Understanding Mortgage Loans
Here’s a guide to help you understand the concept of Mortgage Loans better.
The Principles of Mortgage
The days when people could afford to buy real estate with their own savings are long gone. Most people rely on credit from a bank to buy their own home, office, land or other real estate. The bank extends credit or loan to buy a real estate property on the basis of a conditional pledge that the debtor (person who has borrowed from the bank) will repay the debt and as long as that is done, the banks holds all documents and rights pertaining to the real estate. The buyer signs a document promising to repay the money to the bank with interest and this is known as the note. Both the conditional pledge and the note are filed and maintained in public records. This is helpful not just to the bank and the buyer but also potential buyers, who may be considering buying real estate in the area.
Borrowers are expected to repay lenders through regular payments called installments. Installments are calculated by adding the total amount borrowed and the interest charged by the lender. Borrowers pay monthly or quarterly installments that include both the principal and the interest. However, different lenders could offer different repayment plans. Sometimes, principal payments could be deferred while the interest is repaid. Also, depending on the lender, the frequency of payments could also vary.
Mortgages are offered by many different kinds of lenders. This includes mortgage companies, credit unions, commercial banks and more. Borrowers are advised to ‘shop around’ for the best possible mortgage offer, including repayment terms, interest rates etc. Many people may also work with mortgage brokers to help find them the best possible loan. In principle, brokers specialize in helping their clients find the loan product that is ideal for them. However, you are advised to work with more than one broker, as brokers are not always obligated to find their clients the best deal.
What Are Your Mortgage Options?
There are many different types of Mortgage products. Here is a list of the most common type available in the market and a brief explanation of each.
The Two Primary Types of Mortgage
Adjustable Rate and Fixed Rate Mortgages are the two main types of home loans available in the market.
In this type of mortgage, borrowers choose to adjust the rate of repayment over a period of time. The rate may be lower compared to a similar mortgage that comes with a ‘fixed rate’ (explained below). In Adjustable Rate mortgage, the borrower chooses a low rate for the first few years and this rate is adjusted at regular intervals; the adjusted rate is based on an index. Mortgage repayments start at a lower rate and increase over a period of time. The Adjustable Rate mortgage helps borrowers on a fixed income that’s set to grow. For instance, those working for a big company and expecting regular promotions and salary increments many choose this mortgage type. Another advantage of the Adjustable Rate mortgage is that it lets people on a fixed income borrow amounts greater than they’re eligible for in good faith of their enhanced future position. Often, borrowers may also choose to adjust on a descending scale. This is ideal for those set to retire at the end of the term or people who’d rather be disciplined and complete repayments in the beginning of the mortgage tenure.
Fixed Rate mortgages are long-duration loans where the payment remains constant. Irrespective of the change in interest rates and market conditions, the borrower continues to pay the same interest and principal amounts for the rest of the term. The repayment terms can last anywhere from between 10 and 30 years. Of course, this can vary from lender to lender. Typically, interest rates depend on the duration of the loan; the longer the repayment schedule, the greater the interest paid by the borrower on his mortgage. However, long duration loans do have some advantages, which is why many people opt for Fixed Rate loans with terms as long as 30 years. Since the initial repayments are largely interest payments, borrowers get higher tax deductions. Further, over a period of several decades, mortgage payments can seem very little – thanks to inflation.
Other Types of Mortgages
While the following mortgage types are mentioned as ‘others’, they are still widely and commonly available from several lenders.
The Reverse Mortgage is ideal for seniors or retirees to cash in on the real estate investments made earlier in life. In return for the property, which is taken over by the lender after the death of borrower, the lender pays out monthly payments. Several rules and restrictions apply and individuals have to check with lenders if they qualify for this type of mortgage.
This type of mortgage is ideal for borrowers who are looking for very low rates for an initial period that could last from 5 to 10 years. After the initial period, the remaining loan amount is refinanced.
In this type of loan, the interest rate is adjusted once and then remains the same for the rest of the duration of the loan.
Do You Qualify For A Mortgage?
Lenders calculate the eligibility of a borrower based on his current income and debt levels. The borrower’s gross monthly income before tax deductions is multiplied by a mortgage factor of between 28 and 36%. Further, monthly debts that are long-term, such as credit card payments, insurance etc. are deducted from this amount. The final amount obtained after these deductions is the mortgage that the borrower qualifies for. While this is the general principle for calculating eligibility, lenders may have different methods to qualify borrowers.
Mortgage – Important Terms You Must Know
The borrower pays a monthly effective rate on the principal amount he borrows. This is usually a percentage of the borrowed amount and could be fixed or adjustable. Adjustable interest rates offer certain advantages but also leave the borrower vulnerable to market fluctuations. Typically, a lower interest rate lowers the burden on the borrower, as he can repay higher amounts of the principal. In addition to the interest rate, the lender should also disclose the APR (Annual Percentage Rate) to the borrower. The APR offers the borrower a clear picture of the complete yearly interest rate, and it includes various other costs such as points costs, mortgage fees etc. Because it includes a total percentage of all the costs that the borrower incurs, the APR is a very important figure to take into consideration when finalizing a mortgage. Interest rates are rarely stable over a period of several years and borrowers stuck in fixed rates or simply unhappy with the lender may consider refinancing. An interest deduction of even a couple of percentage points can have a big impact on the borrower’s monthly repayments. However, refinancing does come with a few initial costs such as lender fees.
