How Does a Mortgage REALLY Work? – Local Records Office
LOCAL RECORDS OFFICE: Buying a home is the embodiment of the American dream. However, that wasn’t always the case: In fact, before the 1930s, only four in 10 American families owned their own home, says Local Records Office. That’s because very few people had enough cash to buy a home in one lump sum. And until the 1930s, there was no such thing as a bank loan specifically designed to purchase a home, something we now know as a mortgage.
In simple terms, a mortgage is a loan in which your house functions as the collateral. The bank or mortgage lender loans you a large chunk of money (typically 80 percent of the price of the home), which you must pay back — with interest — over a set period of time. If you fail to pay back the loan, the lender can take your home through a legal process known as foreclosure.
For decades, the only type of mortgage available was a fixed-interest loan repaid over 30 years. It offers the stability of regular — and relatively low — monthly payments. In the 1980s came adjustable rate mortgages (ARMs), loans with an even lower initial interest rate that adjusts or “resets” every year for the life of the mortgage. At the peak of the recent housing boom, when lenders were trying to squeeze even unqualified borrowers into a mortgage, they began offering “creative” ARMs with shorter reset periods, tantalizingly low “teaser” rates and no limits on rate increases.
When you couple bad loans with a bad economy, you get rampant foreclosures. Since 2007, more than 250,000 Americans have entered foreclosure proceedings every month. Now those foreclosures are turning into full-on repossessions, which are expected to reach 1 million homes in 2010.
Looking back at the flood of foreclosures since the housing crash, it’s clear that many borrowers didn’t fully understand the terms of the mortgages they signed. According to one study, 35 percent of ARM borrowers did not know if there was a cap on how much their interest rate could rise. This is why it’s essential to understand the terms of your mortgage, particularly the pitfalls of “nontraditional” loans.
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 plain English, a mortgage is a loan. For many people, it’s the biggest loan they will ever borrow. With a regular loan, there’s no explicit collateral. The lender looks at your credit history, your income and your savings, and determines if you’re a good risk. With a mortgage, the collateral for the loan is the house itself. If you don’t pay back the loan (along with all of the fees and interest that are included with it), then the lender can take your house.
Banks are the traditional mortgage lender. You can either apply for a mortgage at the bank you use for your checking and savings accounts, or you can shop around to other banks for the best interest rates and terms. If you don’t have the time to shop around yourself, you can work with a mortgage broker, who sifts though different lenders to negotiate the best deal for you. Banks aren’t the only source of mortgages, though: Credit unions, some pension funds and various government agencies also offer mortgages.
Like other loans, mortgages carry an interest rate, either fixed or adjustable, and a length or “term” of the loan, anywhere from five to 30 years. Unlike most other loans, mortgages carry a lot of associated costs and fees. Some of those fees only happen once, such as closing costs, while others are tacked onto the mortgage payment every month.
History of Mortgages
You may think mortgages have been around for hundreds of years — after all, how could anyone ever afford to pay for a house outright? It was only in the 1930s, however, that mortgages actually got their start. It may surprise you to learn that banks didn’t forge ahead with this new idea; insurance companies did. These daring insurance companies did this not in the interest of making money through fees and interest charges, but in the hopes of gaining ownership of properties if borrowers failed to keep up with the payments.
It wasn’t until 1934 that modern mortgages came into being. The Federal Housing Administration (FHA) played a critical role. In order to help pull the country out of the Great Depression, the FHA initiated a new type of mortgage aimed at the folks who couldn’t get mortgages under the existing programs. At that time, only four in 10 households owned homes. Mortgage loan terms were limited to 50 percent of the property’s market value, and the repayment schedule was spread over three to five years and ended with a balloon payment. An 80 percent loan at that time meant your down payment was 80 percent — not the amount you financed! With loan terms like that, it’s no wonder that most Americans were renters.
FHA started a program that lowered the down payment requirements. They set up programs that offered 80 percent loan-to-value (LTV), 90 percent LTV, and higher. This forced commercial banks and lenders to do the same, creating many more opportunities for average Americans to own homes.
The FHA also started the trend of qualifying people for loans based on their actual ability to pay back the loan, rather than the traditional way of simply “knowing someone.” The FHA lengthened the loan terms. Rather than the traditional five- to seven-year loans, the FHA offered 15-year loans and eventually stretched that out to the 30-year loans we have today.
Another area that the FHA got involved in was the quality of home construction. Rather than simply financing any home, the FHA set quality standards that homes had to meet in order to qualify for the loan. That was a smart move; they wouldn’t want the loan outlasting the building! This started another trend that commercial lenders eventually followed.
Before FHA, traditional mortgages were interest-only payments that ended with a balloon payment that amounted to the entire principal of the loan. That was one reason why foreclosures were so common. FHA established the amortization of loans, which meant that people got to pay an incremental amount of the loan’s principal amount with each interest payment, reducing the loan gradually over the loan term until it was completely paid off.
