A Financial Literacy Blog for All
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A reverse mortgage can be a valuable financial management tool for seniors and their families. However, if misunderstood or misused, borrowers and their heirs can encounter any one of a number of different challenges. In this post, I’ll define “reverse mortgage” and provide illustrations of …
A mortgage is key to buying a residence for most people. Mortgage loan documents are often lengthy and full of technical terms. As such, many people either don’t read them in their entirety or don’t understand the details. As with all contracts, I recommend that you read your mortgage from beginning to end before you sign on the dotted line. If you don’t understand something, find an independent expert who does. That expert can be a financially savvy family member, friend or a lawyer. It probably isn’t your lender, real estate agent or title agent.
In this post, I explain the basics of residential mortgages and how they compare and contrast to loans in general. I illustrate how monthly mortgage payments are calculated. Probably most importantly, I identify a number of features of mortgages that could cause financial challenges if you don’t understand them or aren’t prepared for them.
A mortgage is a loan. The key components of loans, described in this post, hold for mortgages.
Mortgages have the following characteristics of loans:
The primary differences between loans generally and a mortgage are:
The three factors that influence the amount of your monthly payment are:
The table below compares the monthly payments on a $100,000 mortgage for interest rates ranging from 2% to 5% for 15- and 30-year terms. These interest rates and terms are fairly typical these days.
| Term (years) | Interest Rate | |||
| 2% | 3% | 4% | 5% | |
| 15 | $644 | $691 | $740 | $791 |
| 30 | 370 | 422 | 477 | 537 |
As can be seen, moving from a 30-year mortgage at 2% to a 15-year mortgage with a 4% interest rate doubles your monthly payment ($370 vs. $740).
To give you some context for how high monthly payments can be, I took out my first mortgage in 1982. The interest rate was 16.875% for 30 years. On a $100,000 mortgage, my payment would have been $1,416. The mortgage was even more onerous than that, as it had other features that I’ll discuss below.
In the US, there are three common ways in which residential mortgages are issued:
BankRate has a nice chart comparing the common provisions of these approaches. You can obtain all three types of mortgages from a bank or mortgage broker. From the lender’s perspective, the presence and type of insurance affect the riskiness of the mortgage. If it is insured, the lender considers the mortgage much less risky and can offer a lower interest rate.
VA-insured mortgages (i.e., VA loans) tend to be the most flexible. They do not require a down payment or mortgage insurance. The interest rate on VA loans does not depend on your credit score. There is an upfront fee and you must be a veteran to qualify for a VA loan.
FHA-insured mortgages are slightly more flexible than conventional mortgages, especially if you have a somewhat low credit score and/or only a small down payment. FHA loans require a down payment of at least 3.5% of the purchase price for people with credit scores above 580. For people with credit scores between 500 and 580, the down payment must be at least 10% of the purchase price.
FHA-insured mortgages have an upfront fee to cover private mortgage insurance (discussed below), whereas most conventional mortgages do not. FHA-insured and conventional mortgages can also have annual private mortgage insurance (PMI) fees, whereas there are no annual PMI fees for VA-insured mortgages, just an upfront charge.
The two most common ways to get a residential mortgage are to use a mortgage broker or to contact a mortgage banker directly.
A mortgage banker is an entity (often a local, regional or national bank) that issues mortgages. That is, a mortgage banker uses its own funds when loaning you money. The mortgage banker may borrow the funds from another lender or can sell your mortgage. Nonetheless, when you borrow money for a mortgage, it is the mortgage banker who is providing the cash.
A mortgage broker is like an insurance agent. The mortgage broker learns about your borrowing needs. It then contacts a number of mortgage bankers to try to find you the best deal.
Briefly, the advantages of using a mortgage broker are that it can save you time and will likely provide access to more mortgage bankers than you can contact as an individual. The disadvantages are that, as is the case whenever there is an intermediary, you may pay extra fees and the intermediaries’ interest may not align directly with yours. Investopedia provides a more detailed summary of the pros and cons of using a mortgage broker.
A prudent strategy is to contact several mortgage bankers directly, as well as to work with a mortgage broker. You can compare the offers and see which one best meets your needs.
One of the most important things you can do before you sign your mortgage documents is to read and make sure you understand the entire contract. One of the contributing factors to the lending crisis of 2008 was a lack of understanding by borrowers of the terms of their mortgages. There are several features that could be present in your mortgage contract that could cause you issues down the road. In this section, I’ll identify and explain several of them.
