Previously, I talked about how the mortgage industry works. Today I want to talk about how mortgages work.
We must start by making a few distinctions. A mortgage is not a loan. A mortgage is a legal instrument for the transfer in ownership of a piece of land or property. The transfer is completed once the terms of the mortgage are satisfied. In other words, its a piece of paper that says someone is borrowing money to buy the property, and once they pay off that borrowed money they get the title to the property. A mortgage loan is the actual device used to obtain the money specified in the mortgage. For simplicities sake, I will likely use the terms interchangeably, making distinctions if necessary.
Like many subjects in the College of Weakonomics, I could devote an entire website to mortgages. We will go over the important stuff though, and the types of mortgages available. There are 4 primary components to a mortgage loan: down-payment, principle, length, and interest terms. Yes there are closing costs and taxes and all sorts of fun things, but those are just the random parties trying to get their cut (like real estate agents and the government).
The down-payment is of course the most obvious. It is the amount of cash I’m putting up front to the cost of the property. There is no other more important factor in the terms of a mortgage loan than the down-payment. Not your credit, not the value of the house, not your cousin the mortgage guy. The more money you put down, the less risk there is to the bank lending you money. Less risk, less interest, less payments. If your down payment is above 20% of the value of the house, you don’t have to worry about a little thing called mortgage insurance. This means if you put down 10%, you have to pay the insurance for the bank so they can get back their losses if you default. Once you hit 20% equity in the home, this is usually forgiven. In recent years, mortgage insurance has been ignored all together, hence, credit crises.
The principle is the amount you need to borrow. If I want a $100,000 house and i put 20% down, I’m going to need to borrow $80,000 from the bank. Thats the principle. Many fees are rolled into the principle as well.
The length of the loan is very important to the calculation of interest and payments. The standard these days is 30 years, so you make a payment every month for 30 years. Some ultra-conservative finance folks suggest if you can’t afford the payments at a fixed rate for 15 years, then you can’t afford it. Conservative, but true advice no less. My parents used a 20 year mortgage, and I’ve seen them as high as 50 years. 30 years is reasonable, just make it a goal to pay off sooner.
The interest terms are the most important component to the loan. If we play it simple, a difference of 100 basis points (1%) on an interest rate can save or cost you thousands over the life of the loan. Getting the best possible rate for your credit is wise. The part that got us in a hissy over the last 5 years though is the flexibility of the interest terms. You know about the fixed rate, but what about a variable or adjustable rate mortgage (ARM)? I might qualify for a mortgage at 6%, but if I get the ARM I’ll get 3% for 5 years and then it will adjust after based on current rates. Some people could only afford the payments at 3%, so when rates adjusted after 1, 4, 5, 7, and even 10 years they could no longer afford the house. Boom! Foreclosure.
Here are a few of the crazy and unsafe types of mortgage loans that became mainstream in the past few years:
Balloon Mortgage
Make payments based on a 30 year fixed rate over a shorter term (say 10 years). There is a large balance leftover at the end of ten years that must be paid. This is known as a balloon payment. Popular with commercial real estate where the balloon can be financed into a new loan. Popular with investors interested in holding the property as a rental for less time than the terms of the loan.
Jumbo Mortgage
Standard mortgage rules apply, just the principle of the mortgage is above $417,000. Fannie Mae and Freddie Mac were not allowed to buy these riskier loans until Congress passed a law temporarily allowing them to do so up to $730,000 in 2008 (that economic stimulus thing). They are riskier because luxury homes are more difficult to sell at full price in the event of a default. Principles above $650,000 are super jumbos. Popular with people that have high incomes but no wealth and savings, aka Californians.
Interest Only Mortgage
Your monthly payments do not include anything to pay down principle. Very similar to paying rent only it was usually cheaper. Common with house flippers, “investors”. I could buy a fixer upper at $75,000, invest $50,000 in upgrades and resell for $175,000 for a $50,000 profit 4 months later. The interest over the 4 months in negligible, and the payments that would have gone to principle were better used in the cash for upgrades. Popular with flippers, TLC shows, and morons duped into getting one as a normal mortgage.
Home Equity Loan and Line of Credit (HEL and HELOC)
If you already have some equity in your home or have the house paid off, you can borrow money against that equity. If my home is worth $100,000 and I’ve got $80,000 paid off, I might could borrow $20,000 to do some upgrades. Most banks will even issue checks or a debit card to make purchases. I might take out a HELOC to upgrade a bathroom, or fix a broken garage door a clumsy 16 year old rammed. The problem is you can use the equity for whatever; since the interest rate is typically lower than a credit card, you could buy a car, clothes, children’s college, even a vacation, so it was abused way too often. Popular with house repair, home upgrades, and typical American consumerism.
There are plenty more types but you get the idea.
To wrap up mortgages I do want to point out an advantage. To encourage citizens to buy homes instead of renting them, there is an incentive from the government. Whatever interest you pay on mortgages loans (home equity loans as well) is tax deductible. It means your stated income is less for that year which means you pay less in taxes.
Mortgage loans are great tools. Americans got stupid when they stopped thinking ahead. Most mortgages are long-term commitments. Since you don’t know what you’ll be making in 30 years, its best not to assume you’ll be making more and get a mortgage that can get more expensive over time. 90% of the population belongs in fixed rate 15-30 year mortgages. Don’t treat your house like a piggy bank either and pull out the equity. If your useless son hits the garage door you should have an emergency fund for that. If you want to add granite to your kitchen, save up your money. If you want to go on vacation, don’t leverage your HOME to pay for it. That trip to Cabo will be so worth it when you have to move out of your dream home 3 years later because you can’t afford the payments.
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. |
| Related Websites |
Be First To Comment!