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Mortgage Loans Basics
A mortgage is a long term loan. Like all loans, a bank or other institution loans you money with the agreement that you will pay them back over time at an agreed upon interest rate.
The difference between a mortgage and other forms of debt, such as a car loan, is the mortgage is secured against real estate. For most people, a mortgage is the largest loan taken during their lifetime. Keep reading for answers to frequently asked questions on mortgage loans.
The appeal of a mortgage loan is it allows you buy an asset that you otherwise could not afford with the expectation that its value will increase over time, also known as Leverage. You are leveraging what money you have saved to purchase something that will you will ultimately sell for more than you originally paid for it. This is an asset in your financial portfolio, gives you a tax break, and of course, gives you a place to live.
It makes sense that many people strive to own a home, it simply does not make sense to pay someone else’s mortgage if you can afford to pay your own.
For more on this, read Why Rent When You Can Buy?
Mortgage Loan Basics
Free Download What You Need to Know About Mortgage Process
A mortgage allows you to pay the down payment upfront and the bank loans you the rest. You make a deal with the bank; the arrangement is you pay back the money owed plus interest, over a set amount of time (the term), which is typically 30 years.
The catch is that you are putting the house up as collateral, so if you stop making your payments, the bank can take the house back via a foreclosure. This is what we mean when we say the loan is "secured against the real estate."
You have a lot to gain from having a mortgage, but you need to understand the various components. The lender and the structure of the mortgage you choose could save you (or cost you) thousands or even tens of thousands.
If you take out a mortgage that isn’t right for you, leading to foreclosure, you’ll not only have to move–and in general wait between three and seven years before you are allowed to purchase another home–but your credit score will crash and you could be hit with a huge tax bill. It is best to avoid foreclosure at all costs. Prevention is worth more than then cure in this case.
Lenders & Credit Score
Lenders can be banks or mortgage brokers, who have access to both large banks and other loan lenders, like pension funds. These are the institutions that will lend you the mortgage loan.
Large banks are lenders such as Wells Fargo, Chase and Bank of America. Often, community banks or credit unions will make a loan to you initially, and then sell it to one of these larger institutions. You want to make sure that whoever you work with has a reputation for being reliable and efficient, because any delays or issues with closing on a sale will only cost you more money.
Mortgage lenders don’t lend hundreds of thousands of dollars to just anyone (would you?) They will check your credit score; The credit score is one of the primary ways that lenders evaluate you as a reliable borrower– someone who’s likely to pay back the money in full. A score of 720 or higher generally indicates a positive financial history; a score below 660 could be detrimental, but there’s no official credit score below which a lender won’t grant a loan. Some lenders may reject your application if you have a lower credit score, but there isn’t a universal cutoff number for everyone. Instead, a lower credit score means that you might end up with a higher interest rate.
Points & PITI
A point is a form of pre-paid interest, paid upfront at closing. Paying a point may reduce your interest rate, but in general it is a way for a lender to get some money up front. As points are paid at closing, compare the closing costs with the point compared to the closing costs with no points along with how it effects your interest rate & monthly payments. There is no correct answer, only the loan that works best for you and your unique situation.
Principal, Interest, Taxes & Insurance, aka PITI, is the amount you will pay every month. Some mortgage loans will allow you to pay taxes and insurance separately, but alas you will pay them, so you need to be aware of what these amounts will be throughout the term of your loan. If your down payment is less than 20% of the sale price, the lender may consider your loan to be higher risk and will need to account for that risk with either a higher interest rate or force you to purchase private mortgage insurance, aka PMI.
Here is a breakdown of each component of your full payment, PITI:
Principal: This is the amount you borrowed. If you needed $300,000 to buy a house & had a 10% down payment, the principal amount would be $270,000.
Interest: This is what you pay to borrow the $270,000. The Interest Rate is expressed as a percentage. You’ve probably seen advertisements for lower interest rates, which are a good thing for you as the home buyer. A higher interest rate means higher monthly mortgage payments, lower rates might mean that you can afford to borrow more money or pay the loan off faster.
Taxes: Property taxes are paid by people who own property. If you are new to home ownership, this is a new expense you did not have as a renter. These taxes pay for infrastructure like schools and roads. The Assessor determines what tax you will pay & it changes almost every year. If you’re a high-risk borrower, the lender may establish an escrow account to hold that money until it’s paid to the government on your behalf. The lender does not want the government foreclosing on your property due to unpaid taxes and will do everything necessary to ensure this does not happen. (You should too)
Insurance: Homeowner’s insurance protects your home against fire, theft and other disasters. Again, if you risk borrower and/or lack the 20% down payment, the lender will likely require funds to remain in escrow to be paid to the insurance company. This protects the lender as well as you. Additionally, they may require you to have private mortgage insurance (PMI), which helps guarantee that the lender will get money back if you can’t pay it for any reason. Usually after you’ve paid off a certain amount of your mortgage, you can cancel the PMI. The main difference here is that PMI is meant to protect the lender, not the borrower.
There are a few different forms of common mortgages. First, you need to understand the difference between Fixed Rate & Adjustable Rate Mortgages:
Fixed Rate Mortgage (FRM): A mortgage in which the interest rate is established upfront and remains the same throughout the duration of the loan.
Adjustable Rate Mortgage (ARM): A mortgage in which the interest rate is readjusted periodically to reflect the market rates.
It is also important to understand Amortization. This is the process by which you pay back the loan. Mortgages are structured so that mostly interest is paid at first. As years pass, you will be paying down the actual principal. The payments stay the same, but how they are applied to your loan balance is determined via Amortization.
The most popular & utilized mortgage loan is a 30 year fixed loan. That means the borrower and lender agree upon an interest rate for the next 30 years. Home buyers prefer this set up because they know the exact amount they will pay every month. These are the best loan types for buyers who lock in low interest rates, want a predictable payment, and who plan to stay in the home for a long time.
These loans are basically the same as a 30 year fixed loan, except the home buyer agrees to pay back the loan within 15 years. These loans will have higher monthly payments but often come with a lower interest rate. These are best for home buyers who can make make the higher payments, want to build equity quickly, and want the benefit of a lower interest rate.
Adjustable Rate Mortgages (ARM)
On Adjustable Rate Mortgages, interest rates adjust based on market conditions at predetermined intervals, such as annually. Often these loans are fixed with a lower than average interest rate for the first 3, 5 or 7 years and then adjust to a higher than average interest rate thereafter. These types of loans are best if the buyer plans to re-sell or refinance after the initial term, otherwise they are more expensive than standard 15 or 30 year fixed loans.
A strong credit score and down payment will secure you the best loans in the market. Compare different loan types and find the one that best meets your needs as the home buyer. A mortgage is a debt, but it’s considered good debt. It doesn’t hurt your credit.
Off Market Specialist. Specialties: Buyer's Agent, Listing Agent, Relocation, Commercial R.E. I'm a real estate consultant who's made a career of an excellent track record of outstanding results an....