A balloon payment is a large payment for the remaining principal balance at the end of the term. When there is a balloon payment, there two time periods of importance. The first is the term of the loan. It determines the date that the balloon payment is due. The second is the period over which the initial principal is amortized. It determines the monthly payment and how much principal is paid during the term. When there is a balloon payment, the term is always shorter than the amortization period.
I’ll use a $100,000 mortgage with a 3% interest rate, a five-year term and a 30-year amortization period as an example. The monthly payment on this mortgage is $422. At the end of the five-year term, the remaining principal is $88,906. If your mortgage had these terms, you would have to pay the bank for the remaining principal of $88,906 at the end of five years. You could either take out another mortgage or pay the balance from your savings.
I am told that this type of mortgage is very common in Canada. In fact, my daughter’s mortgage has a balloon payment at the end of five years. The contract indicates that the bank will offer her another mortgage, but with an interest rate that reflects the then-current market interest rates and her then-current credit score.
If interest rates go up or her credit score goes down, her monthly payment could increase significantly. If she takes out another 30-year mortgage and her interest rate doesn’t increase, her payments will go down because the initial principal will be lower ($88,906 vs $100,000 in the example). However, if she repeats this process every five years with 30-year amortization periods indefinitely, she will never pay off the full amount of her mortgage!
The payments for some mortgages include only interest on the initial loan amount. The monthly payment is equal to the annual interest rate times the principal divided by 12 (months in a year). The principal never decreases on an interest-only mortgage, as there is no principal in the monthly payments. Interest-only loans usually have a balloon payment after a fairly short period of time (say, five years). The balloon payment is equal to the initial amount borrowed.
An advantage of an interest-only loan is that the payments are lower. The disadvantage is that you still owe the same amount at the end of the term as at the beginning.
Some mortgages limit the timing and amounts of pre-payments. If you make pre-payments at any time other than those allowed by the terms of the mortgage, you might have to pay a penalty. As such, if you think you might want to re-pay your mortgage more quickly than the standard schedule, you’ll want to make sure that it doesn’t contain any pre-payment penalties or that you can work within their limits.
As an example, pre-payments on my daughter’s Canadian mortgage can be made only on regular payment dates and, in any 12-month period, cannot exceed 21% of her initial loan balance. The pre-payment choices are a lump sum payment of 15% of the initial loan balance, a 15% increase in payments per calendar year and doubling of one or more payments during the calendar year. She can use any or all of these options to pay the principal on her mortgage faster, but is limited to only these options.
Points are a fee whose amount is determined as a percentage of the initial principal. They are less common now than they were when I took out my first mortgage. Nonetheless, you want to be alert for them. In my case, I had to pay three points to the lender when my mortgage originated plus all of the other fees at closing. On a $100,000 mortgage, three points is the equivalent of $3,000. In addition, I paid the interest on the mortgage as part of my monthly payments.
Some mortgages have adjustable interest rates. Mortgages with fixed interest rates (fixed rate mortgages) are more common now than they were. Adjustable-rate mortgages or ARMs were more popular when interest rates were high and changing rapidly.
My first mortgage, in addition to the three points, had an adjustable interest rate. In my case, the interest rate was set at the beginning of each year and changed based on a benchmark rate. There was a maximum amount by which the rate could change in one year and another cap on the total increase over the life of the mortgage. When the interest rate changes, your monthly payment is recalculated based on the new interest rate and the remaining principal and term of the loan.
For more details and an actual example of an adjustable rate mortgage, I suggest taking a look at this post. If you think interest rates are going to stay at their currently low levels for the entire time you plan to own your home, then the recommendation to using an adjustable rate mortgage is reasonable. If, however, you plan to own your home for a long time or think interest rates will increase by more than a point or two from current levels any time soon, I disagree with the author’s recommendation.
In this currently very low interest rate environment, you want to be very careful about adjustable rate mortgages. As an example, let’s say you borrowed $100,000 using a 30-year mortgage with a 3% initial interest rate. As indicated above, your monthly payment will be $422. If the interest rate increases to 4% in the second year, your payment increases to $485. If it increases again in the third year to 5%, you will have an even higher monthly payment of $552 or 31% more than your initial monthly payment.
