Guru Mortgage

Mortgage Basics

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Many people dream of owning their own home, but the high cost of homes generally requires a home mortgage to make this become a reality.

On this page, we discuss some of the basic terms and concepts related to mortgages.

Mortgage Terminology

A mortgage is a loan you obtain to pay for a home and any land it sits on. The home and land is used for collateral on the loan, which means that if you don't make your payments, the lender can take the home away to cover your missed payments.

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; it is a percentage based on current economic indicators.

Because the loan is for such a high amount, it is usually financed for between fifteen and thirty years. The amount of time is called the loan's term. Principal and interest together comprise most of your payment.

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

For example, if you borrow $100,000 dollars with a 30-year loan at 7% interest, amortization will calculate your

payments something like this:

Payment Amount Interest Principal Balance

First Payment $665 $583 $82 $99,918
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 $0

In this example, after thirty years you would have paid off the $100,000 you originally borrowed, but you also would have paid an additional $139,509 in interest. (Try our online amortization schedule calculator to experiment with your own figures.)

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 twenty 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.

If you have less than twenty percent down, your lender will probably also require you to include an amount for private mortgage insurance (PMI) in your payment. These are then added to the required principal and interest amounts to total your monthly payment.

Fixed Rate Mortgages

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There are two main mortgage types: fixed-rate and adjustable rate mortgages or ARMs.

Fixed rate loans mean you pay the same interest rate for the entire life of the loan. Most fixed rate mortgage loans are for 30 years, although you can also get them for 15 or 20 years.

Shorter loans such as 15 or 20 year mortgages usually have lower interest rates, typically one-half or one-quarter of a percent lower than a 30 year loan, but the total monthly payment will probably still be higher than that of a longer term loan, because you have to make bigger payments in order to pay the loan off in the shorter time frame.

You will pay less overall with a short-term loan, however, than if you'd borrowed the same amount with a longer loan. Depending on your situation, carefully consider a shorter loan.

While a longer loan will generally give you a lower monthly payment, if you can afford the higher payment, you may save a lot of money in the long run and build equity much faster.

For example, let's compare the payments and total interest paid for a $150,000 mortgage over 15 years and over 30 years. A fifteen-year loan may be at 6.1% with a payment of $1,274 per month and you will pay a total of $79,303 in interest.

A thirty-year loan at 6.64% will have a payment of $962 per month and you will pay a total of $196,304 in interest. In this example, the difference in monthly payments is only $312 but the difference in total interest paid is $117,001.

[See also: Fixed vs. Adjustable Mortgages]

Adjustable Rate Mortgages

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Adjustable-rate mortgages (ARMs) are the second major type of loan available. With an ARM, your interest rate, and therefore your payment, can go up or down through the life of the mortgage, depending on various economic factors.

The rate is usually tied to a money market index, most commonly the one-year Treasury bill. The lender will usually add between two and four percentage points to the current rate for the Treasury bill to come up with your current adjustable rate. These extra percentage points are called the margin.

The rate for an ARM mortgage usually begins lower than the fixed-rate mortgages available at the same time, sometimes by as much as two percentage points. This depends on the economic conditions at the time. The terms of the rate adjustments, including when they begin and how often they occur, will be specified in the terms of the loan.

The amount of time before the first rate change ranges from one month to ten years, but one year is the most common. If rates drop, your payment could go down, but if they go up, your payment will go up also.

ARMs do usually have a cap, which states the maximum amount a rate can change at one time, and the maximum amount it can vary from the original rate over the life of the loan.

A few ARMs also come with a payment cap, which states the maximum amount the payment can go up over the life of the loan. This is stated in dollars and not percentage rates.

Some ARMs also include something called a conversion option. It allows you to convert the adjustable rate mortgage to a fixed rate mortgage at some point in the future for a set fee. This is a good thing to check on, in case interest rates begin to rise.

[See also: Fixed vs. Adjustable Mortgages]

Comparing Fixed-Rate and Adjustable-Rate Mortgages

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Fixed-rate mortgages and adjustable-rate mortgages (ARMs) both have their pros and cons. This article compares the two mortgage types.

Fixed-Rate Mortgages

The main benefit of a fixed-rate mortgage is that your payment remains the same through the life of the loan. This predictability makes planning easier. They are also much simpler to understand.

However, if want to take advantage of dropping interest rates, you would have to refinance, which requires additional paperwork and costs.

Also, if mortgage interest rates are high, they can be an expensive option since there are no initial rate cuts.

Finally, fixed-rate mortgages are pretty standard from lender to lender, which means there is little room for customization of your loan.

Adjustable-Rate Mortgages (ARMs)
ARMs can allow you to afford a bigger mortgage. If you know your income will be rising or know you will be selling the house in less than five years, ARMs may be a good option for you.

Also, if rates begin to fall, you do not need to refinance in order to see your payments go down; they will automatically be recalculated at the new, lower rates.

However, with an ARM, your payment and interest rate can go up significantly during the life of the loan, even with caps in place. The initial rates are usually lower than market rates, so when you receive your first adjustment, it can be quite a change, especially since the caps don't always apply to the first adjustment.

For example, an annually adjusted ARM for $150,000 may start at 5.75%, but a 6% cap could allow it to go to 11.75% within four years. This would raise the payment from $875 to $1,514, an increase of $639.

