What is Mortgage
A mortgage is a device used to create a lien on real estate by contract. It is used as a method by which individuals or businesses can buy residential or commerical property without paying the full value upfront.
The borrower also known as mortgagor, uses a mortgage to pledge real property to the lender who is also called the mortgagee, as security against the debt (also called hypothecation) for the rest of the value of the property.
The mortgage instrument contains two parts:
The mortgage, which is the pledge and the note, which is the actual evidence of the debt and promise to repay (sometimes called a promissory note).
A Brief History of Mortgages
The word “mortgage” comes from both the Old French (“mort”) and English (“gage”) meaning “dead pledge.” In the late 12th century, the first mortgages were recorded in England. One would borrow money to buy property if they could not afford it. If they did not pay up, the creditor would take the real estate and the property ownership would be dead to them. On the flip side, if a debtor paid off the loan, the debt would be extinguished and therefore dead in that respect.
This system was brought to America with the pilgrims and as people bought property they would take out a loan from a local bank. In those days, the banks were smart and the buyer had to put down 50% of the purchase price and pay back the loan over a shorter period of time. Property ownership was nationwide come the early 1900’s when the depression hit. The government, the people and the banks all went belly up and it was foreclosure city!
In 1938 the Government created FNMA to buy the mortgage loans from the lenders. FNMA would buy the loans and sell them as securities on Wall Street. This way, the lenders had a central location to sell their mortgages to with a conforming set of guidelines to meet. After WWII, the vets returned looking for housing and work and so the housing boom started. In 1944, The Veteran’s Administration was started to insure loans taken out by Veterans and their families.
Not only did the government guarantee (partial) these loans, but they were giving 100% financing. Come, 1970, the Government realized they needed more funding for loans and created Federal Home Loan Mortgage Corporation (FHLMC), known as FreddieMac. Freddie would buy the loans that FNMA would buy and then some. Freddie was known for doing all sorts of weird and commercial loans in addition to the basics. For instance, Freddie would buy multi million dollar loans used to finance coop conversions in Manhattan, big commercial retail projects and health facilities. More of a real estate boom.
So, you can see how housing was able to progress from the caves and huts of simpler times. There will always be housing booms and bubbles that move with the nation’s economy. The difference we are seeing now is that there is a global ripple effect from the bulk sale of mortgages.
Basically, there are two categories of mortgages: the fixed-rate and the adjustable-rate mortgage (ARM). Within these categories, there are some variations. However, in
nearly all mortgages two factors are usually at odds: how predictable the payments are and how low, or affordable, they are at least initially. In addition there is the reverse mortgage, a special loan product that enables homeowners over the age of 62 to convert a portion of their home equity into income.
The 30-year fixed-rate mortgage
Not long ago, there was only one kind of mortgage: 30-year fixed rate (the borrower has 30 years to pay back the mortgage at a fixed interest rate and the payments are the same over the life of the loan). It is still the most common home loan.
Borrowers choose fixed-rate loans because the mortgage payments are steady and predictable, allowing for easier household budgeting and planning. The payments are the same over the life of the mortgage, regardless of interest rate changes. Initially, both the rate and mortgage payment are higher than those of an adjustable-rate mortgage, but the payment is lower than that of a 15-year fixed-rate mortgage (see below). People who choose a fixed-rate mortgage usually are planning to keep their home and mortgage for several years.
The 15-year fixed-rate mortgage
This type of mortgage enables you to own your home in half the usual time, meaning you could possibly own it before your children start college or you reach retirement. Because the loan is shorter, you pay substantially less in the total interest over the life of the loan, often less than half the total interest of a 30-year fixed-rate loan.
However, because the term is shorter, the monthly payments are higher than those of a 30-year mortgage. For people who can afford the higher monthly payments, this is an excellent choice, with lower total costs and a shorter term.
