Understanding
Mortgages
The mortgage world can look
like a bowl of alphabet soup: VHA, FHA, ARM, PMI, PITI. It can be confusing
and perhaps even a little unnerving. This section will give you a basic
understanding of all of the initials and help you prepare for the closing
table.
You can scroll down to continue,
or click on one of the following links:
Tax
and Insurance Reserves
Amortized
Loans
Conventional
Loans
Conventional
Loans and Private Mortgage Insurance
Federal
Housing Administration (FHA) Loans
Veterans
Affairs (VA) Loans
Adjustable-Rate
Mortgages
Discount
Points
Prepayment
From a legal standpoint, a
mortgage is a voluntary lien on real estate. A borrower pledges the land
to the lender as security, or collateral, for the debt. In practical terms,
this means that when you borrow money to buy a piece of property, you
voluntarily give the lender the right to take that property (foreclose)
if you fail to repay the loan.
Tax
and Insurance Reserves
When you borrow money to purchase
real estate, the lender has a vested interest in how well you meet other
financial obligations-in addition to repaying the loan-associated with
the property. For example, if you fail to pay your property taxes and
then default on your loan, the government will be paid first-and the lender
will lose money on your loan. Similarly, if you fail to pay the premiums
on your homeowner's insurance and your home is destroyed by fire, your
loan is no longer secured. For these reasons, many lenders require borrowers
to provide a reserve fund to meet future real estate taxes and property
insurance premiums. In Indiana this fund is called an escrow account.
If your lender requires one, you will make the first deposit at your closing.
It will cover any unpaid real estate taxes and a portion of the insurance
premium liability. For the life of your loan, a portion of each mortgage
payment will be allocated to paying off the principal, another portion
will pay off interest, another portion will be escrowed for taxes, and
the final portion will be escrowed for insurance. Your loan officer may
refer to this as PITI: Principal, Interest, Taxes
and Insurance.
Amortized
Loans
The word amortize literally
means "to kill off slowly, over time." Most mortgage loans are
amortized, meaning they are paid off slowly, over time-typically 15 or
30 years. Each amortized loan payment partially pays off both principal
and interest. Each payment is applied first to the interest owed; the
balance is applied to the principal. At the end of the term, the full
amount of the principal and all of the interest due is reduced to zero.
For fully amortized loans,
monthly payments remain consistent throughout the life of the loan. However,
because the interest is paid first, the portion applied to repayment of
the principal grows and interest due declines as the unpaid balance of
the loan is reduced. Borrowers who make additional payments should instruct
the lender to apply the additional funds toward repayment of the principal.
Conventional
Loans
Conventional loans are viewed
as the most secure loans because their loan-to-value (LTV) ratios are
the lowest. The borrower generally makes a 20 percent down payment and
borrows the remaining 80 percent of the value of the property. This is
important because lenders needs to know that if a property goes into foreclosure,
they can get out of it what they have invested in it.
When making a conventional
loan, the lender is relying on the appraisal of the real estate (as the
only security) and on the reliability of the prospective borrower as indicated
in his/her credit history. No additional guarantees or insurance is necessary.
Conventional
Loans and Private Mortgage Insurance
It is possible obtain a conventional
loan with a lower down payment investment under the private mortgage insurance
(PMI) program. PMI allows borrowers to invest less up front while still
protecting the interests of the lender. If your down payment investment
is less than 20 percent of the purchase price of your home, you will be
required to pay at least some PMI to provide additional security on your
loan. This will generally add between 5 and 10 percent to your mortgage
payment.
You will not have to pay PMI
for the life of the loan, however. Once you have repaid your loan to a
certain level (determined by the lender), you will be allowed to terminate
your coverage.
Federal
Housing Administration (FHA) Loans
FHA loans are insured by the
Federal Housing Administration and must be made at FHA-approved lending
institutions. As with PMI, FHA insurance provides the lender with additional
security against borrower default.
Certain requirements must be
met before the FHA will insure your loan:
- You will be charged a percentage
of the loan as a premium for the insurance. This premium may be paid
up front at closing by the borrower or by a third party. It may also
be financed as part of the total loan amount or paid as monthly premium.
Unlike PMI, these premium payments never stop, but if the FHA doesn't
have to pay a claim, you may receive part of your money back at the
end of the loan.
- FHA regulations set standards
for type and construction of buildings, quality of neighborhood and
credit requirements for borrowers.
- The real estate must be
appraised by an approved FHA appraiser.
- The loan-to-value ratio
must fall within certain limits.
FHA loans are also available
for condominiums if specific requirements are met.
Veterans
Affairs (VA) Loans
The Department of Veterans
Affairs provides guarantees for loans for eligible veterans and their
spouses. Under this program, the VA does not actually lend the money;
rather, it guarantees loans made by approved institutions.
These loans are available with
little or no down payments and at comparatively low interest rates.
To qualify for a VA loan, veterans
must meet the following criteria:
- 90 days of active service
for veterans of WWII, the Korean War, the Viet Nam war and the Persian
Gulf war.
- A minimum of 181 days of
active service during interconflict periods between July 26, 1947, and
September 6, 1980
- Two full years of service
during any peacetime period after September 7, 1980
There are limits on the amount
of the loan the VA will guarantee. A lending institution may choose to
extend a larger loan, but the additional funds won't be guaranteed by
the VA. To determine what portion of a mortgage loan the VA will guarantee,
the veteran must apply for a certificate of eligibility. The VA also issues
a certificate of reasonable value (CRV) for the property being purchased.
The CRV is essentially an appraisal. If the purchase price exceeds the
amount cited in the CRV, the veteran must pay the difference in cash.
At closing, veterans will have
to pay a loan origination fee to the lender and a funding fee to the VA.
The lender may charge additional discount points which may be paid either
by the seller or the veteran.
Adjustable-Rate
Mortgages
An adjustable-rate mortgage
will be originated at one rate of interest and then adjusted up or down
during the life of the loan based on some objective economic indicator.
Because the interest rate may change, the borrower's monthly payment amount
may also change. Details of how and when the interest rate will be adjusted
are specified in the mortgage note.
Common components of an adjustable-rate
mortgage include:
- The interest rate is tied
to the movement of an objective economic indicator called an index.
- The interest rate is the
index rate plus a premium, called the margin.
- Rate caps limit the amount
the interest rate may change. Most ARMs have two types of rate caps:
periodic and aggregate. A periodic rate cap limits the amount the rate
may increase at any one time. An aggregate rate cap limits the amount
the rate may increase over the entire life of the loan.
- A payment cap protects the
borrower by setting a maximum amount for the payments. The downside
is that this can result in negative amortization where the loan balance
is actually increasing over time.
Discount
Points
Your lender may want to sell
your loan to investors. To make the sale more attractive to the investors,
the lender may charge you "discount points." A point equals
one percent of the amount being borrowed. So, if you are borrowing $100,000
and the mortgage company you are considering will charge you three discount
points, that's an additional $3000. Sometimes this amount is financed
as part of the total loan amount, and sometimes it must be paid in cash
at closing. Before you finalize your financing, be sure you understand
the lender's requirements.
Prepayment
If you repay your loan before
the end of the specified term, your lender will not collect as much interest/profit
as anticipated. For this reason, some mortgage notes contain a prepayment
clause which requires the borrower to pay a penalty on any payments made
ahead of schedule. Ask potential lenders about prepayment penalties before
finalizing your financing. Lenders can not charge prepayment penalties
on mortgage loans insured or guaranteed by the federal government.
More
about loan programs
Next>>
F.C. Tucker
on "Buying Your First Home" |
