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Mortgage Basics

Posted Tue, July 8, 2008
A mortgage is a long-term loan that uses real estate as collateral. Mortgages are used for buying a home. Sometimes, a home can serve as collateral for more than one mortgage. When this is the case, the second mortgage is typically used to finance home improvements or a major purchase such as a car or camper. Mortgages are described by their terms, such as the time frame for repayment and whether the interest rate is fixed or adjustable.

Conventional Mortgages

A conventional mortgage is one that is not insured or subsidized by the government. Lenders typically require a down payment of at least 20% on a conventional loan, but offer conventional loans with lower down payments if the home buyer purchases private mortgage insurance (PMI). PMI protects the lender if the home owner defaults on the loan. Conventional mortgage loans are typically fully amortizing. This means that the regular principal and interest payment will pay off the loan in the number of payments stipulated on the note. Mortgage loans are described by the length of time for repayment and whether the interest rate is fixed or adjustable. Most conventional mortgages have time frames of 15 to 30 years and may be either fixed-rate or adjustable. While most mortgages require monthly payments of principal and interest, some lenders offer bi-weekly payment options.

Home buyers who can afford the higher monthly payment sometimes prefer a 15-year conventional mortgage over a 30-year mortgage. Interest rates on 15-year mortgages usually are slightly lower than 30-year rates. In addition, a home buyer financing a home purchase with a 15-year mortgage will repay principal substantially faster and will pay far less interest over the term of the loan. The most common types of conventional mortgages include 30-year fixed-rate mortgages,15-year fixed-rate mortgages and Adjustable Rate Mortgages (ARMs).

The 30-Year Fixed-Rate Mortgage

With a 30-year fixed rate mortgage, the buyer pays off the principal and interest on the loan in 360 equal monthly payments. The monthly payment for principal and interest remains the same during the entire loan period.

The 15-Year Fixed-Rate Mortgage

The 15-year fixed-rate mortgage is paid off in 180 equal monthly payments over a 15-year-period. A 15-year mortgage typically requires larger monthly payments than a 30-year loan and allows an individual to pay off a mortgage in half the time as well as save on interest payments. For example, monthly principal and interest payments on a $100,000 mortgage at 8 percent interest are $734 when repaid over 30 years and $956 when repaid over 15 years. However, the buyer can save tens of thousands of dollars on interest charges by using the 15-year mortgage. Fifteen-year mortgages may carry interest rates slightly lower than those for 30-year loans.

Adjustable Rate Mortgages (ARMs)

With a fixed-rate mortgage, the interest rate stays the same during the life of the loan. But with an ARM, the interest rate changes periodically, usually in relation to a specific index such as the national average mortgage rate or the Treasury Bill rate. Payments may go up or down accordingly.

Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. This makes the ARM easier on your pocketbook at first than a fixed-rate mortgage for the same amount. It also means that you might qualify for a larger loan because lenders sometimes make this decision on the basis of your current income and the first year's payments. Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage -- for example if interest rates remain steady or move lower.

Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It's a trade-off: you get a lower rate with an ARM in exchange for assuming more risk.

Here are some things to consider with an ARM:

Is my income likely to rise enough to cover higher mortgage payments if interest rates go up?

Will I be taking on other sizable debts, such as a loan for a car or school tuition, in the near future?

How long do I plan to own this home? (If you plan to sell soon, rising interest rates may not pose the problem they do if you plan to own the house for a long time.)

Can my payments increase even if interest rates generally do not increase?

Here are some other questions to ask:

What index will be used to adjust the mortgage rate? Try to obtain a table showing movements in the index over the previous 10 years to see how your mortgage payments could change.

How often will the mortgage be adjusted? One year? Three years? Five years? The longer the adjustment period, the better you will be able to plan your future household expenses.

What is the initial mortgage rate? Does it include a special discount? If so, you could have a large increase in your monthly payments when your rate is adjusted for the first time.

What is the margin on the interest rate? The margin is the amount that the lender adds to the index rate to calculate your mortgage rate. For instance, if the index rate is 7 percent and the margin is 2 percent, your overall interest rate would be 9 percent.

What limits or caps have been placed on the adjustments? One of the most important items to discuss with your lender is the maximum amount that your mortgage rate can increase in any single adjustment period and over the life of the loan. Find out the "worst case" situation in the event of a sharp increase in your index rate.

Can negative amortization occur? If an ARM has caps that prevent your payment from rising to the level dictated by the index, you may incur negative amortization. When negative amortization occurs, the monthly payments do not cover the full amount of principal and interest, so the amount of principal that you owe actually increases. Find out what limits there are on negative amortization.

Is the loan convertible? If so, is there a cost to convert? Convertibility allows you to change your ARM to a fixed-rate loan at some designated time in the future.

Is there a prepayment penalty? If you sell your house and pay off your loan early, you may be assessed a fee.

Other Types of Conventional Mortgages

A balloon mortgage is a non-amortizing loan. In other words, the periodic principal and interest payments do not pay off the loan. Some balloon mortgage loans may have a principal and interest payment that is calculated as if it would pay off the loan in 30 years, but the loan comes due in 5 or 7 years. Some lenders offer terms for renewal of the loan at the balloon date if certain conditions, such as a history of timely payment, are met. Some loans may contain provisions to be rewritten as 23- or 25-year fixed- or adjustable-rate amortizing loans with the monthly principal and interest payment based on the balance remaining on the balloon payment date.

Bi-weekly mortgages provide a means for paying off a mortgage more quickly. With a bi-weekly mortgage, the borrower makes half the regular monthly payment every two weeks. Because there are 26 two-week periods in the year, the borrower makes the equivalent of 13 monthly payments each year. This allows the borrower to complete payment on a 30-year mortgage within 16 to 22 years. The lower the interest rate, the longer the term of the mortgage. To reduce the paperwork associated with the extra payments, most lenders require that payments be deducted automatically from a borrower's checking account. Bi-weekly payments may be used with either 30-year or 15-year loans. Some home builders provide funds to the lender to buy down interest rates for two or three years or for the term of the mortgage to help their buyers qualify for mortgages during periods of especially high interest rates. This allows lenders to maintain the necessary yield on the loan.

Shared equity mortgages treat the purchase of a home as an investment that can be shared between a resident owner and an investment owner. The investment owner contributes a share of the down payment, the monthly payments, or both, and proportionately shares in the ownership of the property. At resale, the borrower and the investor split the proceeds after repayment of the balance of the loan. Both buyers may also share the tax benefits, but the type and amount of tax deduction would depend on the form of the agreement. Many lenders limit this type of arrangement to immediate family members.

FHA Mortgages

The Federal Housing Administration (FHA) operates several low down payment mortgage insurance programs that buyers can use to purchase a home with a down payment of five percent or less of the cost of the home. The most frequently used FHA program is the 203(b) program which provides for low down payment mortgages on one- to four-family residences. The maximum loan amount for a one-family home ranges from $67,500 to $152,362 depending on local median prices. FHA-insured loans are available from most of the same lenders who offer conventional loans. Your lender can provide more details about FHA-insured mortgages and the maximum loan amount in your area.

VA Mortgages

If you are a veteran or active duty military personnel, you may be able to obtain a loan guaranteed by the Department of Veterans Affairs (VA). VA-guaranteed loans require little or no down payment.
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