What is a Mortgage? – Part Two

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Last time, we went over the basics of what a mortgage is. Today, we’ll continue by discussing other important terms you should consider when it comes to choosing between different mortgages:

  • Principal: The amount of money you borrow from the lender. The more you put down in the down payment (the amount of money you pay upfront to buy your home), the less your principal is. The general down payment is 20%, however, you can find mortgages that require as little as 3% – 5% down payment (meaning your principal is larger).
  • Amortization: The process of spreading out your loan into fixed payments over time to pay off your loan. While your total payments remain the same for each period, the amount of interest and principal will differ. This allows borrowers to pay off the loan fully instead of having a balloon mortgage at the end of the loan term.
  • Loan Term: The loan term will determine the length of your mortgage. Generally speaking, the longer the loan term, the longer it’ll take for you to build up equity (the value of your home minus your remaining principal balance). Currently, the most common loan terms are:
    • 15-year fixed-rate: These loans generally have lower interest rates and allow borrowers to pay off their loan quicker and accrue equity faster. However, due to the shorter length of the loan, borrowers will have higher monthly payments.
    • 20-year: While harder to find than the 15 or 30-year loans, 20-year loans offer lower monthly payments but higher interest rates than the 15-year loan.
    • 30-year: Considered the longest loan term, the 30-year loan has the highest interest rates but allows you to deduct the most interest payments from your taxes and gives you the lowest monthly payments.
  • Payment Plans: While the most common payment plans are on a monthly basis. Consider also paying bi-weekly to shave off years of your overall loan term.
  • Origination Fees: How lenders make money up-front on your mortgage loans. This fee is usually 0.5% – 1% of the total loan.
  • Annual Percentage Rate (APR): The APR allows you to make a true comparison between the actual costs of loans. It’s the average annual finance charge (includes fees and other loan costs) divided by the amount borrowed (generally expressed as an annual percentage rate). The APR is going to be slightly higher than the interest rate because the fees usually included in the APR calculation includes origination fees, points, buy down fees, prepaid mortgage interest, mortgage insurance premiums, application fees and underwriting costs. Remember, the length of time you stay in the home before you sell or refinance influences the effective interest rate you get. Meaning if you move quicker than you could have an effectively higher interest rate.
  • Interest Rate: The amount of interest due per period, as a proportion of the amount borrowed. Interest paid on a mortgage is tax deductible if itemized on a tax return.
  • Insurance: Most mortgages will require you to buy insurance to protect the property. As mentioned earlier in the article, if you put down less than 20% in down payment then you may also have to purchase PMI. Other insurances you might have to purchase are outlined here.
  • Points: An upfront fee a borrower can pay to lower the ongoing interest rate by a fixed amount. This amount is generally around 1% of the total mortgage amount. It only makes sense to pay for points if you are planning to live in your purchased home for a while. Points paid are tax deductible.
  • Closing Costs: Costs associated with the closing of your purchase. This cost is made up of a variety of fees charged by the lender such as underwriting, appraisal costs, title insurance costs, and processing charges, etc. You may be able to shop around and negotiate for lower fees.

Along with these terms, you’ll also need to make sure you’re aware of the other most common types of mortgages that you might run into. For example:

  • Fixed Rate Mortgages (FRM) vs Adjustable Rate Mortgages (ARM): The primary difference between the two are whether or not the interest rate changes over the loan term.
    • FRMs – Offers the same interest rate over the loan term
      • Monthly payments for FRMs will remain the same for the life of the loan. However, the portion of the mortgage payment that pays down the principal of the loan and the portion that pays off interest does change due to amortization. Generally speaking, in the beginning of the loan term, more of your mortgage payment will go towards paying off interest rather than the principal.
      • FRMS are quite attractive to those who want to stay in their home for decades because of its long-term stability. However, this means that FRMs don’t always offer the lower interest rates.
    • ARMs – Offers interest rates that change (usually once a year) according to market conditions
      • Due to the changing interest rates, the size of your mortgage payments for ARMS will change.
      • ARMs are attractive because their initial interest rates are usually significantly lower than FRMs, making them better for those who may want to sell their homes in a few years.
      • On top of loan terms, something else to consider with ARMs is the adjustment period, how often the interest rate on an ARM changes. Interest rates can adjust monthly, quarterly, annually, every three years, etc. There are also hybrids such as the 5/1 where rates remain fixed for 5 years then start adjusting annually for the rest of the loan term.
      • Be sure to also check the cap on how high your interest rate can go over the loan term and also how much it can change with each adjustment. You should only sign up for an ARM with a cap.
      • Finally, check which index your ARM is tied to because if those rates go up then your interest goes up to and vice versa.
    • Balloon Mortgages: These are short term mortgages (five to seven year) that are amortized as if they were 30 year loan term mortgages. So you get five to seven year with a relatively low monthly payment but at the end of these years, you’ll have to pay the lender the remaining balance on the principal – which can be whole lot. Many people only choose this type of mortgage if they are planning to refinance or flip the home in a few years.
    • Reverse Mortgages: As the name indicates, instead of paying mortgages to the lender, the borrower can relinquish a part of their equity in their homes and convert that into cash (meaning the lender will pay them instead). The borrower does not have to give up their ownership of the property and does not have to pay back the loan unless they sell or vacate the property. This type of loan was designed for homeowners over the age of 62, who need an inflow of cash, who have kept current on property taxes and homeowners insurance.

Next time, we’ll talk about the process of getting for a mortgage.

Missed the first part of the blog post? Don’t worry, check it out here!