Mortgage Fundamentals

As the word is commonly used, a mortgage is a loan to buy real property that is secured by that property. The borrower hypothecates the property, pledging the property as security for a loan but retaining the right to possess it. Real property is land and anything permanently attached to it, such as buildings and trees. A mortgage is actually composed of 2 parts: a promissory note and the mortgage itself, which gives the lender a security interest in the property. The promissory note is a written contract specifying the details of the loan and the borrower's promise to repay the loan to the lender.

Mortgages as Security Instruments

Most people refer to loans to buy real estate as mortgages, even when the security is not really a mortgage, but a deed of trust. A mortgage is a written contract specifying how the property will be used as security for the loan. Almost always, a primary mortgage lender will have a first lien on the property, giving the lender priority over all other lien holders, except for tax liens, which is why all due taxes have to paid before closing, and the mortgagor, or the borrowing buyer of the real estate, will usually have to pay money into an escrow account for taxes and insurance to protect the lender's interest. However, the title is in the name of the mortgagor and if the mortgagor defaults, then the mortgagee — the lender — must go to court to foreclose on the property, which, if approved by the court, will result in a foreclosure sale, where the property will be sold to the highest bidder. However, all states have a redemption period, allowing the borrower to cure the default by redeeming the property within the redemption period; afterwards, the borrower loses the property completely.

In many states, a deed of trust secures the property for the lender. The deed of trust is a special deed, not a contract, giving title to a trustee, a neutral third party who is not partial to either the lender or the borrower. The lender is the beneficiary. If the borrower, the trustor, defaults on the loan, then the lender asks the trustee to foreclose on the property. The trustee follows the procedure specified in the deed of trust and state law to foreclose on the property.

Lenders prefer a deed of trust as security because it is faster and cheaper to foreclose on the property. Nonetheless, mortgages are still the prevalent security instrument in the United States, especially in the east. However, states differ as to whom actually owns the mortgaged property. Those states that treat borrowers as the owners and mortgages as liens on the property held by the mortgagee are known as lien theory states. In these states, the lender must go to court to foreclose. States that treat the mortgage as a conveyance of the title from the mortgagor to the mortgagee for the term of the loan are called title theory states. Title-theory states allow the lender to sell the property without going to court, but strict procedures must be followed, including providing the borrower with adequate notice that the property can be redeemed within a period designated by state statute; the property cannot be sold before the end of the redemption period.

Loan Fundamentals: Principal, Interest, Term, Payment, and Amortization

A loan to buy real estate is like any other loan. The principal is the amount of the loan, the interest is what is charged for giving the loan, and the term is the amount of time you have to repay the loan. The interest is a percentage of the remaining principal, calculated by multiplying the interest rate times the remaining principal. Amortization is the process by which the principal is reduced through periodic payments. The loan is amortized, or paid back, through monthly payments of interest and principal. Because the terms of mortgage loans are usually a decade or longer, the interest portion of the monthly payments is much larger in the beginning. For a 30 year mortgage, it takes a little more than 20 years before the principal portion of the monthly payment becomes larger than the interest portion. Most mortgages are fully amortizing, meaning that the loan will be paid off when the last payment is made.

Note, also, that monthly mortgage payments may include money for taxes and insurance, which protects the lender's security interest.

Points, Private Mortgage Insurance (PMI), and Other Fees

There are various other fees for getting a mortgage: the processing fee, which may include a credit report fee, points, and possibly private mortgage insurance. These are fees charged by and collected by the lender, and must be included in the annual percentage rate (APR) that the lender must disclose. There are other fees that are required by the lender, but must be paid to 3rd parties, such as a home inspection fee or a title search fee. These fees are not included in the APR because the lender has no control over these fees. Note, however, that the APR is calculated using the full term of the loan. If the loan is paid off early, through refinancing or the sale of the home, for instance, then the actual APR will be higher — the shorter the loan term, the higher the APR.

Points, sometimes called loan origination fees, are expressed as a percentage of the loan amount. Thus, 1 point equals $1,000 on a $100,000 loan. Points are prepaid interest, which lowers the monthly interest rate charged on the loan. Because points are prepaid interest, like mortgage interest, they are tax deductible. If the loan is an original mortgage, points can be deducted in the year they are paid; however, in refinancing, they must be prorated and deducted over the life of the loan.