You face a similar, but not quite as dramatic, risk of monthly payment increases if you have a mortgage similar to my daughter’s in Canada. Her payments wouldn’t go up as much at the end of five years for each point increase in the interest rate because the balance remaining at the end of the five-year term is amortized over a full 30-year term and not the remainder of the 30 years in the original term. However, if I remember correctly, there is no cap on how much the interest rate can increase from one five-year period to the next.
Before a lender commits to a mortgage, it will almost always require an appraisal of the property. The lender sets the interest rate on a loan based on its perception of the risk you won’t repay it. The ratio of the amount of the loan to the appraised value (loan-to-value ratio) is part of the risk assessment. The higher the loan-to-value ratio, the riskier the loan to the lender. If the appraisal is less than your purchase price, you may need to either increase your down payment or renegotiate the purchase price. That is, you will be required to bring the loan-to-value ratio in line with the lender’s initial terms.
Some lenders require private mortgage insurance (PMI) on certain residential mortgages. If you have an FHA loan or your conventional loan has a ratio of down payment to your purchase price of less 20%, the lender will likely include a charge for PMI with your monthly payments. There are ways to avoid this charge that you’ll want to research if you have a smaller down payment.
PMI is insurance that protects the lender in case you default on your loan. You get the benefit that the lender is willing to give you a mortgage. Other than that, you get no benefit from PMI even though you pay for it. PMI often costs between 0.5% and 1% of the outstanding principal of your mortgage annually. Once your loan-to-value ratio has increased enough, you can ask your lender to cancel this insurance.
Some lenders require that you bundle your property tax and homeowners insurance costs into your mortgage payment. This bundling increases the lender’s confidence that these bills will be paid. If you don’t purchase homeowners insurance and your home is damaged or destroyed, you are much less likely to re-pay your lender for the mortgage. And, if you don’t pay your property tax bills, eventually the local authorities can foreclose on your property which could significantly diminish the value of the lender’s collateral.
The benefit of this bundling of expenses is that you don’t have to remember to make the separate payments for property taxes and insurance. It can be particularly beneficial as both insurance and property taxes are often large bills that need to be paid only once or twice a year. Many people find it easier to budget for those large expenses by paying them monthly.
The drawback of having your expenses bundled is that the lender often overestimates the amount of these expenses, so you pay more each month and get back the difference on a periodic basis. It also makes it a bit more inconvenient if you want to change insurers.
If you are later in life or have parents who own their home, a reverse mortgage is a variation of a mortgage that might be an option. Reverse mortgages can be very useful in the right situation but are often misunderstood leading to disastrous financial consequences.
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From Susie Q: I’m not as familiar with student debt as I am with the other topics on which I write, so was pleased to accept this guest post from Kate Underwood. With Kate’s permission and approval, I’ve interspersed some comments and numerical examples in italics to expand on a few of her points.
Unless you’ve been living under a rock, you’re probably aware that we’ve got a bit of a student loan crisis on our hands. The amount currently owed by borrowers isn’t in the billions…nope, it’s actually past the $1 trillion mark!
Chances are, you don’t want to be saddled with your own student debt forever. Debt can hold you back from buying a home, starting a family, traveling the world, and other exciting parts of life. Don’t let student loans ruin your dreams – it’s time to start slaying your student debt this year.
Think it’s impossible? Check out the following ways to attack your student loans with a vengeance.
A budget is an essential financial tool that gives a job to every dollar you earn. Get yourself on track by making and following a smart budget. Be sure to account for all necessary expenses, including your student loan payments.
Balance out how much you’re earning with how much you’re spending (and don’t spend money you don’t have). When you’re stuck with student loan debt, it’s key to eliminate luxury spending. Put every spare dollar, after necessities, into paying off your loans.
While it’s tempting to overspend when you get your first “real” job, it’s a bad move. Don’t make the mistake of financing new cars or spending too much on stuff you don’t need. Living within – or below – your means could make a big dent in your student debt. Just live like a college kid for a little longer.
Susie Q adds: For a more detailed discussion of how budgets can be helpful, check out this post or start here for my week-by-week guidance on creating a budget using a spreadsheet template I’ve provided.
Trust me, it’ll be worth it! The faster you pay off your loans, the sooner you can get started building wealth and planning for your next big goal!
That little grace period from your lender is appealing, but don’t hang out there too long. The sooner you can begin repayment, the better.