Qualification for this type of loan may be more difficult because the income requirement may be higher. The adjustable rate mortgage (ARM) In general, adjustable-rate mortgages can offer lower interest rates and mortgage payments at first because the borrower assumes the risk of changes in interest rates. Usually borrowers choose ARMs because the lower initial payment makes
the home more affordable at first, but the borrower must be willing to accept the risk of an increased mortgage payment, which can sometimes be significantly higher. After a specified period of time, the interest rate and payments on an ARM are adjusted based on changes to a specific interest rate index (such as the LIBOR rate). These adjustments occur at times specified in the ARM disclosure you receive from the lender and can result in payment increases.
There is always a floor cap, payment cap, and life cap on the rate. It’s important to understand all the aspects of ARMs before you make your decision. People who choose an ARM usually are intending to sell or refinance before the rate adjusts upward. They also may expect income to increase over time. These borrowers must be confident they could afford the post-adjustment higher payments if they cannot refinance or sell.
NOTE: Fluctuations in the economy often determine whether certain types of the loans listed below are available. During times of slow housing markets and high foreclosure rates, some types of ARM loans listed below may not be available. This is because ARMs are riskier to the borrower and lender, and when the economy is slow, they become even more risky. Just like borrowers, lenders do not want to risk handling foreclosures.
Mortgages allowing interest-only payments
An interest-only option can be a feature of any type of loan; however, it is typically available only for a limited time, after which payments go up sharply. Paying only the interest enables you to make lower payments without increasing your loan balance. At the same time, however, the balance does not decrease and you do not build equity unless the home goes up in value. If the house value doesn’t go up, you may owe money if you sell. In most cases, you can make principal payments at any time during the interest-only period.
People who choose a mortgage allowing interest-only payments usually are those who plan to move (or less often, refinance) before the interest-only period ends; expect their income to increase sharply; receive large bonuses at certain times of the year; or reasonably expect the value of the house to rise sharply.
They must budget wisely and be willing to make lump-sum payments, steering clear of using that money for other purposes. These borrowers must be confident that if they do remain in the home or cannot refinance, they could afford the higher monthly payments. At the end of the fixed period, you must refinance, pay a lump sum or start paying on the principal.
Loans with pre-payment penalties
A pre-payment penalty can be part of any type of loan, so you should check with the lender to find out whether the loan you want carries this type of penalty. However, loans with these penalties may offer initially lower payments in exchange for a promise to pay a specified lump sum if the borrower refinances the date specified in the mortgage agreement.
A reverse mortgage is a special type of home loan that lets a homeowner over the age of 62 convert a portion of the equity in their primary residence into income. These mortgages have become increasingly popular as more baby boomers enter or near retirement and also because they offer seniors an option to pay for a variety of expenses. The reverse mortgages loans are secured by the home and the owner does not have to repay the loan until they die, sell or premanently move out of the home.
More on Reverse Mortgage Loans.
This type of mortgage enables you to get a lower interest rate by paying a lump-sum fee or by paying a fee that is financed over the life of the loan. Buydowns are similar to paying “points” but they usually are paid by the seller or the builder as an incentive to make a sale by creating lower monthly payments. Be aware that the cost of those points may be included in the selling price, and you could end up paying more for a house than its appraised value.
There are two types of buydowns: temporary and permanent.
A temporary buydown lowers the interest rate and the monthly payments for the first few years of the loan. The most common type of temporary buydown is the “3-2-1” buydown. For example, an 8-percent loan with a 3-2-1 buydown would have a 5-percent interest rate the first year, a 6-percent interest rate the second year, a 7-percent interest rate the third year, and an 8-percent interest rate beginning the fourth year through the life of the loan. This type of buydown will generally cost three to four points – that’s $6,000 to $8,000 on a $100,000 loan.
A permanent buydown lowers the interest rate for the life of the loan. Again, this type of buydown will generally cost six to eight points and may reduce the interest rate by only 1 percent for the life of the loan.
A note on home prices: While over the long term homes have historically increased in value, short-term ups and downs in the real estate market can affect some borrowers who are planning to move or refinance prior to any rise in rates and payment. A fall in home prices may make it much more difficult for this borrower to sell or refinance without losing money.