The Mortgage Payment
The down payment on a mortgage is the lump sum you pay upfront that reduces the amount of money you have to borrow. You can put as much money down as you want. The traditional amount is 20 percent of the purchasing price, but it’s possible to find mortgages that require as little as 3 to 5 percent. The more money you put down, though, the less you have to finance — and the lower your monthly payment will be.
The monthly mortgage payment is composed of the following costs, appropriately known by the acronym PITI:
- Principal – The total amount of money you are borrowing from the lender (after your down payment)
- Interest – The money the lender charges you for the loan. It’s a percentage of the total amount of money you’re borrowing.
- Taxes – Money to pay your property taxes is often put into an escrow account, a third-party entity that holds accumulated property taxes until they’re due.
- Insurance – Most mortgages require the purchase of hazard insurance to protect against losses from fire, storms, theft, floods and other potential catastrophes. If you own less than 20 percent of the equity in your home, you may also have to buy private mortgage insurance, which we’ll talk more about later.
With a fixed-rate mortgage, your monthly payment remains roughly the same for the life of the loan. What changes from month to month and year to year is the portion of the mortgage payment that pays down the principal of the loan and the portion that is pure interest. The gradual repayment of both the original loan and the accumulated interest is called amortization.
If you look at the amortization schedule for a typical 30-year mortgage, the borrower pays much more interest than principal in the early years of the loan. For example, a $100,000 loan with a 6 percent interest rate carries a monthly mortgage payment of $599. During the first year of mortgage payments, roughly $500 each month goes to paying off the interest; only $99 chips away at the principal. Not until year 18 does the principal payment exceed the interest.
The advantage of amortization is that you can slowly pay back the interest on the loan, rather than paying one huge balloon payment at the end. The downside of spreading the payments over 30 years is that you end up paying $215,838 for that original $100,000 loan. Also, it takes you longer to build up equity in the home, since you pay back so little principal for so long. Equity is the value of your home minus your remaining principal balance.
Not that long ago, there was only one type of mortgage offered by lenders: the 30-year, fixed-rate mortgage. A fixed-rate mortgage offers an interest rate that will never change over the entire life of the loan. Not only does your interest rate never change, but your monthly mortgage payment remains the same for 15, 20 or 30 years, depending on the length of your mortgage. The only numbers that might change are property taxes and any insurance payments included in your monthly bill.
The interest rates tied to fixed-rate mortgages rise and fall with the larger economy. When the economy is growing, interest rates are higher than during a recession. Within those general trends, lenders offer borrowers specific rates based on their credit history and the length of the loan. Here are the benefits of 30, 20 and 15-year terms:
- 30-year fixed-rate — Since this is the longest loan, you’ll end up paying the most in interest. While that might not seem like a good thing, it also allows you to deduct the most in interest payments from your taxes. This long-term loan also locks in the lowest monthly payments.
- 20-year fixed-rate — These are harder to find, but the shorter term will allow you to build up more equity in your home sooner. And since you’ll be making larger monthly payments, the interest rate is generally lower than a 30-year fixed mortgage.
- 15-year fixed-rate — This loan term has the same benefits as the 20-year term (quicker payoff, higher equity and lower interest rate), but you’ll have an even higher monthly payment.
There is a long-term stability to fixed-rate mortgages that many borrowers find attractive– especially those who plan on staying in their home for a decade or more. Other borrowers are more concerned with getting the lowest interest rate possible. This is part of the attraction of adjustable-rate mortgages, which we’ll talk about next.
An adjustable-rate mortgage (ARM) has an interest rate that changes — usually once a year — according to changing market conditions. A changing interest rate affects the size of your monthly mortgage payment. ARMs are attractive to borrowers because the initial rate for most is significantly lower than a conventional 30-year fixed-rate mortgage. Even in 2010, with interest rates on the 30-year fixed mortgage at historic lows, the ARM rate is almost a full percentage point lower. ARMs also make sense to borrowers who believe they’ll be selling their home within a few years.
If you’re considering an ARM, one important thing to remember is that intentions don’t always equal reality. Many ARM borrowers who intended to sell their homes quickly during the real estate boom were instead stuck with a “reset” mortgage they couldn’t afford. Many of them never fully understood the terms of their ARM agreement. Here are the key numbers to look for:
- How often your interest rate adjusts — A conventional ARM adjusts every year, but there are also six-month ARMs, one-year ARMs, two-year ARMs and so on. A popular “hybrid” ARM is the 5/1 year ARM, which carries a fixed rate for five years, then adjusts annually for the life of the loan. A 3/3 year ARM has a fixed rate for the first three years, then adjusts every three years.
- There will also be caps, or limits, to how high your interest rate can go over the life of the loan and how much it may change with each adjustment. Interim or periodic caps dictate how much the interest rate may rise with each adjustment and lifetime caps specify how high the rate can go over the life of the loan. Never sign up for an ARM without any caps!
- The interest rates for ARMs can be tied to one-year U.S. Treasury bills, certificates of deposit (CDs), the London Inter-Bank Offer Rate (LIBOR) or other indexes. When mortgage lenders come up with their ARM rates, they look at the index and add a margin of two to four percentage points. Being tied to these index rates means that when those rates go up, your interest goes up with it. The catch? If interest rates go down, the rate on your ARMs may not. In other words, read the fine print.
