How Mortgages Work
The Mortgage Payment
According to Lee Ann Obringer & Dave Roos of howstuffworks.com, the monthly mortgage payment is composed of the following costs, appropriately known by the acronym PITI:
- Principal - The total amount of money you are borrowing from the lender (after your down payment)
- Interest - The money the lender charges you for the loan. It's a percentage of the total amount of money you're borrowing.
- Taxes - Money to pay your property taxes is often put into an escrow account, a third-party entity that holds accumulated property taxes until they're due.
- Insurance - Most mortgages require the purchase of hazard insurance to protect against losses from fire, storms, theft, floods and other potential catastrophes. If you own less than 20 percent of the equity in your home, you may also have to buy private mortgage insurance, which we'll talk more about later.
The down payment on a mortgage is the lump sum you pay upfront that reduces the amount of money you have to borrow. You can put as much money down as you want. The traditional amount is 20 percent of the purchasing price, but it's possible to find mortgages that require as little as 3 to 5 percent. The more money you put down, though, the less you have to finance -- and the lower your monthly payment will be.
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 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 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.
FHA started a program that lowered the down payment requirements. They set up programs that offered 80 percent loan-to-value (LTV), 90 percent LTV, and higher. This forced commercial banks and lenders to do the same, creating many more opportunities for average Americans to own homes.
The FHA also started the trend of qualifying people for loans based on their actual ability to pay back the loan, rather than the traditional way of simply "knowing someone." The FHA lengthened the loan terms. Rather than the traditional five- to seven-year loans, the FHA offered 15-year loans and eventually stretched that out to the 30-year loans we have today.
Another area that the FHA got involved in was the quality of home construction. Rather than simply financing any home, the FHA set quality standards that homes had to meet in order to qualify for the loan. That was a smart move; they wouldn't want the loan outlasting the building! This started another trend that commercial lenders eventually followed.
Before FHA, traditional mortgages were interest-only payments that ended with a balloon payment that amounted to the entire principal of the loan. That was one reason why foreclosures were so common. FHA established the amortization of loans, which meant that people got to pay an incremental amount of the loan's principal amount with each interest payment, reducing the loan gradually over the loan term until it was completely paid off.
Wanting an in-depth conversation about mortgages? Call Marty Anders, Realtor (614) 419-1518). She has an understanding of home mortgages and will be delighted to share them! E-mail her: email@example.com