Mortgages Explained
A mortgage is a loan used to purchase property in which that property also serves as collateral for the lender if the borrower fails to pay. For most people, a mortgage is the only route to homeownership. It is also the biggest financial commitment most people make during their lifetimes: loans are typically for hundreds of thousands of dollars and terms often span a 30-year repayment period.
In other words, taking out a mortgage is a major decision. With reams of fine print, it's easy for borrowers to get tripped up in the process. Understanding the basics of how mortgages work will help you avoid surprises and ask the right questions when discussing terms with your lender.
Down Payments Are Back In Vogue
It used to be unheard of to get approved for a mortgage without putting down at least 20% of the home's purchase price. Then came the early 2000's, when lenders got creative and bent mortgage rules to get as many people into homes (and paying interest on mortgages) as possible. In addition to loans structured to increase acceptance rates among poorly-qualified buyers, lenders started offering low- and even no-down payment mortgages.
In case you don't remember how that all turned out, all those easy loans created a housing bubble. The bubble popped just as the economy was turning south and we ended up in the Great Recession.
Since 2009, cooler heads have prevailed. Lenders are back to insisting on a 20% down payment and, in some hotter real estate markets, it's not unheard of for sellers to want a 40% down payment. While you still may be able to find a lender willing to accept lower down payments, you should head into the house buying process expecting to need at least 20% of the purchase price in the bank for a down payment.
What If I Don't Have A 20% Down Payment Saved Up?
There are programs that can get you into your dream home if you haven't been able to save up a 20% down payment. The most common is private mortgage insurance, or PMI.
In short, PMI pays your mortgage if you can't. PMI offers lenders protection and also gives younger people who have not had as many working years to save up a down payment a chance to reap the benefits of home ownership. PMI is a monthly fee added onto your mortgage.
Your mortgage will be structure so that you stop paying the monthly PMI premium as soon as you have 22% equity in your house. And you're still going to need some sort of down payment in the current environment. But PMI can help you turn that $10,000 you have saved into a down payment on a $100,000 house, as opposed to the $50,000 you would be able to finance under the traditional 20% down payment model.
ARMs vs. Fixed-Rate Mortgages
The modern mortgage came into being in 1934 as part of the Federal Housing Administration's effort to pull the country out of the Great Depression and, for most of its history, a 30-year, fixed-rate mortgage has been standard. You and the lender agree to an interest rate at the start of the loan and that rate never changes. As a result, your monthly payment is about the same in year 30 as it was in year one. Fixed-rate mortgages are boring and vanilla but, more importantly, they're predictable.
Then in the 1980s, banks started offering Adjustable Rate Mortgages. ARMs entice borrowers with lower initial rates, but then the rate resets – or adjusts – every year. Part of the housing bust we told you about stemmed from lenders coming up with more and more creative ARMs: too-goo-to-be-true teaser rates, shorter reset periods and no limits on rate increases.
That story didn’t have a happy ending, either: between 2007 and 2010, more than 250,000 American homeowners went into foreclosure. Home repossessions peaked at 1 million homes in 2010. The big culprit ended up being borrowers who didn’t understand the loan agreements they had entered; according to one study, 35% of ARM borrowers were not sure whether there was a cap on how much their interest rate could increase.
As we will discuss, not all ARMs are evil, and not all fixed-rate mortgages are simple. But part of the Great Recession fall-out is the lenders and borrowers alike are feeling more comfortable in longer-term, fixed rate mortgages.
Where Can I Get a Mortgage?
Traditionally, banks have been the mortgage lenders of choice, and many borrowers are happy to use the bank they already use for their checking and savings accounts. Other borrowers will shop around to get the best interest rate, and some even work with mortgage brokers who help them sift through offers and negotiate the best possible deal.
Keep in mind that unlike other types of loans, mortgages contain more than principal and interest fees. There are costs and fees baked into the loan, including one-time charges like closing costs and other costs you pay throughout the loan as part of your monthly payment. A lower interest rate doesn’t always mean the lowest monthly payment, so make sure you understand all the fees and costs included in your mortgage.
Will I Be Approved For My Mortgage?
A lot of factors play into a bank's decision to give you a loan, but there are some general rules of thumb. For starters, having a good credit history, as shown through your credit score, will not only increase your odds of getting approved, but will also lower the interest rate you pay on your mortgage.
Most lenders want a 28/36 debt-to-income ratio, but that varies based on your down payment, the type of loan and other factors. What this means is that housing costs should not exceed 28% of your total income and no more than 36% of your monthly income can go towards paying debt (including your mortgage payment).