Now let’s look at some of the less common mortgage options, like government-sponsored loans, balloon mortgages and reverse mortgages.
Other Types of Mortgages
Let’s start with a risky type of mortgage called a balloon mortgage. A balloon mortgage is a short-term mortgage (five to seven years) that’s amortized as if it’s a 30-year mortgage. The advantage is that you end up making relatively low monthly payments for five years, but here’s the kicker. At the end of those five years, you owe the bank the remaining balance on the principal, which is going to be awfully close to the original loan amount. This “balloon” payment can be a killer. If you can’t flip or refinance the home in five years, you’re out of luck.
Reverse mortgages actually pay you as long as you live in your home. These loans are designed for homeowners age 62 and older who need an inflow of cash, either as a monthly check or a line of credit. Essentially, these homeowners borrow against the equity in their homes, but they don’t have to pay the loan back as long as they don’t sell their homes or move. The downside is that the closing costs can be very high, and you still have to pay taxes and mortgage insurance.
Three agencies of the federal government work with lenders to offer discounted rates and loan terms for qualifying borrowers: Federal Housing Administration (FHA), which is part of the U.S. Department of Housing and Urban Development, the Veterans Administration (VA) and the Rural Housing Service (RHS), which is a branch of the U.S. Department of Agriculture.
These agencies don’t directly lend money to borrowers. Rather, they insure the loans made by approved mortgage lenders. This includes the refinancing of mortgages that have become unaffordable. Borrowers with bad credit histories might 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 pick up the bill. FHA loans only require a 3 percent down payment, all of which can come from a family member, employer or charitable organization. Commercial mortgages wouldn’t allow that.
Veterans Administration loans, like FHA loans, are guaranteed by the agency, not lent directly to borrowers.VA-backed loans offer generous terms and relaxed requirements to qualified veterans. Vets can pay no money down as long as the home price doesn’t 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.
Probably one of the most confusing things about mortgages and other loans is the calculation of interest. With variations in compounding, terms and other factors, it’s hard to compare apples to apples when comparing mortgages. Sometimes it seems like we’re comparing apples to grapefruits.
For example, what if you want to compare a 30-year fixed-rate mortgage at 7 percent with one point to a 15-year fixed-rate mortgage at 6 percent with one-and-a-half points? First, you have to remember to also consider the fees and other costs associated with each loan. How can you accurately compare the two? Luckily, there’s a way to do that. 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) that you hear so much about allows you to make true comparisons of the actual costs of loans. The APR is the average annual finance charge (which includes fees and other loan costs) divided by the amount borrowed. It is expressed as an annual percentage rate — hence the name. The APR will be slightly higher than the interest rate the lender is charging 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.
Here’s an example of how the APR works. You see an advertisement offering a 30-year fixed-rate mortgage at 7 percent with one point. You see another advertisement offering a 30-year fixed-rate mortgage at 7 percent with no points. Easy choice, right? Actually, it isn’t. Fortunately, the APR considers all of the fine print.
Say you need to borrow $100,000. With either lender, that means that your monthly payment is $665.30. If the point is 1 percent of $100,000 ($1,000), the application fee is $25, the processing fee is $250, and the other closing fees total $750, then the total of those fees ($2,025) is deducted from the actual loan amount of $100,000 ($100,000 – $2,025 = $97,975). This means that $97,975 is the new loan amount used to figure the true cost of the loan. To find the APR, you determine the interest rate that would equate to a monthly payment of $665.30 for a loan of $97,975. In this case, it’s really 7.2 percent.
So the second lender is the better deal, right? Not so fast. Keep reading to learn about the relation between APR and origination fees.
The Origination Fee
The origination fee is how lenders make money up front on your mortgage loan. Origination fees are calculated as a percentage of the total loan, usually between 0.5 and 1 percent on U.S. mortgages. Going back to our APR example, let’s say that the second lender charges a 3 percent origination fee, plus an application fee and other costs totaling $3,820 at closing. That brings the new loan amount down to $96,180, which yields an APR of 7.39 percent. So there you have it: Although the second lender advertised no points, it ended up with a higher APR because of its steep origination fee.
The take home message is simple: Don’t just look at the interest rate. Ask for the APR and compare it with other lenders. Also, make sure you know which fees are being included in the APR calculation. Typically, these include origination fees, points, buy-down fees, prepaid mortgage interest, mortgage insurance premiums, application fees and underwriting costs. But note that some fees are charged by all lenders and are non-negotiable, such as title insurance and appraisals.
Luckily, you don’t have to calculate the APR on your own. The lender will give it to you when it gives you the Federal Truth in Lending Disclosure; you just have to understand its importance.
Here are some other things to take into account when you examine the APR:
- The more you borrow, the less impact all of those fees will have on the APR, since the APR is calculated based on the total loan amount.
- The length of time you’re actually in the home before you sell or refinance directly influences the effective interest rate you ultimately get. For example, if you move or refinance after three years instead of 30, after having paid two points at the loan closing, your effective interest rate for the loan is much higher than if you stay for the full loan term.