How Mortgages Work

 

Not that long ago, there was only one type of mortgage offered by lenders: the 30-year, fixed-rate mortgage. A fixed-rate mortgage offers an interest rate that will never change over the entire life of the loan. Not only does your interest rate never change, but your monthly mortgage payment remains the same for 15, 20 or 30 years, depending on the length of your mortgage. The only numbers that might change are property taxes and any insurance payments included in your monthly bill.

The interest rates tied to fixed-rate mortgages rise and fall with the larger economy. When the economy is growing, interest rates are higher than during a recession. Within those general trends, lenders offer borrowers specific rates based on their credit history and the length of the loan. Here are the benefits of 30, 20 and 15-year terms:

  • 30-year fixed-rate — Since this is the longest loan, you’ll end up paying the most in interest. While that might not seem like a good thing, it also allows you to deduct the most in interest payments from your taxes. This long-term loan also locks in the lowest monthly payments.
  • 20-year fixed-rate — These are harder to find, but the shorter term will allow you to build up more equity in your home sooner. And since you’ll be making larger monthly payments, the interest rate is generally lower than a 30-year fixed mortgage.
  • 15-year fixed-rate — This loan term has the same benefits as the 20-year term (quicker payoff, higher equity and lower interest rate), but you’ll have an even higher monthly payment.

There is a long-term stability to fixed-rate mortgages that many borrowers find attractive– especially those who plan on staying in their home for a decade or more. Other borrowers are more concerned with getting the lowest interest rate possible. This is part of the attraction of adjustable-rate mortgages, which we’ll talk about next.

Adjustable-rate Mortgages

An adjustable-rate mortgage (ARM) has an interest rate that changes — usually once a year — according to changing market conditions. A changing interest rate affects the size of your monthly mortgage payment. ARMs are attractive to borrowers because the initial rate for most is significantly lower than a conventional 30-year fixed-rate mortgage. Even in 2010, with interest rates on the 30-year fixed mortgage at historic lows, the ARM rate is almost a full percentage point lower [source: Haviv]. ARMs also make sense to borrowers who believe they’ll be selling their home within a few years.

If you’re considering an ARM, one important thing to remember is that intentions don’t always equal reality. Many ARM borrowers who intended to sell their homes quickly during the real estate boom were instead stuck with a „reset“ mortgage they couldn’t afford. Many of them never fully understood the terms of their ARM agreement. Here are the key numbers to look for:

  • How often your interest rate adjusts — A conventional ARM adjusts every year, but there are also six-month ARMs, one-year ARMs, two-year ARMs and so on. A popular „hybrid“ ARM is the 5/1 year ARM, which carries a fixed rate for five years, then adjusts annually for the life of the loan. A 3/3 year ARM has a fixed rate for the first three years, then adjusts every three years.
  • There will also be caps, or limits, to how high your interest rate can go over the life of the loan and how much it may change with each adjustment. Interim or periodic caps dictate how much the interest rate may rise with each adjustment and lifetime caps specify how high the rate can go over the life of the loan. Never sign up for an ARM without any caps!
  • The interest rates for ARMs can be tied to one-year U.S. Treasury bills, certificates of deposit (CDs), the London Inter-Bank Offer Rate (LIBOR) or other indexes. When mortgage lenders come up with their ARM rates, they look at the index and add a margin of two to four percentage points. Being tied to these index rates means that when those rates go up, your interest goes up with it. The catch? If interest rates go down, the rate on your ARMs may not [source: Federal Reserve]. In other words, read the fine print.

Now let’s look at some of the less common mortgage options, like government-sponsored loans, balloon mortgages and reverse mortgages.

Other Types of Mortgages

Let’s start with a risky type of mortgage called a balloon mortgage. A balloon mortgage is a short-term mortgage (five to seven years) that’s amortized as if it’s a 30-year mortgage. The advantage is that you end up making relatively low monthly payments for five years, but here’s the kicker. At the end of those five years, you owe the bank the remaining balance on the principal, which is going to be awfully close to the original loan amount. This „balloon“ payment can be a killer. If you can’t flip or refinance the home in five years, you’re out of luck.

Reverse mortgages actually pay you as long as you live in your home. These loans are designed for homeowners age 62 and older who need an inflow of cash, either as a monthly check or a line of credit. Essentially, these homeowners borrow against the equity in their homes, but they don’t have to pay the loan back as long as they don’t sell their homes or move. The downside is that the closing costs can be very high, and you still have to pay taxes and mortgage insurance [source: Moore].

Three agencies of the federal government work with lenders to offer discounted rates and loan terms for qualifying borrowers: Federal Housing Administration (FHA), which is part of the U.S. Department of Housing and Urban Development, the Veterans Administration (VA) and the Rural Housing Service (RHS), which is a branch of the U.S. Department of Agriculture.

These agencies don’t directly lend money to borrowers. Rather, they insure the loans made by approved mortgage lenders. This includes the refinancing of mortgages that have become unaffordable. Borrowers with bad credit histories might find it easier to secure a loan from an FHA-approved lender, since the lender knows that if the borrower fails to pay back the loan, the government will pick up the bill. FHA loans only require a 3 percent down payment, all of which can come from a family member, employer or charitable organization [source: HUD]. Commercial mortgages wouldn’t allow that.

Veterans Administration loans, like FHA loans, are guaranteed by the agency, not lent directly to borrowers.VA-backed loans offer generous terms and relaxed requirements to qualified veterans. Vets can pay no money down as long as the home price doesn’t exceed the loan limitsfor the county.

