A mortgage is a legal contract that pledges property to a
creditor as collateral for a loan, and is typically
arranged through a bank or other mortgage lenders.
Because mortgages are such large loans, consumers pay
them off over a long period of time, typically 15 to 30
years.
How the mortgage market works
It is useful when shopping for a mortgage to have a basic
understanding of how the mortgage market works.
- Bankers and other mortgage lenders
use short-term borrowings to make
mortgage loans to
home buyers. This is typically referred to as the
primary market.
- These loans are then grouped
together into packages and put up for sale to
outside investors, which are usually large
institutions.
- The proceeds from the sale are used
to pay off the initial bank loan and replenish the
lending capital.
- There is also a secondary market
where pools of residential loans are sold and resold
after origination. This secondary market includes
such participants as thrifts, commercial banks, life
insurance companies, pension and mutual funds, and
institutions such as the Federal National Mortgage
Association (Fannie Mae), the Government National
Mortgage Association (Ginnie Mae), and the Federal
Home Loan Mortgage Corp. (Freddie Mac).
What's in a payment?
A monthly mortgage is known as PITI payment, made of up
the following four costs:
-
Principal - The loan balance
-
Interest - Interest owed on
the balance
- Real Estate
Taxes - Taxes
levied by different government agencies to pay for
public projects like school construction, fire
department service, etc.
- Property
Insurance -
Insurance coverage against theft and natural
disasters such as fire, hurricane, flood, etc.
Often, a separate levy for government-backed
mortgage insurance premiums - also known as private
mortgage insurance (PMI) - is also included.
The
down payment is the lump sum paid
upfront that reduces the amount of money that needs to
be paid back later. If the down payment is less than 20
percent equity of your home (equity is the amount of
your home's value already paid for), a
PMI will be
charged. The PMI can be eliminated once the principle
balance reaches the loan-to-value (LTV) ratio, which is
80 percent of the sale price or appraised value of the
property.
Mortgages are typically paid off in
incremental payments based on a repayment formula called
amortization. This means that the interests owed on the
mortgage is spread over many payments so that the
overall loan is as affordable as possible. For the first
few years, the portion of the mortgage payments that
goes towards paying the interest is much higher than the
portion that goes to the principal. During the final
years of the loan, payments will be applied primarily to
the remaining principal.
Example: A
30-year, $200,000 mortgage with a fixed interest rate of
6.5 percent, a homeowner will have to pay $255,088.98 in
interest. Because the interest is so high, it is spread
over the full 30-year term. This keeps the monthly
payments at a manageable $1,264.14, most of which will
go towards paying off the interest in the early years of
the loan, with more and more of the payment going
towards paying off the principle as time passes.
Despite the high interest rate, there
are advantages in taking out a home mortgage, including
the pleasure of living in your own home while building
equity, as well as tax incentives, since mortgage
interest is a deduction on your federal income tax.
Mortgage Glossary7
