Understanding Mortgage Basics

Understanding how mortgages work
When you choose to finance a home, the property loan is called the mortgage. The amount of the mortgage, also known as the principal, will be determined by the price of the property, minus the down payment. A larger down payment will reduce the amount of the mortgage, and will result in smaller monthly payments. The principal is reduced gradually with each monthly payment. Your monthly payments will be mostly interest in the beginning, since your interest is calculated according to your current principal amount. As you begin to make a dent in the principal, more of your monthly payments will go to pay down the principal.

The amount of equity in the home is the value of the home, minus the total amount of all the loans on that property, whether first or second mortgage, including home-equity lines of credit. Home equity can be increased by a large down payment, the appreciation of home values, gradually with the monthly payment, or a combination. Negative equity happens when the amount of the mortgage exceeds the value of the home, which can be caused by a drop in the home's value, with over-extended home-equity lines-of-credit, or due to certain mortgage products that are designed that way.


The mortgage term determines how long it will take to pay off the mortgage if you pay according to the amortization schedule. The most common mortgage terms are fifteen or thirty years, but some mortgage lenders may offer loans with terms of ten, twenty,or even forty years. The longer the term, the more total interest you will pay. Also, all else being the same, shorter terms usually get better interest rates. Most mortgages allows extra payments to principal; if you pay extra you will pay your mortgage off sooner than the stated term, and will save money in interest charges.

Many mortgages, especially those with a low down payment, are set up so that your monthly payment includes PITI, which stands for principal, interest, taxes, and insurance. You'll pay your principal and interest that's owed to the mortgage lender, and they will also collect a monthly prorated amount to cover the yearly real estate taxes and homeowner's insurance annual payments. This money that is collected will be put into an escrow account, and the mortgage lender will pay those lump sum payments when they are due. It will increase your monthly payments, but it also takes two important home ownership expenses off your mind and ensures those requirements are paid on time.

Make sure you are being given a PITI payment when real estate brokers quote you a monthly payment for a particular home. Some of them will tell you just a P&I payment so the home seems more affordable than it really is, which can make it hard to accurately budget for your new home.

Pre-payment penalties are designed to keep you in debt, to discourage you from paying extra to principal or to prevent you from refinancing for better rates. Pre-payment penalties are common with sub-prime mortgages, but pre-payment penalties have been popping up in other types of mortgages, too. Pre-payment penalties are often assessed if you refinance your mortgage in the first three or five years of purchasing, but some brutal mortgage contracts will allow this penalty even if you sell your home.

Some will allow you to pre-pay up to 20% of your mortgage in a given year without penalty and some will hit you with the penalty fee if you over-pay by even a dollar. Mortgage lenders may entice you with a lower interest rate to get you to agree to a mortgage with pre-payment penalties. It's your choice, but a mortgage with a pre-payment penalty is probably not a good idea unless you believe you are getting a rock-bottom interest rate and don't plan on moving or paying extra to your mortgage in the near future.


There are several types of mortgages
Interest rates for mortgages can vary according to your credit history, the size of the down payment, whether you have a fixed-rate or adjustable-rate mortgage, or whether the mortgaged property is your home, business, or an investment property. Interest rates will also depend on the type of mortgage you get.

The fixed rate mortgage is the traditional home loan, and is still very popular with home buyers. The main benefit of a fixed rate mortgage is that it offers the security of always knowing what your mortgage payment will be. No matter what interest rates are doing in the future, your mortgage interest rate will stay the same. If you happen to be buying a home when mortgage rates are at a low, it's smart to lock in that fixed rate for the life of your mortgage.

The adjustable rate mortgage (ARM) usually starts off at a fixed rate for a specified amount of time, and then periodically adjusts according to the index that it is tied to, commonly the London Interbank Offered Rate (LIBOR). For example, a 5/1 ARM will be fixed for the first five years, and then it will adjust each year in step with the market, for the rest of the loan term. Your house payment can go down, or it can go up, but remember that it's impossible to predict what the market will be doing in five years.

An ARM can be the right choice for someone who plans on selling their home before the fixed term is over. ARM rates are typically about a half percent less than a fixed rate mortgage, so going with the ARM may save money over a fixed rate mortgage. For example, if you plan on selling in five or six years, and got a 7/1 ARM, then your mortgage rate would stay fixed for the first seven years and adjust each year after. Since you'd plan on selling before the rate changed, you would still have the security of a fixed rate mortgage for the first seven years, and likely to have sold the property before the rate begins to adjust.

An ARM can also be the right choice for someone who knows that their income will increase in the near future. An ARM may help you afford a little more house, maybe one that may be a bit out of reach with a fixed rate mortgage. It's possible that the interest rate will become lower when it adjusts, but it's smart to be prepared for them to go up. Take on an ARM only if you are sure that you will have more income at your disposal before the rates begin to adjust.

The danger of an ARM is evident in light of our nation's recent sub-prime ARM problem. An ARM is a bad choice for those who are simply trying to buy more house than they can afford. Those who are now facing the possibility of losing their home to foreclosure opted for the ARM, thinking they could refinance before the rates adjusted. Now that the housing market has taken a hit, many cannot refinance because they now owe more than their house is worth, and they are stuck with a mortgage with payments that will increase beyond what they can afford.

