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
A mortgage is a loan. The key components of loans, described in this post, hold for mortgages.
Mortgages have the following characteristics of loans:
- You are a borrower and borrow money from a mortgage lender.
- You make a down payment. The down payment is the amount that you pay towards the house at the time you buy it.
- The principal is the amount you borrow. That is, it is the difference between the price of the house, including closing costs, and your down payment.
- The loan has an interest rate. With each payment, you pay interest on the remaining principal. The following factors can lower your interest rate:
- Your down payment as a percentage of the purchase price is higher.
- The term is shorter.
- Your credit score is higher.
- Your mortgage payment includes both principal and interest components.
- Each mortgage has a term. The terms of most mortgages in the US are either 15 or 30 years. In Canada, the payments are sometimes determined as if the loan has a 30-year term, but the actual term is only five years. More about Canadian mortgages later.
The primary differences between loans generally and a mortgage are:
- Mortgages tend to be much larger than most other personal loans.
- Your residence acts as collateral for the loan. That is, if you don’t make your loan payments, the lender can foreclose on your home (take ownership of it).
Monthly Mortgage Payments
The three factors that influence the amount of your monthly payment are:
- Initial principal (loan amount) – a lower initial principal leads to a lower payment.
- Interest rate – a lower interest rate leads to a lower payment.
- Loan term – a longer term leads to a lower payment.
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.
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.
FHA, VA, Traditional Residential Mortgages
In the US, there are three common ways in which residential mortgages are issued:
- Insured by the Federal Housing Administration (FHA).
- Insured by the Department of Veterans Affairs (VA).
- Uninsured (known as conventional mortgages).
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.
Mortgage Broker vs. Mortgage Banker
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 Up Front
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.
Risks of Adjustable Rate Mortgages
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.
Private Mortgage Insurance
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.
Bundling of Expenses
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.