Because foreclosure and selling property costs money, the down payment must be large enough to cover these costs for the lender. When the down payment is less than 20%, then the lender may require private mortgage insurance (PMI). The cost of PMI includes an origination fee and monthly premiums. PMI is not tax deductible and can cost $1,000 or more annually. The cost of PMI is proportional to the loan-to-value ratio (LTV), which is the loan amount divided by the appraised real estate value. The greater the LTV, the more PMI will cost. The premiums for adjustable-rate mortgages is higher than for fixed rate because of the interest rate risk. PMI can be discontinued when the LTV exceeds 20%, either because the principal has been paid down, or the property has appreciated in value. However, to take advantage of property appreciation, an appraisal must be done, usually costing several hundred dollars.

Prepayment Penalties

Prepayment penalties are sometimes included in the loan terms in those states that allow it. When it is assessed and how much is determined by the contract. Typical values for the penalty may be up to 3% of the loan, or 6 months interest. Prepayment penalties may be waived by the lender if the borrower gets a new loan from the lender or sells the real estate.

If there is a prepayment penalty, what are its terms? Prepayment might be allowed up to a certain percentage (ex: 20%) without penalty, or a prepayment of a specific amount or percentage of the mortgage, quarterly, yearly, or for some other term may be allowed. The prepayment penalty might be limited to a shorter term than the loan term, or may decline with the loan — example: 5% for the 1st year, 4% for the 2nd, etc.

Tip: It is best to avoid loans with prepayment penalties. Even when the penalty is limited, it is almost always in effect at the beginning of the loan when prepayments would save the most money for the borrower. Prepayment penalties are not allowed in government-guaranteed loans. Read the federal truth-in-lending disclosure and promissory note to ensure that prepayment penalties are not being charged. If a prepayment penalty is specified in the contract, then there is a prepayment penalty regardless of what the lender says.

Mortgage Categories

Mortgages can be categorized in several ways, but the most fundamental and important classification is whether the interest rate is fixed or adjustable over the term of the loan. Because a fixed interest rate incurs an interest rate risk to the lender, the longer the period with a fixed interest rate, the higher the interest rate will be.

Government and Conventional Mortgages

Government loans are loans that are guaranteed by an agency of the federal government; otherwise, they are conventional loans. None of these agencies lend money; they merely guarantee the loans made by approved lenders. The Federal Housing Administration (FHA), started in 1934, guarantees loans for low-to-moderate income people to buy homes. The Department of Veteran Affairs (VA), started in 1944, guarantees mortgages for military people and veterans. The Farmers Home Administration (FmHA) insures mortgages for farms or houses in rural areas.

These loans benefit low- to moderate-income people because there is little or no down payment, and they have long terms, lower interest rates, and no prepayment penalty. However, the mortgage amount is limited, and it takes a long time to get these loans, which is why in a bidding, people with conventional mortgages usually win because of faster financing. The ratio of people with government mortgages to conventional mortgages is about 20/80.

Conforming or Jumbo Mortgages

Most lenders sell their mortgages in the secondary mortgage market. The federal government has sponsored agencies, the Federal National Mortgage Association (FNMA, Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac) to buy mortgages in the secondary market, securitize them, and sell the resulting securities to investors, yielding a much bigger pool of money for mortgages. These agencies were created to help lower income people afford homes, thus, the mortgage size that can be resold to these agencies is limited. Loans for less than the limits are conforming loans; otherwise, they are jumbo loans; jumbo loans have a 3/8 to 1/2% higher interest rate than conforming loans.

Fixed-Rate Mortgage (FRM)

A fixed-rate mortgage charges a fixed rate of interest over the term of the loan. The most common loan terms are 15 and 30 years. FRMs typically have the highest interest rates, because the lender incurs significant interest rate risk with these loans. The longer the loan term, the greater the interest rate charged. However, many borrowers prefer this type of mortgage because it is easier to plan one's finances when the monthly payment is the same. The payments are fully amortizing. Each payment includes both interest and principal, with initial payments being mostly interest. For a 30-year loan, for instance, it takes a little more than 20 years before the principal portion of each payment exceeds the interest portion.

Below is a bar chart showing the interest and principal components of total yearly payments on a $200,000 mortgage at 6.5% interest. Note that the interest portion constitutes the major portion of the payments for the 1st 20 years.
Bar Chart: 30-year mortgage payments for $200,000 loan at 6.5% interest showing the interest and principal portion of the total payments for each year.