For example, let's say you make $60,000 per year, or $5,000 per month. You're looking at a home that, after your down payment, will cost you $1,200 per month. That keeps you below the 28% threshold most lenders require. But you also have a $300 per month car payment, a $350 per month student loan payment and a $100 per month credit card payment. Now your total debt, counting your mortgage, is $1,950 per month, or 39% of your total income, which puts you above the 36% threshold.
Calculators like this one from Redfin are abundant online and can give you a good idea of what price range you should be looking in as you start your house hunt. Keep in mind these are guides and you should talk with your lender for a more accurate estimate of how much house you can afford.
What's Included In My Monthly Payment?
Typically, your monthly payment is the sum of four different payments: there's the money that goes to paying down the principal, there's the interest, there are taxes, and, finally, many mortgage payments include monthly insurance payments.
Taxes typically go into a third-party escrow account, where they are held until property taxes are due. Insurance protects both you and the lender from calamities such as fire, storms, theft and floods. Additionally, you may have to pay mortgage insurance if your down payment is under 20%.
While your monthly payment is fairly consistent over the life of a fixed-rate mortgage, you will notice that you pay much more towards the interest in the principal during the early years of the loan repayment. This helps you avoid a big balloon payment at the end of your mortgage, but it also means it takes longer to build equity in your home.
Take, for instance, a 30-year, $100,000 mortgage at a fixed interest rate of 6%. At the outset, about $500 of your $599 monthly payment goes to interest. Not until year 18 will you be paying more towards the principal than interest. This gradual repayment of the principal and interest is known as amortization.
Calculating Equity
Equity is simply the amount of principal you have paid off. If you secure a mortgage with a 20% down payment, you'll have 20% equity in your home the day you move in. As you chip away at the principal, your equity will increase. Note that the amortization schedule of fixed rate mortgage payments front load interest, so it takes a while to build equity in your home as you don't start making big dents in the principal until later in the life of the mortgage.
Lenders like you to have equity in your home: study after study has shown that the more equity a borrower has in their home, the less likely they are to default.
Pros and Cons of Fixed Rate Mortgages
Fixed-rate mortgages can range from five to 30 years, with 30 years being the most common. Generally speaking, longer loan terms mean lower monthly payments. The downside is that over the life of the loan you end up paying more interest than if you select a shorter loan term with higher monthly payments.
The appeal of fixed-rate loans is their predictability: interest and principal payments are the same, meaning you only have to prepare for changes in insurance and property tax rates.
The interest rate charged has nothing to do with the length of your loan. Instead, interest rates are offered by lenders based on the borrower's credit history. Many borrowers prefer the predictability of fixed-rate mortgages, but some people who want a lower interest rate opt for Adjustable Rate Mortgages.
Pros and Cons of Adjustable Rate Mortgages
Adjustable Rate Mortgages offer borrowers low interest rates at the start of the loan, making them a favored choice for people planning to stay in the house for a short period of time. Most ARMs have rates that change once a year, but there are an increasing number of variations, including rate changes every six months, every two years or so-called 5/1 ARMs, which have a fixed rate for the first five years then adjust every year thereafter.
Regardless of the terms, in the first year ARMs typically offer interest rates a full percentage point lower than fixed-rate mortgages, on average. Interest rate changes are usually tied to an index, and there are often caps on not only how much the rate can increase in a given year but caps on the maximum interest rate over the life of the loan. Simply put, a good ARM will have some protections built into the terms.
Where many people get into trouble with ARMs is that circumstances change. One of the fallouts of the increased use of ARMs that led to the great recession is that when the housing bubble popped, people ended up having to hold onto their houses longer than they had expected, which left them paying the higher rates. Even without an economic calamity, your circumstances may change and you may want to stay in a house longer than you had planned. That could come with a steep increase in your monthly payment.
Other Types Of Mortgages
While fixed-rate and ARMs are the most common types of mortgages, there are other types of mortgages available.
Balloon Mortgages
A balloon mortgage offers borrowers terms over 5-7 years that are amortized as if they were a 30-year mortgage. This gives the borrower low monthly payments. The tradeoff is that they owe the balance of the loan – the balloon, so to speak – after that 5-7 year term.
Reverse Mortgages
Reverse mortgages have high closing costs but can offer income to people over 62 who have built up equity in their home. Essentially the bank pays you monthly, and then you repay the bank when you sell your home. You will also still be responsible for taxes and insurance on the home.
Guaranteed Mortgages
Several branches of the federal government, including the Federal Housing Administration, the Department of Housing and Urban Development, the Veterans Administration, and the Rural Housing Service, guarantee mortgages secured from pre-approved lenders. Because the loan will be paid by the federal government if the borrower fails to make payments, lenders working within these programs will often waive down payment requirements and offer lower interest rates.