Less Points or Lower Interest Rates?

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When you receive a quote from a lender, it will usually include the interest rate and points. A point is one percent of the loan amount, and lenders can charge from one to several points on a loan. Points are paid as part of closing costs.

Discount points are prepaid interest; the more points you pay at closing, the lower the interest rate on your mortgage is.

Origination points are basically just a fee to cover the lenders cost of making a loan.

Discount points are tax deductible, but origination fees are not. When choosing between loans with points or no points, consider how much money you have available for closing, and how long you plan to own the home.

If you do not have much money for closing, a loan with no points will require less money up front. However, if you plan to live in the home for a long time, a lower interest rate will ultimately be better for you.

You can ask the seller to pay the points as part of the purchase agreement; if they agree to pay the points, you still get the tax deduction.

What Does My Credit Score Mean?

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When a lender is considering your application, they will get a copy of your credit report. This report gives all the details about your financial history, payment records, total debt, and any bankruptcies.

The information on this report is used to create your credit score or FICO score, a numerical rating of your creditworthiness. Credit scores range from 300 to 900, with most people falling somewhere between 600 and 700.

The higher your credit score, the more appealing you are to a lender, and the more likely they will offer you good rates and loan terms. Factors affecting your credit score include the number and frequencies of your delinquencies, how long you've had credit, and how close you are to your credit limits.

If you know you will be applying for a mortgage in the near future, it is wise to request a copy of your own credit report in order to look at it before the lenders do.

It's estimated that almost 80% of credit reports contain errors, so this gives you a chance to correct them before you apply for a loan, as well as take basic steps to improve your credit score.

You should look for credit cards you don't use anymore and close those accounts. Resolve any outstanding accounts, verify all listed account numbers to make sure they are yours, and check your loan balances and late payments. You may be required to explain these to lenders.

To improve your credit score, pay all of your bills on time and reduce the amount of credit you have outstanding.

What If I Don't Have A Down Payment?

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A down payment is the biggest hurdle most first-time homebuyers face. Most lenders prefer at least 20% down and require at least 5% to 10% down.

Financing a mortgage with less than 20% down requires you to get private mortgage insurance (PMI). Putting more money down on a house may persuade lenders to overlook credit problems, as well as loan you more money.

To come up with a down payment, you can save money by cutting out extras, borrowing from your 401(k), or borrowing from family members.

You should have your down payment available at least two months before you apply for a mortgage.

If you are still unable to come up with 20% down, look for special mortgages or programs for first-time homebuyers or those with low income.

What If I'm Turned Down for a Mortgage?

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Many people applying for a loan worry about this possibility, but it is actually a somewhat unusual occurrence. Lenders can usually adjust loan terms in many ways in order to help you qualify for a loan.

However, if you are denied, there are several steps you should take:

First, ask the lender for an explanation. They are required to tell you, in writing, exactly why your application was denied within thirty days. The most common reasons given are inadequate down payment, too much debt, and poor credit rating. All of these can be corrected with time however.

Second, ask for a review of the decision. It is possible you could still qualify if you can satisfy the reviewer that your credit was damaged by an isolated and unpredictable incident such as a major illness.

Finally, if the first lender still denies your application, go to another lender. Just because one lender feels you are not qualified for a loan doesn't mean they will all feel the same way. Different companies operate under different guidelines, and although you may pay higher rates, you should be able to find someone who is willing to offer you a loan.

How Much Can I Borrow?

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How do banks decide how much money to lend you? They base their decision on their estimate of your ability to repay the loan.

To make this estimate, they look at your income, your available cash, your debt, and your credit history.

There are two debt-to-income ratios that banks check based on the information you provide on your loan application.

Front-End Ratio

First, they check to see how much of your income would go toward the mortgage payment. This is called the front-end ratio.

Their guideline is that your total payment, including principal, interest, and escrow payments, should not be more than 28% of your gross (pre-tax) monthly salary.

To calculate this for yourself, take your annual salary and multiply it by .28, then divide it by 12. This number is your maximum total mortgage payment per month.

Back-End Ratio

Banks also check how much of your gross income is required to pay all of your debts combined. This is called your back-end ratio and includes the mortgage as well as car payments, credit card payments, student loans, and child support and alimony payments.

Their guideline for this ratio is that your total debt payments should not be more than 36% of your gross income.

To calculate this for yourself, take your annual salary and multiply it by .36, then divide it by 12. This is the maximum allowable amount of your total monthly debt payments.

Don't Be House Poor

Be cautious with these numbers however. Just because the bank says they are willing to lend you a certain amount, doesn't mean you need to borrow that amount!

(Real estate agents and lenders make more commission on bigger houses and will naturally encourage you to borrow as much as you can.)

Instead, consider your own budget and lifestyle, and make sure you don't end up with such a high mortgage payment that you can't put money away for retirement, go for a nice vacation, or even go out to eat.

Some debt counselors recommend that your total payment should not be more than 28% of your net pay (after taxes), leaving you money for a comfortable lifestyle as well as the other costs of home ownership, such as repairs, maintenance, and higher utility bills.

Another common rule of thumb is to not buy a house that costs more than two and a half times your current annual salary.