We’ve seen how the APR is different from the interest rate and how the lender benefits by lending mortgages. What are the other fees that lenders usually charge? Here’s a brief list.
Application Fee: The lender charges borrowers for processing the loan. This has to paid irrespective of whether or not the loan is approved.
Origination Fee: Once the mortgage is approved and the process is initiated, the lender charges the borrower a percentage of the total principal amount.
Insurance Fee: Before the loan is finally closed, the borrower has to take out an insurance that protects the property from fire and other accidents. Some lenders also charge the Insurance Fee as part of the monthly or quarterly repayments.
Closing Fee: At the time of the closing of the entire transaction and just before the money is loaned, borrowers are charged a closing fee for the cost incurred by the lender to process and disburse the loan.
Lender’s fees are almost always negotiable. Borrowers or brokers often try to get deductions in the earlier stages of negotiations. So you can expect to get a reduction on the application fee or origination fee. However, as the deal is sealed, further negotiations on fee reductions are not easy. Sometimes, the fees are high enough for lenders to include the fees in the total loan amount. This means that borrowers don’t have to make payments upfront and can pay the fees in smaller installments along with the loan repayments. Several lenders also offer loans without any fees. These are usually advertized as ‘No Cost’ or ‘Zero Cost’ loans. However, borrowers need to be careful of higher rates and hidden costs.
Lenders usually do not lend the entire amount required for a mortgage. Borrowers need to make an initial payment of about 20% of the loan amount. The initial payment that the borrower makes from his savings or other sources is called the Down Payment. Many people hesitate to buy real estate due to the misconception that down payments are a huge percentage of the loan. This is not always true and borrowers can also negotiate the down payment amounts. Besides, borrowers also have the option of getting a PMI (Private Mortgage Insurance). If the borrower can only afford to put down less than 20% of the loan amount as down payment, the PMI protects the lender in case the borrower defaults. PMI allows borrowers to obtain higher amounts and after several years of regular repayments, the lender might agree to cancel the PMI.
Amortization is a payment plan or a repayment schedule that shows how the debt is paid off over the period of the loan term, provided the payments are made regularly. The term of repayment is usually outlined in the mortgage note. Borrowers might also choose to pay a higher amount than the amount outlined in their schedule, if they wish to complete repayments sooner. Amortization is a technical term and often used by those in the business of mortgage lending and finance.
Speaking of amortization, it is very important for borrowers to also understand the concept of negative amortization. Also known as negAm, this basically means that monthly payments are low but the borrower is only repaying the principal amount and the interest amount that he owes the lender continues to add up, only increasing the amount he has to pay and the term of the loan.
Borrowers can choose to pre-pay their interest with discount points. Typically, each single discount point is equivalent to a single percentage point of the interest. For instance, for every point that is pre-paid on a loan for a 30-year-term, the borrower secures an interest rate reduction of .125 %. If you’re considering discount points, an easy way to understand the difference it makes to your overall payments, is to ask the lender to break down both the options for you. Generally, you should be able to earn equity on the home sooner than you would without discount points. Further, discount points also offer borrowers tax deductions. Sometimes, savvy borrowers negotiate with sellers to pay for their discount points.
An Escrow Account is established by the lender to hold money that goes towards annual payments such as mortgage insurance, property taxes etc. Borrowers ensure that 1/12 of the annual costs are deposited into this account every month so the lender has enough funds to make annual payments. For instance, if your annual home insurance cost is $1,200, you will have to deposit $100 every month into the Escrow account.
Credit scores is an important factor that helps the lender decide if he should agree to offer credit to an applicant. Further, Credit Scores also indicate how much the lender can safely agree to lend a particular borrower. Borrowers with poor Credit Scores are usually offered loans and other credit at higher rates.
So how is your credit score calculated?
Credit Rating companies have access to your ‘credit history’, including your credit card payments, car repayments, insurance payments, tax etc. Your credit report is a history of your credit. Based on this history, Credit Rating companies arrive at personal Credit Scores.
Credit Scores can have a big impact on the borrowing capability of people. Bad scores could result in rejection of loan applications, higher interest payments and more. It is also known as the FICO Score, which is an acronym for Fair Isaac Credit Organization
The following table shows different Credit Score ranges
720 - 780
675 - 720
620 - 690
Many people with average or fair credit scores may be nervous about approaching lenders for loans or mortgages. However, if your credit scores have been affected by special situations such as illness, lenders may make an exception and offer you a fair deal. Also, people’s circumstances change and if you can demonstrate that this is true for you and you don’t have a reason to default on your loan anymore, you may be able to get a good offer despite minor problems in your credit report.
These days, lenders have tailor-made options for new home buyers and individuals who may have been more adversely affected by their credit history in the past. Potential borrowers have lots of options when it comes to mortgages and they shouldn’t hesitate to seek the best rate they can get in the market – irrespective of their scores and history. Besides, several agencies are dedicated to helping consumers repair their credit scores for a small fee. This could also help borrowers when it comes to securing a loan.