Adjustable-Rate Mortgage (ARM)

The interest rate on adjustable-rate mortgages (ARMs) is adjusted periodically and pegged to some index or other interest rate, such as for Treasury bills, the Cost of Funds Index (COFI), or the London InterBank Offered Rate (LIBOR). The initial interest rate is often a teaser rate — lower than prevailing interest rates to attract borrowers, that is in effect for a short time. Afterwards, the rate is adjusted upward according to the terms of the contract. The interest rate can be adjusted annually, semi-annually, or monthly — called the adjustment period. Because the fixed-rate mortgage has a significant interest-rate risk to the lender, the interest rates on fixed-rate mortgages are always higher than comparable ARMs. The interest rate is the index rate + a margin. Rate caps limit the interest rate change, both up and down. A periodic cap limits how much the interest rate can increase at one time; an aggregate cap limits the total increase allowable over the term of the loan. A payment cap limits the monthly payment to keep it affordable, but it could lead to negative amortization — the principal continues to increase with each payment because the interest due each month exceeds the payment. There may also be a conversion option — during certain periods of time, the borrower can change the ARM into a fixed-rate mortgage.

The adjustment period for an ARM is when the interest rate can be adjusted, which can change every 6 months, annually, or every 3 or 5 years. ARMs are frequently designated by their adjustment period; thus, a 6-month ARM's interest rate is adjusted every 6 months, whereas a 1-year ARM adjusts annually.

The monthly payment is recalculated at each adjustment period using the new interest rate with the new term of the loan being the remaining time, and the loan amount being the remaining principal at the time of adjustment.

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Hybrid, or Fixed-Period ARM

Hybrid mortgages have payments and interest rates that are fixed for a time that may be 3, 5, 7, or 10 years, then becomes an ARM. Hybrids generally have a lower interest rate than a fixed-rate mortgage, and higher than an ARM. However, hybrids frequently have prepayment penalties that are effective for the 1st 3 years of the loan in those states that allow prepayment penalties. Hybrids have less risk for the consumer than an ARM, but more so than a fixed-rate mortgage, and, naturally, the interest rate is also intermediate between the 2 loan types. Hybrids help consumers buy homes by lowering their initial payments because of the lower initial interest rate, or to qualify for a larger loan. Since they are also generally assumable, this helps the homeowner to sell the house.

In addition to ARM caps, a hybrid may also have an initial adjustment cap, which limits how much the interest rate can rise for the 1st time.

Hybrids are concisely expressed as a series of numbers separated by forward slashes, like a date. If there are only 2 numbers, the 1st number designates the length of the fixed period and the 2nd number designates how frequently the interest rate in the adjustable period changes after the fixed period. Thus, a 5/1 hybrid, like the 50-year mortgages that are being sold in California, means that the fixed period is 5 years, and the interest rate of the ARM phase is changed annually.

If there are 3 numbers, then the 1st number designates the loan term. Thus, a 30/7/1 is a 30-year mortgage with a 7-year fixed period, then a subsequent ARM period that is adjusted annually.

Balloon Payment Fixed Mortgages

A balloon mortgage is a mortgage with monthly payments that are not fully amortizing, and have a short term of 5, 7 or 10 years. At the end of the term, the remaining unpaid balance on the mortgage is due. This is called a balloon payment. These loans often have lower interest rates than either 30-year fixed-rate loans or fixed-period ARMs.

This loan is often used because the borrower expects a sum of money in the future, expects to refinance, or expects to sell by then. It allows a lower monthly payment than a fully amortizing loan, thus making it more affordable for more people.

Interest-Only Mortgage (IO)

An interest-only mortgage has an initial period where the monthly payments only cover interest, thus allowing lower initial payments, since nothing is paid toward the principal. However, because most of the initial mortgage payments are mostly interest anyway, this doesn't really lower the payments too much, which is why they are mostly used in jumbo mortgages. The larger the loan amount, then the lower the initial payment of an IO mortgage compared to other mortgage types.

After the initial interest-only period, which may range from 3 to 15 years, the loan becomes fully amortizing — the monthly payment increases substantially to cover both interest and principal for the remainder of the loan term.

An interest-only mortgage can be a fixed-rate mortgage or an ARM, and usually, there are no prepayment penalties. If the mortgage rate is fixed, then monthly payments can be reduced over the loan term by paying toward principal during the interest-only period. After the interest-only period, then the monthly payment amount becomes fixed. Paying more than the minimum simply pays off the loan sooner, just like a regular mortgage. The interest-only period for an ARM or hybrid usually coincides with the initial period of fixed interest; thereafter becoming fully amortizing, with adjustable interest rates.

Although interest-only mortgages sound like a nasty beast, they do have distinct advantages:

The main risk with an IO is payment risk, because at some point, without any prepayments, the monthly payment will increase substantially, and if the mortgage is an ARM, then there will be an interest rate risk as well, because rising interest rates can also increase the monthly payments. Refinancing may not be an option because there is little or no equity in the house, especially if the value of the home has declined, as sometimes does occur in a buyers' market, which also happens to coincide with rising interest rates — a double whammy for someone with an ARM! This scenario puts the seller in a potentially desperate situation, because he may not be able to afford the payments, but he may not be able to sell the property at a high enough price to pay off the mortgage.

