It is an undeniable fact that many people have the dream of owning their own home. Yet, unfortunately, most of them do not have the financial resources available to make this dream a reality. For most people, the expense associated with purchasing a new home is totally out of their financial means. It is for this reason that there are numerous banks, credit unions and mortgage lenders that operate for the purposes of supplying the funds for people who want to buy a home. This is accomplished through loans called mortgages. They are specifically offered to home buyers.
The terminology of mortgages can be confusing, especially to the uninitiated. As a borrower it is vitally important to have a good understanding of the mortgage loan, including the total cost, the terms and potential risks inherent in the process.
What Is A Mortgage?
A mortgage is simply a form of loan used by prospective home buyers to purchase a new house. Mortgages are the standard method for obtaining home financing. However, there are some essential provisions that are present in mortgage loans that you should be aware of.
When you get a mortgage, you are bound by the terms of a legal contract that includes a provision which states that if you fail to pay the loan (including associated fees and interest), the lender has the right to take the house and sell it to repay the debt. In other words, you will be pledging your home as collateral to secure the mortgage loan.
A Brief History of Mortgages
Early mortgages originated in England when people did not have the financial means to purchase land up front. However, the mortgage as we know today is an instrument of the early 20th century. Interestingly enough, when the mortgage debuted in the 1930s, it was the product of not banking institutions but insurance companies. The motivation of these early insurance companies was not to make a profit off the various fees and interest charges but to gain ownership of the properties from borrowers who defaulted on their loans. Many insurance companies amassed considerable wealth through the ownership of properties gained from defaulted mortgage loans.
In 1934 the Federal Housing Administration (FHA) played a critical role in initiating a new type of mortgage aimed at people who couldn’t get a mortgage under the existing programs. At that time, the United States was in the grips of a serious economic crisis, known as the Great Depression. During this pivotal time, the FHA sought to reinvigorate the economy by offering a new form of mortgage that would allow many more families to purchase a home for the first time.
The existing programs at that time were far more limited than today. In fact, the number of households that owned homes through the mortgage system was about 4 in 10. The mortgages covered only half the cost of the homes. Also, most mortgage terms only lasted about three to five years. Afterwards, the borrower was required to make a balloon payment to pay off the remaining debt. The terms were extremely limiting and most Americans ended up becoming renters of one kind or another.
The FHA began to implement a number of new changes that altered the face of the lending and mortgage market.
1. Lower down payment
The first area of change focused on creating lower down payment requirements which helped a greater number of people with limited financial resources to qualify for a mortgage loan.
2. Greater percentage of the cost of home
Second, the FHA created new types of loans that covered a greater percentage of the cost of homes than previous mortgages. Commercial banks and lenders were forced to change over to these new types of mortgage loans in order to stay in business. This stimulated competition and opened the doors to many new customers who previously had no financial opportunities available to them.
3. Change in the application and qualification process
The third major change instituted by the FHA was a regulatory requirement. In the past, the ability to obtain a loan was often based on personal knowledge or acquaintance with the borrower. The new approach was to create an application and qualification process in getting a mortgage loan. This method was based on the potential borrower’s actual capability to pay back the loan.
4. Longer loan repayment terms
A fourth area of change involved the lengthening of loan repayment terms. While the borrower was required to pay the loan back in only five to seven years before, the FHA created the first loans that were fifteen years in length. Finally, we now have the 30-year mortgages which are so common today.
5. Establishment of home construction standards
The fifth area of change was the FHA’s involvement in the establishment of home construction standards. In the past, it was possible to get financing on any house regardless of its condition. The new regulations made quality standards a part of the mortgage application process.
6. Introduction of the amortization system
Due to the FHA’s activities, commercial lenders continued to change and develop their practices to keep up with the requirements. Most mortgages had been based on an interest-only payment model followed by a balloon payment to take care of the principal at the end of the loan term. This was a major reason for most of the foreclosures on homes up until that time.
The FHA responded by developing the amortization process. This allowed for payments to include not only the interest but a small amount of the principal as well. The loan amount was gradually decreased throughout the course of the loan term until it was paid off entirely.
Anatomy Of A Mortgage Loan
Now let’s have a look at the different aspects of a typical mortgage loan. Every loan is made up of a predetermined series of payments that must be remitted by the borrower over the course of the loan term which is the time period established to pay the loan back. The usual time frames for mortgages vary between twenty and thirty years.
Prior to getting a home loan, you will have to make a deposit or down payment so you can reduce the total amount of money required for mortgage financing. Many home buyers come up with at least a decent amount of money to put toward the down payment. In some cases, the borrower can put down as little as 3-5% of the purchase price of the home. Obviously, the more money you can come up with at the beginning as a down payment, the less financing you will have to request. This means that your monthly mortgage payments will be lower.
PITI (Principal, Interest, Taxes, Insurance)
Once a down payment is made and the financing is settled, your monthly mortgage payments can be calculated. A typical mortgage payment consists of four main components: Principal, Interest, Taxes and Insurance. Collectively, they are known by the single term “PITI.”