Even during the grace period, interest accrues for many types of loans. So, while you’re allowed to postpone repayment for a time (usually 6 months), it’s prudent to begin repayment as soon as possible.
Susie Q adds: As an example, if you have a $30,000 balance on a 5% loan with 15 years left in the term and don’t defer your payments during the grace period, your payments will be $237 a month. You’ll pay a total of $12,703 in interest over the life of the loan. If you make the same payments and defer your loan, you’ll pay an extra $1,628 in interest payments and extend your loan by 13 months (6 months of grace period and 7 months of extra payments to cover the extra interest).
Once you know what your minimum payment amount is every month, don’t get too comfy with it. If you push yourself to increase that amount by even $25 or $50 more each month, you could destroy those loans much faster! At the very least, round up to the nearest $10 or $50 mark. So, a minimum payment of $62 could be rounded up to $70 or $100.
Just be sure that, if you’re making extra payments, they’re applied to the principal, not the interest. If you’re in doubt, talk directly to your lender or loan provider to find out how you can go about doing this.
Susie Q adds: Using the same example as above, if you don’t defer your loan for the grace period and round up to $250 a month, you’ll save over $1,000 as you’ll pay only $11,676 in interest and will pay off your loan a full year earlier. You can include your student debt in your debt repayment strategy to figure out how much you can pre-pay each month, as discussed in this post.
Another tip: make biweekly payments rather than monthly. After one year, this simple step will add up to having slashed an extra month’s payment off your total. However you choose to set it up, paying more than the minimum will lead to student loan freedom sooner!
One strategy for paying off your loans faster is to refinance your student loans. The general idea is that if you refinance to a lower interest rate, you’ll end up paying less over the life of the loan. Plus, you can pay them off faster, since you won’t owe as much in interest! Win-win!
A couple of factors to beware of: you usually don’t want to refinance if your credit score has taken a recent hit. That will likely only get you a higher interest rate – you definitely don’t want that! Also, if you plan on utilizing student loan forgiveness programs, you typically need to stay away from refinancing. Most of the forgiveness programs will disqualify you if you’ve refinanced.
If you’re unsure about how to go forward with refinancing, Credible is an online loan marketplace that can make that decision easier. Compare interest rates for which you may qualify with different lenders in order to make the best choice.
Susie Q adds: Using the same example as above, if you are able to re-finance your loan at 3.5% and continue to make the same $237-a-month payment, you’ll save over $5,000 as you’ll pay only $7,485 in interest and will pay off your loan almost two years earlier. This savings will be offset by any fees you need to pay when you re-finance your loan.
Now, if you’re such a rock star that you plan to pay off the full balance within a really short time, like 2 or 3 years, refinancing might not be worth the trouble. Just pay those babies off and be done with them!
One of the best ways to pay off any debt fast is to increase your income. I’m a big proponent of side hustles. You can make extra cash to pay down debt and side hustles are often super flexible with your other responsibilities.
If you’re looking to begin your own side hustle, you can check out these work-from-home jobs and see which might be a good fit. The possibilities are nearly limitless, so be creative and think about your skills and things you enjoy doing anyway.
You could start doing freelance writing or blogging from home (our favorites!). Or start selling your to-die-for cakes for special occasions. Try your hand at bookkeeping, photography, or proofreading or any number of other ways people are raising their income.
Susie Q adds: For more ideas about ways to increase income or reduce expenses to help free up money to reduce your student loan debt, check out this post. Also, if you decide to pursue a side hustle, you’ll want to make sure you don’t spend more money than you earn!
Just imagine how much extra money you could throw at your student debt by starting a side hustle!
Some companies are looking to build positive relationships with employees by offering student loan repayment assistance. So, before you decide to take a job, it might be beneficial to ask if it offers this option. If you’ve already signed on to work somewhere, talk to your HR department to see if it’s available.
You should also explore various government student loan forgiveness programs. Though it’s extremely important to follow all of their rules to be eligible, if you’re working in a career field that allows you loan forgiveness, you might as well go for it!
A piece of advice: save enough during your repayment period that you could pay the entire loan balance off just in case the forgiveness doesn’t come through! Most applications for forgiveness so far have been rejected, so those borrowers are still on the hook for the full balance.
Debt sucks. You know you don’t want to keep your student loans around forever, so use any and all of these tips to slay your student debt as fast as you can!
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