Balloon mortgages start off like a fixed rate mortgage, in which you'll pay amortized payments for five to ten years. At the end of that period, the entire principal will be due. At this point, many will refinance to pay off the principal. A balloon mortgage may also be a good choice for those who plan to sell before the balloon payment is due. The interest rate for a balloon mortgage is typically lower than that of a fixed rate mortgage, which may help a home buyer afford more house. Balloon mortgages often have a clause that allows you to convert to a traditional mortgage through the original lender when the balloon payment is due. At that time, you'll have to convert or refinance at the market's current rate.

Reverse mortgages are a way for homeowners who are age 62 or over to cash out on the equity in their home. They still own their home, but may take cash payments in a lump sum, use it as needed like a credit line, or take a set monthly payment. Reverse mortgage payments are not taxable by the IRS as income. The homeowner does not have to make any payments to the lender as long as that home is used as their primary residence. The homeowner may receive payments up to the value of their home, but may never exceed that amount. The outstanding debt will be due to the lender if the homeowner sells their home, moves out of the home but does not sell, or dies. At that point, they or their heirs may pay back the debt with other funds, funds from the sale of the home, or they may refinance.


Mortgages are either government-backed or conventional.Government-backed mortgages include FHA loans insured through the Federal Housing Authority and VA loans guaranteed by the Department of Veteran's Affairs. Both types of loans are guaranteed by the federal government and allow qualified home buyers to purchase a home with little or no down payment. They are more lenient about the borrower's credit history, but still require good credit. FHA limits the amount of the mortgage to 125% of the median home price for your area. The VA does not set loan limits, but most lenders will not approve a loan above $417,000, but allowing more in high-cost areas. Government-backed mortgages are assumable for qualified buyers and have no prepayment penalty.

Conventional loans are not backed by the government. They require a bigger down payment, at least ten but often twenty percent. Conventional mortgages usually require very good to excellent credit. Within the conventional loans, there are conforming loans, which must fall below the limit of $417,000, allowing more for high-cost areas. Non-conforming loans, also known as jumbo loans, are for mortgages that are larger than the conforming loans limits in your area, and have a higher interest rate than conforming loans.


Mortgage payment options may be the right choice for certain home buyers.
Mortgage options are not a type of mortgage; these options may be attached to any type of loan, fixed or adjustable. You will still get the type of mortgage you want, and for the term you choose, and then add the payment options to that mortgage.


Interest-only (IO) options are just what they sound like, a mortgage payment that does not pay down principal. The interest only period usually lasts for about five to ten years, at which point you'll begin to pay down principal just like you would with a regular mortgage. IO mortgages are becoming popular for those who simply want to live in a nicer house, but do not care about building equity right away. IO mortgages allow a home buyer to buy more house than if they were paying down the principal. It may be the right choice for home buyers who know they will soon outgrow a home if they purchased within their current means, but they also know that they will have more income before the principal payments are due. An IO option may allow someone to bypass the typical process of buying a starter home, and moving up to their permanent home when their income increases. They can move straight into their permanent home from the beginning.


IO options are also popular for some who would rather invest the extra cash than use it to pay down principal. If the mortgage interest rate is 6%, then, in essence, paying down your principal will earn you 6%. When you consider the tax benefit of the mortgage interest deduction, you are earning even less than that, depending on your tax bracket. If you can invest the money you aren't spending on principal, and earn more than 6% on your investments, then you would come out ahead using this strategy. It's essential that someone who chooses an IO option for this reason has the discipline to invest regularly. The home buyer could end up in a much worse position if they failed to invest the extra cash at a profit.

Another option is the minimum payment, which allows a choice of payment each month. You may pay the full payment, which will pay the entire payment due that month including principal and interest. You may pay more than the full payment, which pays down additional principal. You may pay interest only, which does not reduce your principal. Or you can make the minimum payment, which may not include all the interest, resulting in negative amortization. This type of payment option may be suitable for those who work on commissions or those who otherwise have inconsistent income. You have the freedom to pay more when your income is greater, and you can pay less when your income is limited.


A non-traditional mortgage may be the best answer for some in certain circumstances. These days, people relocate more often than they used to, move to bigger houses sooner, and have various income situations that may draw them to the flexibility of mortgage payment options. Payment options put the homeowner in control of how and when they pay for their home. But also keep in mind that many people would not ever be able to build their wealth if it wasn't for the forced savings that a traditional mortgage payment provides. Those homeowners depend on that mortgage payment to chip away at the loan principal, increasing their net worth. Many would not invest on their own, and so they count on their home to be their biggest asset over many years of principal payments and long term home value appreciation.
Fully think out the pros and cons of any type of mortgage you are considering. You must consider your current and future income, how likely you are to move and when, how much discipline you have to save or invest for future mortgage payments, as well as how you can deal with the fluctuation of a mortgage payment. You'll be glad you thoroughly researched your choices once you have matched the perfect home with the perfect mortgage for your situation.


Sources:
Federal Reserve Board
The Department of Housing and Urban Development
reverse.org