Chapter 1: Mortgage Basics
Mortgage Basics
A mortgage is a loan used to finance the purchase of real estate. Mortgages make it possible to purchase real estate without having to pay the entire purchase price of the property with your own funds.
The mortgage is paid back over time, by paying the original amount of the loan, the principal, plus interest. The interest rate of the mortgage is the percentage of the principal that the borrower pays each year in interest. This guide covers the three major types of mortgages:
- Fixed-rate mortgages: Mortgages with interest rates that do not change over the lifetime of the loan
- Adjustable-rate mortgages (ARMs): Mortgages with interest rates that periodically change
- Government-issued mortgages: Mortgages offered and financed by the government to qualified buyers
The Way Mortgages Work
There are two main steps to the mortgage process: getting a mortgage loan then paying the loan off. This guide covers the entire method in detail.
Getting a Mortgage Loan
If you are a prospective property owner, also known as a buyer or borrower, you apply for a mortgage from a lender. A lender is either a bank or other financial institution that specializes in mortgage loans. Most lenders require that a borrower make a down payment, which is a lump- sum cash payment equal to 20% of the property’s purchase price. The principal covers the remaining amount of the purchase price. For example, if a home’s purchase price is $300,000 and you pay a 20% down payment ($60,000), the principal would be $240,000.
Paying Off a Mortgage
Once you have a mortgage, it is repaid in monthly mortgage payments that make up the principal plus interest over a set period of time. The length of time is called a term (usually equal to 15 or 30 years). The 30-year fixed-rate is the most popular mortgage type.
The Contents of a Typical Mortgage Payment
Most mortgage payments are made up of the following:
- Principal: Some amount of the original loan balance is paid back in each payment.
- Interest: Some amount of interest on the loan is paid back in each payment.
- Property Tax: All property owners pay property tax charged by their local government. The precise amount varies based on the location of the property. Most lenders will allow bundling of prorated property tax into monthly mortgage payments for convenience.
- Private Mortgage Insurance (PMI): If your down payment is less than the 20% of the property’s purchase price, you are required to pay for PMI, which protects the lender in the event that payments are not made or that you abandon the property.
- Fees: Most lenders charge annual account maintenance fees that are bundled into each mortgage payment. The amount of these fees varies according to the specific terms of the loan.
The Amortization of a Fixed-Rate Mortgage
The amortization of a mortgage is the schedule at which the loan’s principal plus interest is paid off over time. Mortgages are set up by lenders so that in the early years, of a mortgage, payments are made up of primarily interest and a small amount of principal. Gradually, over the life of the mortgage, the balance shifts the other way: later payment are primarily principal and a small amount of interest.
A 30-year fixed mortgage with an interest rate of 6% and a principal of $200,000 would require 359 monthly payments of $1,199.10 plus one additional final payment of $1,200.16. The following table shows the amount of principal and interest paid in each monthly payment over specified lengths of time, as well as the effect of those payment on the remaining balance of the loan.
| Payment No. | Interest | Principal | Balance |
| 1 | $1,000.00 | $199.10 | $199,800.90 |
| 12 (1 year) | $988.77 | $210.33 | $197,543.99 |
| 60 (5 years) | $931.88 | $267.22 | $186,108.80 |
| 120 (10 years) | $838.66 | $360.44 | $167,371.66 |
| 240 (20 years) | $543.32 | $655.78 | $108.007.66 |
| 360 (30 years) | $6.00 | $1,194.16 | $0.00 |
There are a few key items to take away from this table:
- The time required to pay off the principal: Favoring interest above principal means that it will take a long time to pay down the principal. In this instance, it takes over 20 years to reduce the principal balance by only half.
- The amount paid in interest: Over the loan’s 30-year term, $431,676.00 is paid in interest, more than double the amount of the principal. Most borrowers pay similar amounts in interest (relative to principal), unless they have chosen to pay down more of the principal sooner. Most loans allow the principal to be paid down at any time.
By paying even a small amount extra in principal each month, a loan can be paid off years earlier and with a savings of huge amounts of money. In the previous example, if additional principal payments of only $100 per month were made, the loan would be paid off in less than 25 years, with a savings of $49,000 in interest charges.
Mortgage Interest Rates
Lenders determine the appropriate interest rate to charge for each mortgage loan issued based on three factors: the size of the loan, the riskiness of the loan, and the current interest rates:
- Size of the loan: Mortgage loans that total more than $417,000 (as of 2007) are considered jumbo loans; loans below that amount are called conforming loans. (There are two exceptions: in Alaska and Hawaii, jumbo loans are $625,000 and above.) In general, interest rates on jumbo loans are higher than interest rates on conforming loans.
- Riskiness of the loan: the riskiness of the loan depends on the financial stability and reputation of the borrower. Financial stability is based on income, saving, and other factors, such as being self- employed. Financial reputation is reflected in your credit score, a numerical representation of reliability as a borrower. Borrowers who pay off their debts reliably and in full have high credit scores (greater than 700 is considered a high credit score). A blend of financial stability and a high credit score will secure the lowest interest rates from lenders.
- Current interest rates: The U.S. government sets a variety of interest rates, including mortgage interest rates, based on certain economic factors. Over the last 25 years, interest rates have ranged from about 5% to 18%.
Why Get a Mortgage
Mortgages make it possible for people to own homes who otherwise could not afford the entire purchase price. (In 2006, the average price for a single-family home was $307,000; the average price for a home of any type was $230,000.) There are two more important reasons to get a mortgage:
- Take advantage of tax benefits: In order to encourage people to become homeowners, the government allows most homeowners to deduct 100% of the mortgage interest and property tax they pay annually from their income taxes. If you are in the 28% federal income tax bracket and have a mortgage payment that includes $1,000 in interest and property tax, after tax deductions you will only have to pay 72% of that $1,000, or $720. These type of tax benefits can amount to thousands of dollars in savings each year. Quite the opposite, if you rent, you are unable to take any tax deductions related to rent payment. Similarly, if you purchase property without a mortgage, you can only deduct property tax payments.
- Avoid tying up money in your home: Money spent on a home cannot be “withdrawn” until the home is sold. With a mortgage, you are only responsible for paying the down payment and making monthly payments, so you don’t have to sink hundreds of thousands of dollars into your home all at once. Instead, that money can be used to pay the monthly mortgage payment and all of the other bills. The money will also be free to invest in investments that you expect to perform better than real estate over time, like stocks or mutual funds.
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