Millions of Americans have mortgages on their homes, but not all of them understand exactly what makes up their mortgage payment and why it takes decades to pay off!
What is a Mortgage?
A mortgage is basically a long-term secured loan from a bank or other financial institution. The house and/or property act as the collateral for the loan.
A monthly mortgage payment typically includes the following, known as PITI:
- Real Estate Taxes
- Property Insurance and, often, private mortgage insurance, known as PMI.
PMI gives the lender protection if the homeowner should default on the loan. PMI usually can be eliminated once the principle balance of the mortgage reaches 80% of the sale price or appraised value, which is known as the loan-to-value (LTV) ratio.
The process of paying the principal takes years because mortgages are based on a repayment plan called amortization. During the first few years, most of the mortgage payments will be applied toward the interest. During the final years of the loan, the payments will be applied primarily to the remaining principal balance.
Equity grows as the principal balance of the mortgage decreases as well as when the property appreciates in value.
Lenders offer several different types of mortgages. Following is a list of some types currently offered.
- 30-Year Fixed Rate: This mortgage is an industry standard, as total payments are spread over so many years the monthly payments are typically lower than they would be on a shorter-term loan. The interest rate, which locked in at the time of obtaining the mortgage, remains the same throughout the life of the loan. Borrowers end up paying a considerable amount more in interest compared with a shorter-term loan.
- 15-Year Fixed Rate: With this type of mortgage borrowers pay a lower interest rate in exchange for larger monthly payments. The shorter the term, generally the lower the interest. The advantage of this mortgage type is that borrowers can save a tremendous amount in interest.
- Adjustable-Rate Mortgages: Commonly referred to as ARMs, these differ from fixed-rate mortgages because the interest rate fluctuates. ARMs are tied to a number of indexes, the most common being the one-year U.S. Treasury bill. The lender adds a margin to the index, usually two to four percentage points, to establish the initial interest rate of the ARM.
- Jumbo Mortgage: This is considered a nonconforming loan because it exceeds the loan limit set by Fannie Mae and Freddie Mac, the two corporations that buy mortgage loans from lenders. The 2001 single-family loan limit is $275,000. If you need to borrow more than that, you will need a jumbo mortgage, which generally has a higher interest rate than "conforming" loans.
- Hybrid Mortgages: These are mortgages that combine elements of fixed and adjustable-rate mortgages. One example would be Fannie Mae's two-step mortgage. It is a special type of ARM because it adjusts only once, either at five years or at seven years. After the initial adjustment, the mortgage maintains a fixed rate for the remaining years of a 30-year repayment term. This new rate can never be more than six percentage points higher than the old rate. There are no limits on how much lower the adjusted interest rate can be. At the adjustment date, there are no additional refinancing costs, no forms to complete, and no re-qualification necessary.