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What is a Mortgage?

By Arvin Sahakian · Mar 30, 2015 · Mortgage

What is a Mortgage?

Image courtesy of Flickr, Daniel M Viero

A mortgage is a lien against a property that's used as security for the repayment of a loan. Mortgage is also a word commonly used to refer to a home loan.

A mortgage is likely to be one of the largest and most complex financial transactions you will undertake in your life time, which is why it is important to have a solid, fundamental understanding of what a mortgage is. People refer to the word mortgage in different ways. A mortgage is a term commonly used to refer to a home loan, although it is not technically a loan itself, but a document which acts as a security for the repayment of a loan.

We will review the common mortgage types and loan options available to you. You will also learn what your monthly mortgage payments include, and some helpful tips on how you should shop for a mortgage loan.

Mortgage Definition

The textbook definition for mortgage is to convey property by a borrower to a lender as security for a debt (especially one incurred by purchasing a property), on the condition that ownership will be returned upon payment of the debt within a certain period of time.

When you sign a Deed of Trust to finance the purchase of a property or to refinance an existing home loan, you are entering into a legal agreement with your lender. This deed of trust, also known as a mortgage contract, specifies that you are promising to repay the total amount borrowed, plus interest incurred. The property acts as collateral or the security for that loan until the loan is paid back. Upon doing so, the property is conveyed back to the borrower to own the property free and clear.

How Does a Mortgage Work?

Once you have been approved for a loan, signed the required documents and received notice that your loan has funded, you have taken on a mortgage loan.

The reoccurring payment period is known as a Loan Amortization. You will receive a monthly bill by mail or by email (unless you have set up automatic payments), notifying you that your next month's payment is due. This cycle will repeat until your last payment is made (Your 360th payment if you have a 30 year fixed loan).

In the early years of the loan, you will pay mostly interest, with very little towards the principal balance.

As the years go by, more of your payments will be designated towards the principal balance, while less will be designated towards the interest. Using this loan amortization schedule calculator, you will be able to visualize this process.

6 Different Mortgage Loan Options

There are many different options to choose, from popular loan types to unique niche loans. Here, we explain in detail the different mortgage loan options you will commonly find using any lending institution.

1. Fixed Rate

This is the traditional mortgage loan. Depending on which program you choose, this loan is designed to be completely paid off in a period anywhere from 10 to 40 years. Your interest rate and payments will determined accordingly, and will not change for the life of the loan.

2. ARM (Adjustable Rate Mortgage)

The loan payment and interest rate for this option will not change for a set period of time (typically 3-10 years). The interest rate on ARM loans tends to be lower than the fixed rate option, however, your monthly payments will still go towards the principal and interest balance of the loan. After the fixed period expires, your rate can fluctuate up or down on a monthly basis according to the index and margin specified by your lender.

3. Interest Only

The loan payment and interest rate for this option will not change for a set period of time (typically 3-10 years). Your monthly payments will go towards the interest balance only and not the principal, which is why the payments for this option are lower than the fixed rate and ARM. Once the loan period ends, your loan will revert to an ARM loan option with fluctuating interest rates and you will see a rise in your monthly payment obligations. It is not uncommon for your monthly payments to nearly double as a result. Before your interest only period expires, it is wise to begin shopping to refinance your existing loan in order to avoid experiencing what is known as "payment shock."

4. FHA (Federal Housing Administration)

The FHA loan option can be a fixed rate or an ARM. These loans are insured by the U.S. Department of Housing and Urban Development (HUD) against default, which puts lenders at ease to allow for less strict qualifying requirements from their borrowers, such as lower down payment requirements and lower credit qualifying standards. Take note, that every FHA loan requires an upfront mortgage insurance payment equal to 1.75% of the loan amount. This can be rolled into the loan if you choose to avoid the out of pocket expense. In addition, you will have to pay for an annual mortgage insurance premium on a monthly basis.

5. VA (Department of Veterans Affairs)

The VA loan options can be a fixed rate or an ARM and are available only to U.S. Military service members, veterans and their families. These loans are insured by the VA (Department of Veterans Affairs) against default, not unlike how FHA Loans are insured by HUD. The VA loan options have low or no down payment requirements and provides bypasses of the conventional terms and conditions lenders must follow.

6. Reverse Mortgage

This loan option is known as the Home Equity Conversion Mortgage (HECM), and is only available to those over the age 62. With a reverse mortgage, a percentage of the equity in the home becomes available to the home owner as regular monthly income to spend as they wish. The percentage of equity given will be higher with an 80 year-old home owner than would be a 65-year old home owner. Upon relocation or death, repayment of the loan is due at once, or the property is returned to the lender to list and sell.

