The Basics of a Mortgage

If you have been reading my blog you probably know that I will be taking out my first mortgage on a condo on October 3rd. I have been reading up on the basics of a mortgage to fully understand what I am getting myself into. A mortgage is a long-term loan that allows for the purchase of a home. There are three important factors in determining your mortgage payment: term, interest rate and initial principal.

Term

The term of the mortgage refers to the time line over which the principal will be repaid. The term length has an inverse relationship with the value of the mortgage payment. A 30 year mortgage will provide a lower mortgage payment, however, more interest will be paid over the course of the loan. A 15 year mortgage will provide a higher mortgage payment, however, less interest will be paid over the course of the loan.

Interest Rate

The interest rate determines not only how large the mortgage payment is, but also how much of the mortgage payment goes towards interest and how much of the mortgage payment goes towards paying down your principal. As the interest rate increases, the mortgage payment increases and as the interest rate decreases, the mortgage payment decreases.

Initial Principal

The initial principal is the amount of money you are borrowing from the lender. It’s pretty easy to understand that the more money you borrow, the higher your mortgage payment. The less money you borrow, the lower your mortgage payment.

Types of Mortgages

There are numerous different types of mortgages available to prospective home buyers. I will not go into every available type of mortgage. The two most common are fixed rate mortgages and adjustable rate mortgages (ARMs)

Fixed Rate Mortgages

A fixed rate mortgage has a defined or fixed interest rate that allows for a fixed mortgage payment over the life of the loan. The most common type of fixed rate mortgage is the 30-year variety, however, 15-year fixed rate mortgages are also quite common. Fixed rate mortgages will generally offer a higher interest rate than the ARM because you are getting the peace of mind that your mortgage payment will not change if the interest rates rise. Also, fixed rate mortgages are advantageous taking into consideration the time value of money and the future promise of income increases. A 15-year fixed rate loan is preferable over a 30-year fixed rate loan as they come with lower interest rates and less of your mortgage payment goes towards interest. 30-year fixed rate loans are the most common because they provide a lower mortgage payment compared to a 15-year fixed rate loan.

Adjustable Rate Mortgages

An ARM always offer a lower interest rate when compared to a fixed rate loan, however, this lower interest rate only stays fixed for a certain time period. Once the fixed time period is up, the interest rate adjusts yearly based on the current market conditions. This new adjusted interest rate can end up being quite higher than what you could have received for a fixed rate mortgage. The advantages of an ARM are obvious if you are only planning on staying in your house for a minimal amount of time. It may be beneficial to take out an ARM that stays fixed for seven years at a lower interest rate than a fixed rate mortgage if you are planning on moving within seven years. Also, as my parents did, if the interest rates are high, gambling and taking out an ARM with the hope that interest rates will fall and you can refinance to a fixed rate mortgage at a lower rate. There is always a gamble in taking out an ARM if the interest rate adjusts above the interest rate for a fixed rate mortgage.

Components of a Mortgage Payment

I have already touched on the factors that determine your mortgage payment. A mortgage payment is quite often made up of four components: principal, interest, taxes and insurance.

Principal

A portion of every mortgage payment goes straight towards paying down the remaining principal owed on the house. Initially, the amount of the mortgage payment that goes towards paying down the remaining principal is very minimal. With each payment, more and more of the payment is going towards the principal so at the end of the mortgage term, almost all of the mortgage payment goes towards paying down the remaining principal.

Interest

A portion of every mortgage payment goes straight to the lender’s pockets. Initially, most of the mortgage payment goes towards interest so the lender can protect themselves from borrowers who do not intend to own the real estate long enough to pay off the entire mortgage. Everybody wants as large a piece of the pie that they can get. At the end of the mortgage term, very little of the mortgage payment goes towards interest. An amortization schedule exists that keeps track of the periodic mortgage payments and the amount that goes towards principal and the amount that goes towards interest, which is a topic for another blog.

Taxes

Real estate taxes are often added to the monthly mortgage payment. In these instances the lender collects one twelfth of the real estate taxes for the year with the monthly mortgage payment and holds them in an escrow account until the taxes are due. This is done to protect the lender from the borrower falling into default with the IRS because they forgot to or did not properly save for real estate taxes.

Insurance

Similar to real estate taxes, property insurance can be collected monthly and held in an escrow account. Another type of insurance is sometimes added into the mortgage payment. The lender holds the real estate as collateral if the borrower defaults on the loan. Escrowing the property insurance ensures the lender that the collateral is insured.

Private Mortgage Insurance (PMI) is often required to be paid without a down payment of 20%. This is to protect the lender from a borrower biting off more than they can chew and defaulting on the loan. If you can’t come up with a down payment, you most likely can’t afford the house. Once a borrower holds equity in 20% of the value of the house, not 20% of the original purchase price, the PMI can be eliminated.

My Mortgage

After doing my research on mortgages, I set my goal of saving for a 20% down payment to avoid paying PMI. As of this last month I have reached my goal and will not be forced to pay PMI. As interest rates are at a relative low, I decided on a fixed rate mortgage over an ARM. As much as I would like to take out a 15-year fixed rate mortgage, I just can’t afford the payments. I will be taking out a 30-year fixed rate loan with a maximum interest rate of 6.5%, however, I am hoping to lock in at 6.3% or lower. I do not know if I will be forced to escrow my real estate taxes or property insurance, but I am hoping not to as I am confident in my ability to properly save for these two items, using a high interest rate savings vehicle of course!

As I finalize my mortgage, I will discuss the exact nature of my mortgage in a future blog post. Also, I will most likely blog in the future about the amortization schedule and how or if I plan to make additional principal payments.

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2 Responses to The Basics of a Mortgage

  1. jim morrison says:

    Hi,

    I am Jim, I am really satisfied to visit your blog. Its so informative & helpful for us that I cant express my gratitude for giving me the infos. I am really impressed with the blog. I like to have a discussion with you on your blogs. If you are ready for the discussion please mail me at jimmorrison122@gmail.com.

    Thanking you.

    -Jim

  2. […] presents The Basics of a Mortgage posted at Personal Finance Start-Up […]

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