Mortgages 101

When you buy a house, you'll make some important decisons that will impact your finances for many years.  One of the most important decisions is deciding on a type of mortgage.   

A mortgage is a loan you obtain from a lender to pay for a home. The lender pays for the house, and then you pay back the lender through a mortgage. The loan principal is the amount you actually borrow to purchase the home. Interest is the amount the bank charges you to use their money.  Until you pay off your mortgage, the lender can take possession of the house if you don't make your payments. 

Because a mortgage loan is for a large amount, it usually takes 15-30 years to pay back the lender.  The amount of time is called the loan's term. Principal and interest together comprise most of your monthly payment, while the remainder of your payment is often a set amount escrowed for property taxes, home insurance and possibly mortgage insurance.

The total is then divided into equal payments over the life of the loan using a process called amortization. Your payments mostly pay toward interest early in the loan, and then more goes toward the principal later in the life of the loan.

Amortization Example - For example, if you borrow $100,000 with a 30-year loan at 7 percent interest, amortization will calculate your payments something like this:

Payment Amount Interest Principal Balance
First Payment $665 $583 $82 $99,118
At 5 years $665 $550 $115 $94,132
At 10 years $665 $501 $164 $85,812
At 20 years $665 $336 $329 $57,300
Last Payment $665 $4 $661

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In this example, after 30 years you would have paid off the $100,000 you originally borrowed, but you also would have paid an additional $139,509 in interest.

Escrow Account - Your total payment is more than just the principal and interest. The acronym PITI can help you remember all the parts of your payment. It stands for principal, interest, taxes and insurance. If you put less than 20 percent down on the loan, the bank considers it a little riskier and requires an escrow account. They pay your annual insurance and taxes from this account, and collect money monthly to gather the required amounts.

Private Mortgage Insurance (PMI) - If your down payment is less than 20 percent of the purchase price, your lender will probably also require you to purchase private mortgage insurance (PMI) on your loan. PMI protects the lender in case of default, but the premiums are paid by the borrower. An additional amount is added into your PITI payment to account for PMI. Generally, when you have accrued 20% equity in your home, you may request to have PMI removed from your loan.

 

FIXED VS. ADJUSTABLE RATE

Fixed-rate mortgages are the most popular type of mortgage loan.  They offer security, stability, and the comfort of knowing that your interest rate is locked in. The monthly principal and interest mortgage payment amount remains the same for the entire term of the loan.  Here are some considerations for fixed-rate mortgages:

  • If interest rates increase or decrease, your mortgage payment won't be affected. You know what your monthly mortgage expense will be for the entire term of your mortgage, which helps make budgeting easier.
  • The interest rate may be higher than other types of loans, such as adjustable-rate mortgages.
  • Although your principal and interest payment will not change, your total monthly payment can occasionally increase based on changes to your property taxes and homeowner’s insurance. 

Adjustable-rate mortgages (ARMs) are attractive to some customers because they usually start with a lower interest rate and a lower monthly payment. However, the interest rate can change during the life of the loan. It's important to understand the specifics of an adjustable-rate mortgage:

  • All ARMs have adjustment periods that determine when and how often the interest rate can change. There is an initial period during which the interest rate doesn't change.  This period can range from as little as 6 months to as long as 10 years. After the initial period, most ARMs adjust the interest rate periodically.
  • At the end of the initial period and at every adjustment period, the interest rate can change based on two factors: the index and the margin. Interest rate adjustments are based on a published index that reflects current financial market conditions.  The margin is an additional percentage that can be added to the index. Based on these two factors, the interest rate on your mortgage can increase or decrease. So if the interest rate on your mortgage increases, your monthly payment will increase.
  • All ARMs have rate caps that limit how much the interest rate can increase or decrease at each adjustment period and over the life of your loan.
  • If interest rates are high when you get your mortgage and drop during an adjustment period, your monthly payment may decrease. But a decrease is very unlikely, so don't base your choice of mortgage on this.

 

INTEREST-ONLY LOANS

To make monthly mortgage payments more affordable, some lenders offer home loans that allow you to pay only the interest on the loan during the first few years.  After that, you must repay both the principal and the interest.

Most mortgages that offer an interest-only payment plan have adjustable interest rates, which means that the interest rate and monthly payment will change over the term of the loan. The changes may be as often as once a month or as seldom as every 3 to 5 years, depending on the terms of your loan.

The interest-only payment period is typically between 3 and 10 years. After that, your monthly payment will increase even if interest rates stay the same or go down.  That is because you must pay back the principal as well as the interest. 

Payment-Option ARM - A payment-option ARM is an adjustable-rate mortgage that allows you to choose among several payment options. The interest rate on a payment-option ARM is typically very low for the first 1 to 3 months (2%, for example). After that, the rate usually rises to a rate closer to that of other mortgage loans. Your monthly payments during the first year are based on the initial low rate, meaning that if you only make the minimum payment, it may not cover the interest due. The unpaid interest is added to the amount you owe on the mortgage, resulting in a higher balance. This is known as negative amortization.

Whether you are buying a house or refinancing your mortgage, this information can help you decide if an interest-only mortgage payment is right for you. Lenders have a variety of names for these loans, but keep in mind that with interest-only mortgages and payment-option ARMs, you could face payment shock.  Your payments may go up significantly --- as much as double or triple --- after the interest-only period or when the payments adjust.

 

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