Mortgage Payments Include PITI (Principle, Interest, Taxes & Insurance)

The PITI calculation represents your total monthly mortgage payment. It consists of four components which are listed in detail on every bill. Due to the nature of some of these components (such as taxes and insurance), the amount of the monthly bill may fluctuate from time to time.

Principal

This represents the monthly payments for the total principal amount of your mortgage loan. For example, if you purchased a $400,000 home with a 20% down payment, your principal loan amount would be $320,000. A portion of your monthly mortgage payments will go towards paying this down.

Interest

This represents the monthly payments on the interest charges for your mortgage loan. The interest rate on your mortgage directly affects the amount of the monthly payment. The higher the interest rate, the higher your monthly mortgage payment.

Taxes

Most financial institutions will have a requirement to collect and hold, in escrow, tax payments from you on a monthly basis. The concept "being held in escrow" means that a neutral third party maintains an account on your behalf and then releases the funds for payment of taxes when due, usually every 6 months.

Insurance

Most mortgage lenders will have a requirement to collect and hold, in escrow, homeowners insurance payments from you on a monthly basis. You will be required to have the traditional kind of property insurance for coverage of fire, theft and specific kinds of "acts of God," otherwise known as natural disasters. In addition, based on government mandates, you may be required to have flood insurance as well.

4 Common Types of Mortgages

There are four common financial tools you could leverage to accomplish your goals which can range from buying a new home and lowering your mortgage payments, to funding necessary remodels to your existing home. Although they are all framed as mortgage instruments, their function, terms and conditions are different.

Purchase Mortgage

This type of mortgage is a loan you would attain in order to purchase a particular property. A purchase mortgage is available at any national, state or local lending institution. The options available for this type of mortgage can be a fixed fate, ARM, interest only, FHA, or VA loan, as described in this article.

Rate and Term Finance

This is a type of refinance for an existing mortgage. Through this approach, you change the interest rate, term and perhaps the type of loan option. The amount of the mortgage remains the same, and you will not be able to cash-out any amount from your homes equity. This loan type is popular during times when interest rates decline, or the term for an existing fixed rate loan expires (such as an Interest Only loan).

Cash-Out Refinance

This is a type of refinance for an existing loan where you can take cash out from the equity of your home. You will also have the opportunity to change your interest rate and loan option during the process. This loan type is popular, not only for when interest rates decline or when the term for an existing fixed rate loan expires (such as an Interest Only loan), but when a home owner has an immediate need for larger quantities of cash (such as for major home repairs or remodels).

Home Equity Line of Credit (HELOC)

As with a credit card, HELOC allows borrowing up to a specified limit during a specified period of time. This limit will depend on amount of your home's equity, and the interest rate can be variable or fixed, depending on the program. The terms and conditions might include an initial withdrawal amount and minimal amounts for all future withdrawals. Essentially, the amount of your payments are determined by how much you withdraw from the account. This loan is popular for when the homeowner knows they will need access to their equity sometime in the near future, but do not want to make payments on the entire amount when they do not have an immediate use for the funds.

Shopping for a Mortgage

When shopping for a mortgage lender, you need to factor in both your trust in the integrity of the institution and your comfort level in the relationship you will have with the representative of the bank. In addition, you have to be alert to accuracy, efficiency and the timeliness of your communications with the lender. Mistakes and delays on the part of the lender can make the loan process very difficult.

Being alert to the "sales pitch" is a prerequisite of course, but what really counts is using best practices and processes when searching for a lender, such as:

Monitor Current Mortgage Rates

When you begin searching for a mortgage loan, you will notice there are a wide range of rates and programs available. For example, online-only lending institutions may offer you different deals than a traditional brick and mortar lending institution.

Don't Judge a Lender by Size or Brand Name

Large companies and established brand names have the resources to promote themselves to a far reaching audience regardless of whether or not they have the best rates and loan options. You can gain access to your perfect loan by reviewing a number of institutions first to see what programs they have available for your particular circumstance and needs. Some lenders will be small, who are not on the national or even regional radar, and other lenders might be large, such as a global institution like Citi or B of A.

No matter the size or the brand, it's the individual working directly with you who will make all the difference. Ultimately, you want to choose a lender who will help you walk away knowing more about the process than when you first started, while thoroughly explaining all the mortgage types and options available to you.

Key Takeaways

As a mortgage consumer, you will have many options available to you. Whether you are in the market to purchase your first home, refinance your existing loan to lower payments, or to get cash out from your equity, it is important to be informed and understand the basic fundamentals of what a mortgage is.

By knowing how a mortgage works, you will be able to assess which type of mortgage type and loan option will be best suited for what your objectives are. It's also important to take note that your total monthly mortgage related costs don't just include the principle and interest payments, but tax and insurance payments in addition as well. Lastly, when shopping for a mortgage lender, you need to factor in both your trust in the integrity of the institution and your comfort level in the relationship you will have with the representative of the bank.


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