A real example of an interest-only mortgage is Fannie Mae's InterestFirst mortgage. This mortgage can be fixed or adjustable. The IO period can be 10 or 15 years for a fixed-rate mortgage, or it can be 3, 5, 7, or 10 years for an ARM.

Example: Fannie Mae's InterestFirst Mortgage

You take out a 30-year fixed-rate mortgage with a 15-year interest-only period.

Loan Amount: $300,000

Annual Interest Rate: 6.5%

Monthly Payment for the 1st 15-year interest-only period: $1,625.00

Total Interest Payments during the IO period: $292,500.00

After the IO period, the payment is recalculated as a 15-year, fully amortizing loan. If you only paid the interest during the 1st 15 years, then the loan amount remains $300,000.

Monthly Payment for remaining 15 years: $2,613.32

Total Interest Paid in this Period: $170,397.60

Total Payments for this period: $470,397.60

Total Interest Payments over the full term of the loan: $462,897.60

Total Payments for $300,000 loan: $762,897.60

Now compare this with a 30-year, fully amortizing loan:

Monthly Payment: $1,896.20

Total Interest Paid: $382,632.00

Total Payments: $682,632.00

As you can see, with this loan, you are paying about 1.5 times the loan amount in interest. During the IO period, your monthly payment is reduced by $271.20 (14%), but after the IO period, your payment will increase by almost $1,000 per month.

Special Mortgages

A growing equity mortgage (GEM) is a fixed-rate mortgage, authorized under Section 245(a), National Housing Act, as amended (12 U.S.C. 17152-10(a)) that has initial payments corresponding to a 30-year fully amortizing mortgage, but the monthly payments are increased every year by 1-5%, depending of which of 5 plans are chosen, so that the mortgage is paid off sooner — 22 years or less. This program was designed to help young families with growing incomes to buy their 1st home, but the Housing and Urban Development (HUD) agency is considering ending this program.

In a reverse annuity mortgage (RAM), or reverse mortgage, the lender pays the home owner, either as a lump sum, monthly payments, or as a line of credit. This fixed-rate mortgage is frequently used by seniors to convert the equity of their home into cash, but without having to move out. The loan is repaid when the house is sold, or from the borrower's estate.

There are many misconceptions and complications about the reverse mortgage. For instance, the reverse mortgage is a non-recourse loan, meaning the lender can only be repaid from the proceeds of the sale of the home — the lender can't go after other assets, even if the sale doesn't cover the loan completely. For more complete information, check out: Consumer Information on Reverse Mortgages from the National Center for Home Equity Conversion.

Financing a Mobile Home

Many people save money by buying a mobile home. Mobile homes, also called manufactured homes, are built in a factory and placed on a trailer chassis for moving. Owners then either rent or buy the land or join a cooperative for the land on which to place the mobile home. However, there are disadvantages to owning a mobile home.

The value of a mobile home will depreciate rapidly. If the mobile homeowner also owns the underlying land, then the land that may appreciate over the years, but the mobile home itself will decline in value. Because most mobile homes lacked permanent foundations, they are more easily damaged by natural disasters, such as storms or earthquakes.

Although, nowadays, mobile homes are better built, there is still a stigma. Mobile homes are difficult to resell, especially if they are already on a rented lot. Moving a mobile home can cost thousands of dollars.

Mobile homes may cost more to own. Mobile home mortgages typically have 15-year terms and interest rates averaging 4% higher than conventional mortgages. According to Mortgages - Changes in Mobile-Home Lending -

Although mobile homes are cheaper to buy, renting land from a landlord can make living in the mobile home an expensive proposition, nullifying the benefit of the lower cost of the mobile home itself. If you do not own the land on which the mobile home is placed, then you become a captive audience, allowing the landlord to jack up your rent continually. Landlords can do this because it is very expensive to move the mobile home once it is set, the number of mobile parks is limited by zoning, and moving the mobile home can weaken the structure. Therefore, it is best to move the mobile home to land that you own or to a mobile park cooperative owned by the people living there.

Obtaining a Mortgage on a Condominium

Obtaining a mortgage or refinancing on a condominium may be problematic, for not only are lenders concerned about the borrower's creditworthiness but also with the condo association's financial statements. Signs that a condo association may experience financial stress may make it harder to get a loan. If too many condos remain unsold, for instance, or if too many condo owners are behind on their condo-association fees, then maintenance costs may have to be increased on the remaining tenants, including the would-be borrowers.

Generally, lenders are reluctant to lend if: