Mortgage Basics
Mortgages are long-term loans that use real estate as
collateral. Mortgages are typically used for buying one home
but can serve as collateral for more than one mortgage. When
this is the case, the second mortgage is typically used to
finance home improvements or another purchase such as a car
or boat. Mortgages are defined by their terms, such as the
time frame of repayment and whether the interest rate is
fixed or adjustable.
Conventional Mortgages
Conventional mortgages are not insured or subsidized by the
government. Most lenders require a down-payment of at least
20% on a conventional loan, but offer them with lower
down-payments if the buyer purchases private mortgage
insurance (PMI). PMI protects the lender if the home owner
defaults on the mortgage.
Conventional mortgage loans are generally fully amortizing.
This means that the regular principal and interest payment
will pay off the loan in the number of payments stipulated
on the note.
Mortgages are described by the length of time for repayment
and whether the interest rate is fixed or adjustable. Most
conventional mortgages have time frames of 15 to 30 years
and may be either fixed-rate or adjustable. While most
mortgages require monthly payments of principal and
interest, some offer bi-weekly payment options.
Home buyers who can afford the higher monthly payment
sometimes prefer a 15-year conventional mortgage over a
30-year mortgage. Interest rates on 15-year mortgages
usually are a little lower than 30-year rates. In addition,
a home buyer financing a home purchase with a 15-year
mortgage will repay principal much faster and will pay far
less interest over the life of the loan.
The 30-Year Fixed Rate Mortgage
With a 30-year fixed rate mortgage, the homebuyer pays off
the principal and interest on the loan in 360 equal monthly
payments. The monthly payment for principal and interest
remains the same during the full loan period.
The 15-Year Fixed Rate Mortgage
The 15-year fixed-rate mortgage is paid off in 180 equal
monthly payments over a 15-year-period. A 15-year mortgage
typically requires larger monthly payments than a 30-year
loan and allows an individual to pay off a mortgage in half
the time as well as save on interest. For example, monthly
principal and interest payments on a $100,000 mortgage at
7.25 percent interest are $682 when repaid over 30 years and
$913 when repaid over 15 years. However, the buyer can save
thousands of dollars on interest charges by using the
15-year mortgage. Fifteen-year mortgages typically carry
interest rates a little lower than those for 30-year loans.
Adjustable Rate Mortgages (ARMs)
With a fixed-rate mortgage, the interest rate stays constant
during the life of the loan. But with an ARM, the interest
rate changes periodically, usually in relation to an index
such as the national average mortgage rate or the Treasury
Bill rate. Payments can go up or down accordingly.
Initial interest rates for ARMs are generally lower those
for fixed-rate mortgages. This makes the ARM easier on your
payments at first than a fixed-rate mortgage for the same
amount. It also may help you qualify for a larger loan
because lenders sometimes make this decision on the basis of
your current income and the first year's payments. Moreover,
an ARM could be less expensive over a period of time than a
fixed-rate mortgage -- for example if interest rates remain
steady or move down.
Against these advantages, you have to discern the risk that
an increase in interest rates would lead to higher monthly
payments in the future. It's a trade-off: you get a lower
rate with an ARM in exchange for assuming more risk.
Here are some things to consider with an ARM:
- Is your
income likely to rise enough to cover higher mortgage
payments if interest rates go up?
- Will you be taking on other sizable debts, such as a
car loan or school tuition, in the near future?
- How long do you plan to own this home? (If you plan on
selling soon, rising interest rates may not pose the
problem they would if you plan to own the house for a
long time.)
- Can your payments increase even if interest rates
generally do not increase?
- What index is used to adjust the mortgage rate? Try to
obtain a table showing movements in the index over the
past 10 years to see how your mortgage payments could
change.
- How often will the mortgage be adjusted? One year?
Three years? The longer the adjustment period, the
better you will be able to plan your future expenses.
- What is the initial mortgage rate? Does it include a
special discount? Is there an increase in your monthly
payments when your rate is adjusted for the first time?
- What is the margin on the interest rate? The margin is
the amount that the lender adds to the index rate to
calculate your mortgage rate. For instance, if the index
rate is 6 percent and the margin is 2 percent, your
overall interest rate would be 8 percent.
- What limits or caps have been placed on the periodic
adjustments? One of the most important items to discuss
with your lender is the maximum amount that your rate
can increase in any single adjustment period and over
the life of the mortgage. Find out the "worst case"
scenario in the event of a sharp increase in your index
rate.
- Can negative amortization occur? When negative
amortization occurs, the monthly payments do not cover
the full amount of principal and interest, so the amount
of principal that you owe actually increases. Find out
any limits there are on negative amortization.
- Does the mortgage have a convertible feature? If so,
is there a cost to convert? This option allows you to
change your ARM to a fixed-rate loan at some designated
time in the future.
- Is there a prepayment penalty if you sell your house
and pay off your loan early?
Other types of
conventional mortgages
Balloon mortgages are a non-amortizing loan. In other words,
the periodic principal and interest payments do not pay off
the loan within the term. Some balloon mortgages may have a
principal and interest payment that is calculated as if it
would pay off the loan in 30 years, but the loan comes due
in 5 or 7 years. Some lenders offer terms for renewal of the
loan at the balloon date if certain conditions, such as a
history of timely payment, are met. Some loans may contain
provisions to be rewritten as a fixed- or adjustable-rate
amortizing loans with the monthly principal and interest
payment based on the balance remaining on the balloon
payment date.
Bi-weekly mortgages provide a way for paying off a mortgage
more quickly. With a bi-weekly mortgage, the borrower makes
half the regular monthly payment every two weeks. Because
there are 26 two-week periods in the year, the borrower
makes the equivalent of 13 monthly payments each year. This
allows borrowers to complete payment on a 30-year mortgage
within 16 to 22 years. The lower the interest rate, the
longer the term of the mortgage required for pay-off. To
reduce the paperwork associated with the extra payments,
lenders typically require that payments be deducted
automatically from a borrower's checking account. Bi-weekly
payments may be used with either 30-year or 15-year
mortgages.
Some builders provide concessions to buy down interest rates
for one to three years or for the term of the mortgage to
help their buyers qualify for mortgages during periods of
especially high interest rates. This allows lenders to
maintain the necessary yield on the mortgage.
Shared equity loans treat the purchase of a home as an
investment that can be split between a resident owner and an
investment owner. The investment owner contributes a share
of the down-payment, the monthly payments, or both, and
proportionately shares in the ownership of the home. At
resale, the borrower and the investor split the proceeds
after repayment of the balance of the mortgage. Both buyers
may also share the tax benefits, but the type and amount of
tax deduction would depend on the type of agreement. Many
lenders limit this kind of loan to immediate family members.
FHA Mortgages
The Federal Housing Administration (FHA) operates several
low down-payment mortgage insurance programs that homebuyers
can use to purchase a home with a down-payment of 3 percent
or less of the cost of the home. The most commonly used FHA
program is the 203(b) program which provides for down
payment assistance on one- to four-family homes. The maximum
loan amount for a one-family home varies from $67,500 to
$152,362 depending on local median prices.
FHA loans are available from most of the same lenders who
offer conventional loans. Your loan officer can provide more
details about FHA-insured mortgages and the maximum loan
amount in the area you are looking.
VA Mortgages
If you are a veteran or active duty military personnel, you
might be able to obtain a mortgage guaranteed by the
Department of Veterans Affairs (VA). VA-guaranteed loans
require little or no down-payment.
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