If you live in a rural area or small town, you may qualify for a low-interest loan through the Rural Housing Service. RHS offers both guaranteed loans through approved lenders and direct loans that are government funded. Theyenable low-income families to get loans for homes.

On the next page, learn all about interest. What do all these percentages mean, anyway?

Understanding APR

Probably one of the most confusing things about mortgages and other loans is the calculation of interest. With variations in compounding, terms and other factors, it’s hard to compare apples to apples when comparing mortgages. Sometimes it seems like we’re comparing apples to grapefruits.

For example, what if you want to compare a 30-year fixed-rate mortgage at 7 percent with one point to a 15-year fixed-rate mortgage at 6 percent with one-and-a-half points? First, you have to remember to also consider the fees and other costs associated with each loan. How can you accurately compare the two? Luckily, there’s a way to do that. Lenders are required by the Federal Truth in Lending Act to disclose the effective percentage rate, as well as the total finance charge in dollars.

 The annual percentage rate (APR) that you hear so much about allows you to make true comparisons of the actual costs of loans. The APR is the average annual finance charge (which includes fees and other loan costs) divided by the amount borrowed. It is expressed as an annual percentage rate — hence the name. The APR will be slightly higher than the interest rate the lender is charging because it includes all (or most) of the other fees that the loan carries with it, such as the origination fee, points and PMI premiums.

Here’s an example of how the APR works. You see an advertisement offering a 30-year fixed-rate mortgage at 7 percent with one point. You see another advertisement offering a 30-year fixed-rate mortgage at 7 percent with no points. Easy choice, right? Actually, it isn’t. Fortunately, the APR considers all of the fine print.

Say you need to borrow $100,000. With either lender, that means that your monthly payment is $665.30. If the point is 1 percent of $100,000 ($1,000), the application fee is $25, the processing fee is $250, and the other closing fees total $750, then the total of those fees ($2,025) is deducted from the actual loan amount of $100,000 ($100,000 – $2,025 = $97,975). This means that $97,975 is the new loan amount used to figure the true cost of the loan. To find the APR, you determine the interest rate that would equate to a monthly payment of $665.30 for a loan of $97,975. In this case, it’s really 7.2 percent.

So the second lender is the better deal, right? Not so fast. Keep reading to learn about the relation between APR and origination fees.

The Origination Fee

fee is how lenders make money up front on your mortgage loan. Origination fees are calculated as a percentage of the total loan, usually between 0.5 and 1 percent on U.S. mortgages [source: Investopedia]. Going back to our APR example, let’s say that the second lender charges a 3 percent origination fee, plus an application fee and other costs totaling $3,820 at closing. That brings the new loan amount down to $96,180, which yields an APR of 7.39 percent. So there you have it: Although the second lender advertised no points, it ended up with a higher APR because of its steep origination fee.

The take home message is simple: Don’t just look at the interest rate. Ask for the APR and compare it with other lenders. Also, make sure you know which fees are being included in the APR calculation. Typically, these include origination fees, points, buydown fees, prepaid mortgage interest, mortgage insurance premiums, application fees and underwriting costs. But note that some fees are charged by all lenders and are non-negotiable, such as title insurance and appraisals.

Luckily, you don’t have to calculate the APR on your own. The lender will give it to you when it gives you the Federal Truth in Lending Disclosure; you just have to understand its importance.

Here are some other things to take into account when you examine the APR:

  • The more you borrow, the less impact all of those fees will have on the APR, since the APR is calculated based on the total loan amount.
  • The length of time you’re actually in the home before you sell or refinance directly influences the effective interest rate you ultimately get. For example, if you move or refinance after three years instead of 30, after having paid two points at the loan closing, your effective interest rate for the loan is much higher than if you stay for the full loan term.

In order to qualify for a mortgage, most lenders require that you have a debt-to-income ratio of 28/36 (this can vary depending on the down payment and the type of loan you’re getting, however). This means that no more than 28 percent of your total monthly income (from all sources and before taxes) can go toward housing, and no more than 36 percent of your monthly income can go toward your total monthly debt (this includes your mortgage payment). The debt they look at includes any longer-term loans like car loans, student loans, credit cards or any other debts that will take a while to pay off.

Here’s an example of how the debt-to-income ratio works: Suppose you earn $35,000 per year and are looking at a house that would require a mortgage of $800 per month. According to the 28 percent limit for your housing, you could afford a payment of $816 per month, so the $800 per month this house will cost is fine (27 percent of your gross income). Suppose, however, you also have a $200 monthly car payment and a $115 monthly student loan payment. You have to add those to the $800 mortgage to find out your total debt. These total $1,115, which is roughly 38 percent of your gross income. That makes your housing-to-debt ratio 27/38. Lenders typically use the lesser of the two numbers, in this case the 28 percent $816 limit, but you may have to come up with a bigger down payment or negotiate with the lender.

You also have to think about what you can afford. The lender will tell you what you can afford based on the lower number in the debt-to-income ratio, but that’s not taking any of your regular expenses (like food) into account. What if you have an expensive hobby or have plans for something that will require a lot of money in five years? Your lender doesn’t know about that, so the $1,400 mortgage it says you qualify for today may not fit your actual budget in five years — particularly if you don’t see your income increasing too much over that period. Take a look at this calculator to see how much house you can afford based on your current income.

In general, it’s more difficult to qualify for a mortgage now than it was during the housing boom, when just about any motivated homebuyer could find credit — even many who couldn’t afford to buy a house. In the next section, we’ll explain what kind of credit history and income capacity you’ll need to pass the lender’s background check.

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