The principal is the total amount of money that is being borrowed from the lender once the down payment has been made. This is your financing amount.
The lender charges the borrower a particular amount of money called interest. The interest is typically provided as a percentage of the principal.
As you begin to examine the cost of a mortgage loan, you may get confused about how to calculate the amount of interest you will pay. To calculate this figure, you have to multiply your monthly mortgage payment by the total number of payments you’ll make. Then subtract the principal amount from that number to obtain the interest you have to pay on your mortgage.
Various factors contribute to the amount of interest you will pay on a home loan such as compounding method, length of the repayment term, extra costs and fees relating to processing loan application, down payment, insurance and taxes. It is important to remember that there may be considerable variation in these factors from one loan to another as well as with each lender’s policies.
Often the money that you will use to pay your property taxes is included in your mortgage payment. This is done by using a special escrow account. The escrow account is where the lender deposits a part of your monthly mortgage payment that cover taxes and insurance premiums. By setting aside the money in an escrow account each month, lender makes sure that those obligations are met on time. The escrow account reduces the risk for the lender if you fall behind on your obligations to the government or your insurance provider. This protects the lender from tax liens and uninsured losses. Third party escrow companies hold onto a set amount until certain conditions are met and then pay.
In some cases, you may be able to avoid escrow. Some lenders may permit you to pay your own property taxes and home insurance premiums. This may be possible especially if your loan-to-value (LTV) ratio is below 80%. However, in that case the lender may try to increase your interest rate to compensate for the extra risk it is taking.
As a side note, the loan-to-value (LTV) ratio is a financial term used by lenders which shows how much you’re borrowing against the down payment you put down. LTV ratio is calculated by dividing the amount of money you borrow by the appraised value of the property, expressed as a percentage. For example, if you buy a home with a total appraised value of $100,000 and make a $20,000 down payment, you will borrow $80,000 resulting in an LTV ratio of 80% ($80,000 / $100,000).
A mortgage payment may also include one or more types of insurance coverage such as:
- Hazard insurance: This is for protection or coverage against any loss or damage from fire, storms, theft, etc.
- Flood insurance: This is a form of coverage for those who live in designated flood risk zones. If the mortgage loan you have is one that has been insured by the federal government, some sort of flood insurance is mandatory.
- Private mortgage insurance (PMI): For those who do not have 20 percent equity paid on their home or as a down payment, some form of private mortgage insurance is necessary. The less you put down as a deposit, the more expensive your PMI coverage will be, and the larger your monthly payment will be as well.
Amortization was a later addition and improvement to the mortgage payment process. Amortization is the process of spreading out your loan into a series of equal payments over time. A certain part of each payment goes toward the principal and the other part goes toward the interest. With mortgage loans, the larger portion of each payment goes to pay the interest while the rest pays for the principal. For fixed-rate mortgages, the amount going toward interest declines over time.
When you are looking at different mortgage loan options, there may be different amortization rates with each offer. Amortization rate is the percentage of a periodic payment that is applied to the reduction of the principal. Naturally, the greater the amortization rate you obtain, the more of your principal can be paid for with each payment.
Mortgage loan payments are scheduled and calculated in such a way to ensure that a loan is paid for within a certain time period. Amortization rates are directly linked to the length of the mortgage repayment schedule.
APR (Annual Percentage Rate)
For the benefit of home buyers, the government has provided some clear guidelines that lenders must adhere to in order operate in accordance with the law. Specifically, the Federal Truth In Lending Act was instituted to deal with such issues. One of its chief provisions requires lenders to disclose the effective interest rate and the total amount of the finance charge that will be incurred by the borrower in U.S. dollars.
This is where the annual percentage rate, or APR as it is commonly called, comes handy. By knowing what your APR will be, you can make definite comparisons between different loan quotes and determine what that mortgage loan will actually cost. Here, the APR is your average annual finance charge divided by the total amount you borrowed. This figure also includes fees and other associated loan costs. This sum is your annual percentage rate.
You will notice that the APR is usually higher than the interest rate the lender quotes as it incorporates additional fees and costs including private mortgage insurance, origination fee, mortgage or discount points and premiums.
Mortgage Debt Collection
Depending on the state you live in the United States, the terms by which the mortgage lender may collect debt upon a defaulted mortgage payment may differ. There are two main debt collection approaches that are implemented across the country regarding the property that was pledged as collateral during the loan application process.
Using this approach, the mortgage lender holds the title to your home for the duration of the loan. Title is the legal documentation that shows the ownership of the property, often in the form of a deed. Deed, on the other hand, is the legal document that transfers title from one person to another. The title is returned to the borrower once the debt has been paid in full. If for whatever reason you are unable to make the mortgage payments or default on the loan, the lender can then take the house and resell it to recoup the financial loss it suffered.
With this approach, the mortgage lender takes out what is called a lien which is the “right to take and hold or sell the property of a debtor as security or payment for a debt or duty.” In this approach, the title remains with the buyer. The lender’s lien is removed once the loan is paid off. With the lien, the lender has the right to foreclose on the property and resell it to compensate for the money it lost when the borrower defaulted on the mortgage.