BALANCE: The Road To Homeownership

Chapter 2: Understanding Mortgages

If you are like the vast majority of people, you will borrow money to pay for your new home. When you do, you have possession and use of the property but the financial institution that lends you the money owns it until you repay the loan (your mortgage) in full. To get the right mortgage for your needs and circumstances, it is important to understand how they work.

Mortgage Terms
A term is the number of years that you agree to pay back the amount you borrow. The term directly affects the cost of your mortgage payments – shorter repayment periods mean higher monthly payments but less interest you pay over the life of the loan, while longer terms will give you lower payments but will cost more over the long run. The traditional mortgage term is 30 years, but they can range from ten to 40 years.

PITI
When you buy a home, the money you will pay for your total housing costs consists of several different items – principal, interest, taxes, and insurance – typically shortened to the term “PITI”:

Principal – The amount you borrow is the principal. Each month when you make your mortgage payment you are paying back a portion of the principal and building equity (the difference between what your home is worth and the amount you owe on your mortgage). In the beginning of the loan, most of your payment will go toward the loan’s interest. As the years go by though, a greater portion of your payment will go toward the principal, and interest becomes a smaller part of your monthly payment.
Interest – Your lender will charge you interest to borrow the principal. Download the Mortgage Payment Calculator (PDF) to view an example of monthly principal and interest payments for various loan amounts at different interest rates.
Property taxes – When you own a home, you have to pay property taxes – money that goes to your local government to pay for schools, roads, and other regional expenses. The amount you pay depends on where you live, but it is always a percentage of your property value. Depending on the lender, you may be required to pay these taxes with your monthly mortgage payment, or pay them on a quarterly basis.
Insurance (Hazard) – All lenders require homeowners to have a minimum of homeowner insurance. This insurance protects both the lender and the borrower from the extreme financial loss in the event of such hazards as fire, wind, or other types of property destruction. If the home you wish to purchase is in an area that is prone to floods, earthquakes, or other destructive forces that aren’t covered by basic hazard insurance, you may purchase additional insurance to protect your investment.

Other Mortgage-related Costs
Depending on your financial situation and the type of home you buy, you may also be responsible for other mortgage-related costs:

Private Mortgage Insurance (PMI) – PMI is an insurance product that allows you to buy a home with less than a 20 percent down payment. This policy pays mortgage lenders for part of their financial losses if you can’t pay your loan. Once you have reached the full 20 percent of equity in the home, you can drop the coverage.
Homeowner’s Association Dues/Condo Fees – These mandatory dues/fees go toward the property management and upkeep of common areas, and sometimes include utilities and property insurance.

Mortgage Types
There are several types of mortgages available, with the most common being conventional, adjustable, and interest-only:

Fixed rate mortgages come with an interest rate that remains constant over the life of the loan. 30-year mortgages are the most common, but you may also choose a 20-year, 15-year, and even 10-year fixed-rate mortgage. In certain high-cost areas some mortgage lenders are even offering 40 year-loans. Though interest rates for these mortgages tend to be higher than for other loan types, the rate is fixed and your payment won’t change. This stability makes them the most secure type of mortgage for buyers.
Adjustable Rate Mortgages (ARMs) have a period of fixed interest, but after that the payment changes with whatever index the loan is based on. The period of fixed interest may be three, five, or seven years. With a 5/1 (the first number stands for the number of years in the initial fixed period, while the second indicates how often the new rate will adjust) ARM, for example, the initial interest rate remains fixed for the first five years, and then adjusts annually for the remaining term.

There are several types of caps that may apply to an ARM: an overall cap limits how much the interest rate can increase over the life of the loan; a periodic cap limits the amount the interest can increase from one period of adjustment to the next; and a payment cap limits the amount the monthly payment can increase at each adjustment.

While ARMs are less secure than conventional mortgages (since the rates fluctuate), they tend to have lower initial rates and therefore lower monthly payments. They can be a good option for homebuyers who are just starting out, as long as they are confident they can meet future interest and payment increases.

Interest-only mortgages are loans that allow homebuyers to pay just interest for between three and ten years. Once that period is over, the payment rises to include both principal and interest. While qualification can be easier and the monthly costs can be lower than other mortgage types, they can be a gamble. A downturn in housing prices could mean that you end up owing more than you own, and an interest rate hike could put the payments beyond your reach.

Beware Predatory Lending
Most lenders are honest and legitimate, but there are some who are not. Predatory lenders prey on those who do not know their rights, understand the lending process, or whose credit rating is too low to qualify for a good conventional loan. These individuals or companies use a variety of methods to part you from your money, including:

Selling you a home for more than it is worth
Falsifying your income, expenses, or assets so you can qualify for a loan
Lending you money knowing that you can’t afford to repay the loan
Adding fees for unnecessary or nonexistent products and services
Pressuring you into a risky or unaffordable loan

If you suspect a lender is not above board and is using these or other illegal practices, contact the Federal Trade Commission’s Division of Credit Practices.