeover, Fannie and Freddie were still publicly traded companies until their share prices dropped below the minimum price requirements and were dropped from the New York Stock Exchange in 2010. Despite their problems, Fannie and Freddie remain the largest purchasers of mortgages on the secondary market and an essential component of the nation’s credit system. Foreclosure is the legal process by which a lender takes possession of a home and sells it to get its money back when a borrower misses mortgage payments. The US experienced a foreclosure crisis in 2008, with lenders filing 2 million foreclosure proceedings and 1 million mortgage borrowers losing their homes. Many Americans have first and second mortgages they can’t afford, but the government offers refinancing and loan modification programs to help borrowers avoid foreclosure. The Home Affordable Refinancing program allows homeowners whose properties are rapidly losing value to refinance their mortgage at a lower rate. The Home Affordable Modification program helps negotiate an affordable new rate and payment plan with lenders for borrowers whose monthly mortgage payments exceed 31 percent of their monthly gross income and have experienced significant hardship. The Second Lien Modification program offers incentives to lenders to allow qualifying borrowers to have their second liens forgiven or interest rates lowered to 1 percent. The Home Affordable Foreclosure Alternatives program encourages a short sale or a deed in lieu of foreclosure to avoid the credit stain of foreclosure. In both cases, the government will supply the borrower with up to $3,000 to cover relocation expenses. Foreclosures are also lousy for lenders, costing them more than $50,000 per home just to process the claim.

If you’re facing foreclosure, there’s no need to pay for mortgage counseling or loan modification services. Many of these services are scams, according to the government. Instead, call the HOPE Hotline (888-995-HOPE) run by the Housing and Urban Development office for free advice. To save money on your mortgage and avoid foreclosure, here are some tips: negotiate for better rates or fee waivers, choose the right type of mortgage, make extra payments, switch to biweekly payments, avoid paying private mortgage insurance, and make sure paying points will save you money. Use a points calculator to figure out if paying points will impact your interest rate and monthly payment. For more information on mortgages and related topics, see the links on the next page.

FAQ on Mortgage

A mortgage is a loan where your home is put up as collateral. The lender lends you a large sum of money to buy a house (minus your down payment) that you have to repay, with interest, over a set period of time. The following are some frequently asked questions about mortgages that can help you understand the process better.

What is the method to calculate monthly mortgage payments?

Your monthly mortgage payment will be lower if you have a larger down payment. The easiest way to find out is to use an online tool such as Bankrate’s Mortgage Calculator. Alternatively, your mortgage broker can help you understand how unique factors influence your monthly payment.

How is interest calculated on a mortgage?

Interest is calculated as a percentage of the money borrowed that is generally calculated monthly. At the end of each month, the lender multiplies the outstanding loan amount by the agreed-upon interest rate and then divides that amount by 12 to get the monthly payment.

How can you determine how much mortgage you qualify for?

The simplest way to do this is to speak with a broker and get pre-approved for a mortgage. They will consider factors like your debt-to-income ratio, credit score, and down payment to figure out what size of mortgage you are eligible for. There are also several online estimators, such as the one from Realtor.com, that you can use beforehand.

What is a good interest rate for a mortgage?

Interest rates fluctuate over time but are currently at historic lows. The rate you get will depend on various factors, including your credit score, but 30-year fixed-rate mortgages are available with interest rates around 3 percent and are expected to stay there through 2021, according to Bankrate.com.

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FAQ

1. What is a mortgage?

A mortgage is a loan that is used to buy a property. It is a legal agreement between the borrower and the lender, where the borrower receives a certain amount of money to buy a property and agrees to pay back the loan with interest over a period of time.

2. How do mortgages work?

When you apply for a mortgage, the lender will assess your income, credit score, and other financial information to determine the amount of money you can borrow and the interest rate you will pay. If approved, you will receive the money to buy the property. You will then make regular payments to the lender, which will include both the principal (the amount borrowed) and the interest, until the loan is paid off.

3. What is a down payment?

A down payment is the initial payment you make when you buy a property. It is usually a percentage of the total purchase price, and is paid upfront to the seller. The rest of the purchase price is covered by the mortgage loan.

4. What is the interest rate on a mortgage?

The interest rate on a mortgage is the amount of money the lender charges you for borrowing the money. It is usually expressed as a percentage of the loan amount, and can either be fixed (stays the same throughout the loan term) or variable (changes over time).

5. What is a mortgage term?

The mortgage term is the length of time over which you will pay back the loan. It can vary from a few years to several decades, depending on the lender and the type of mortgage you choose.

6. What is a mortgage payment?

A mortgage payment is the amount you pay to the lender each month to cover the principal and interest on the loan. It may also include other costs such as property taxes and insurance.

7. What is a mortgage amortization schedule?

A mortgage amortization schedule is a table that shows how much of each mortgage payment goes towards paying off the principal and how much goes towards paying off the interest. It also shows how much of the loan is left to be paid off over time.

8. What is a prepayment penalty?

A prepayment penalty is a fee that some lenders charge if you pay off your mortgage early or make extra payments towards the principal. It is designed to compensate the lender for the lost income from interest payments.

9. What is mortgage insurance?

Mortgage insurance is a type of insurance that protects the lender in case you default on your loan. It is usually required if you make a down payment of less than 20% of the purchase price.

10. What is a mortgage broker?

A mortgage broker is a professional who helps you find and apply for a mortgage. They work with multiple lenders to find the best rates and terms for your financial situation.

11. What is refinancing?

Refinancing is the process of replacing your current mortgage with a new one, usually to take advantage of better interest rates or terms. It can also be used to access the equity in your home.