Breaking Down The Complexity Of Mortgages

By Kaci Cooper, 23 Jan 18:57

If hearing the words: fixed rate, adjustable rate, balloons, and negative amortization makes your hand twitch with desire to close out your browser, wait! In order to own, buy, or sell a home, you must understand mortgages and they are not as complicated as you might think. By taking advice from those you know with a mortgage and doing a little homework, you are on your way to making great financial decisions.

So, here’s the big question, what’s a mortgage?

A mortgage is a loan, sometimes called a lien, to obtain property, your house and land. The lender uses your land and property as security. In the case that you do not pay back your loan, the bank forecloses on your house. Remember, you are still the owner of your house, it merely serves as collateral to those who have lent you money.

In the mortgage world there is a difference between what you can afford and what you can borrow. Lenders do not take into account your entertainment needs for the month or how well you are prepared emotionally to handle a large payment. Only you understand your lifestyle, which deals with how much you can afford.

Lenders look at the ratio between how much you money you make every month (or the possible amount you could eventually make each month) and the amount of debt that you have acquired. They also keep in mind your credit and savings history. Through this they determine the risk of lending you money, thereby determining how much money to lend you. Hopefully this amount will meet or exceed the amount you need to purchase your home.

There are many kinds of mortgages, so where should you start?

First you need to determine your goal. Are you planning on living in this house for the next ten years, or are you merely living there until you can move into something else? The answers to these questions will help you narrow your mortgage choices.

Why is the length of time one plans to stay in a house important?

It is important because it helps the lender decide what type of loans suits you best, and it determines whether your priority is interest rates or points. If you plan to stay in your home, paying off your mortgage over the years, then you can get a fixed rate loan which will prevent your payments from changing. Keep in mind, however, that although the mortgage payment might stay the same, the insurance and taxes that are usually built into a loan might change over time. The downside to a fixed rate is that the interest rate is higher than in an Adjustable Rate Mortgage, although the upside is that you always know what your payment will be.

However, if you only plan to stay in your house for a limited amount of time, you can seek out a lower interest rate through an ARM (Adjustable Rate Mortgage). This means that if rates sky rocket in the next few years, you will have sold by this time anyway and it will not matter. Keep in mind that you can find a hybrid ARM that will remain fixed for five years before the lender can alter the interest rate.

A lender may charge points, just as required third parties have costs for their services. These fees will raise the cost of a loan. The danger here is that if you sell your home after a short amount of time, you may not be able to regain these costs. Also, you will only have a minimal equity in the house. This procedure is based on the plan that your home will appreciate enough or the money you save in interest will make the fees irrelevant. Be aware that if you end up staying in a house longer than you expected you take the risk of paying more in interest as rates adjust, just as you risk not have the ability to refinance.

Loans are not free. Either you pay a lower interest rate with higher points or vice versa. The best thing you can do is to make the decision about you, ensuring that the mortgage you choose will always suit your needs. Also be careful that there is a bonafide reason if your lender tries to charge you more that 1 to 1 ½ point, like bad credit or a superb interest rate. Try to discuss the effect of discount rates with a mortgage professional.

What are the rates of today?

Each city is different, so you will have to check out your local lenders and banks. Make sure that any advertised loans are legitimate because ads can be misleading. You need to shop around to find the best rate for you.

Why are some rates shown as both a percentage and an APR?

The Annual Percentage Rate is the final cost you will end up paying in addition to the principal. It includes all fees (interest, points, fees, etc.) into a final rate. With regard to this, most lenders with only quote you the interest, so make sure you ask to see the APR. This will allow you to make good comparisons between lenders by making sure you are on the same page with each of them. When looking at two of the exact same loans with different APRs, choose the one with the lesser rate.

What is amortization?

Amortization is a true judgment of what you pay per year against your loan. A loan has a life, which means it last for a set amount of time, whether that is fifteen or twenty years. You pay in installments, which eventually decreases your total amount owed, unless it is only a loan or a negative amortization, until it is completely paid off. This is why you need to pay close attention to the amortization schedule. This will show you all the payments for the life of the loan including interest. It helps if you split your payment schedule in two. For example, if you pay half your house payment every two weeks, this allows you to pay more on principal and less on interest. The extra payments will continue to help pay the principal on the loan.

What does it mean when ARM rates are tied to an index?

The index is a representation of an ARM loan’s interest rate which adjusts periodically, including a preset margin. The index changes every so often, and the more the change the more alteration of the ARM itself. Make sure you base your loan on a stable index, or at the very least make it a factor for consideration. It is always best to have your lender explain how the index will affect your loan.

The following are popular indexes:
-T-Bills, the most common index based on the federal treasury
-LIBOR (London Interbank Offered Rate Index), based on international rates
-COFI (11th District Cost of Funds Index), which is based on moving average of rates
-Prime Lending Rate

What else to keep an eye out for regarding your mortgage:

Be careful that if you decide to pay your loan off early, you check to see if there is a prepayment penalty on your loan. Usually penalties only last for 1 to 3 years after the loan is set in motion. The penalties vary based on the bank or lender, but most likely penalties involve six months of interest or two percent of the principal on the loan.

Why do people attach themselves to loans with prepayment penalties?

Oftentimes lenders set enticingly low interest rates or it could be a string due to a record of bad credit. Sometimes it can save you thousands in interest, but in the end it is a personal, financial decision.

The difference between a traditional and a non-traditional loan:

Especially if the real estate market is doing well, lenders will often get very creative to give people money to buy a home, without consideration of a buyer’s ability to pay.

Non-traditional loans include:
- Interest only loans: Most beneficial to the buyer if it is short term because this type of loan involves no principal and interest for a certain amount of time.
- Payment Option ARMs: The buyer may choose from a selection of loans (negative amortization, interest only, fully amortized, etc). Be wary of choosing the lowest payment loan which in some cases can lead to more debt.
- Zero-down loans: These loans do not require a down payment. This allows the loan amount to be higher than normal. It is called a “piggyback loan” when the buyer decides to take out a second mortgage.

Traditional loans involve those with an agreed upon payment schedule and a normal down payment. They also include fixed and ARM loans.

Why do people need mortgage insurance?

This protects the lender if you default by requiring that on low down payments (less than twenty percent) Private Mortgage Insurance guarantees the lender eighty percent of the loan. You can also take out a second mortgage to pay for the down payment.

Government programs have protection under the government. With government loans you cannot get insurance on VA loans, though FHA loans offer it.

Check with a financial advisor if you have specific questions and make sure you do research when considering your different mortgage options.

Tags: mortage finance