Understanding Mortgages
Buying a home is probably the largest personal purchase one makes. If you’re like the average consumer, you won’t be buying your home with a lump–sum cash payment – you’ll be financing your purchase with the help of a financial institution or other specialized lender.
With hundreds of different types of mortgages from which to choose, and many conditions which must be met in order for the mortgage to be approved, the process of financing a home can often seem confusing, especially to the first–time buyer. Mortgage–Advisor.org can help to take some of the mystery out of the mortgage process by giving you the background and tools you need in order to become a more educated homebuyer.
This article summarizes the basics elements of a mortgage, the history of mortgages, and where residential lending is headed as an industry.
What Is A Mortgage?
By definition, a mortgage is a specialized type of loan that is used to finance the purchase of real property – usually real estate. Payments, or installments, representing the total amount of the loan plus all applicable interest, are made to the lender on a regular basis. The loan is collateralized – or secured – by the property itself, meaning that the lender retains an ownership interest in the property until the loan is completely repaid. If the borrower defaults on the agreed-upon repayment plan, the lender has the option of foreclosing on the property and reselling it to someone else.
Since a mortgage is often the largest individual debt that consumers carry, home loans tend to be a bit more complicated than the average personal loan or car loan. First-time homebuyers are often surprised at the amount of additional expenses involved in purchasing a home. Various fees known as “closing costs” must be paid before a mortgage can officially be issued. Some of these fees cover items such as inspections, attorney services, public recording, and notary services. Real estate agents are forever remind their clients to bring a checkbook with plenty of blank checks to the closing.
With so much money at stake, lenders want to make sure that there is an excellent chance that the loan will eventually be repaid according to agreed-upon terms. If the mortgage amount exceeds 80 percent of the home’s value, the lender will almost always require private mortgage insurance (PMI) to be purchased, ensuring that the loan will be repaid satisfactorily. PMI can usually be discontinued when the buyer reaches a 20 percent equity position in the home, though a separate appraisal will be required to substantiate the home’s market value upon reaching this milestone. Prior to underwriting the mortgage, the lender will also want to ensure that there aren’t any existing liens or claims of ownership to the property, and will require a title search and title insurance to protect their interests.
Without a doubt, a mortgage is an expensive proposition for almost any consumer. But for most people, the personal satisfaction that comes long with becoming a homeowner outweighs the short-term trauma of giving a majority of your hard-earned dollars to a mortgage bank.
Where Did Mortgages Come From?
Most of us couldn’t conceive of the possibility of purchasing a home without some sort of financial assistance, whether it be from parents, relatives, friends or from a financial institution that specializes in making property loans. So when and where did mortgages first originate? History is somewhat vague on the subject of who took out the very first mortgage and whether or not it was repaid, but the concept of a specialized, secured loan made exclusively for the purpose of purchasing land and property probably came into being sometime before 1000 B.C. in Asia or Europe. Interestingly enough, in the United States, modern mortgages didn’t come into being until well into the 20th century.
In the midst of the Great Depression of 1929-1939, the Federal Housing Administration (FHA) was established by the U.S Congress for the purpose of helping more Americans to become homeowners. Up until that time, bank loans for residential property were typically limited to just 50 percent of the property’s total market value, and repayment terms were limited to just three to five years, with a large “balloon” payment due at the end. This arrangement made home ownership an unattainable dream for many Americans, and as a result, only four in ten households owned their home.
FHA radically changed the concept of home buying beginning in 1934 by introducing several unique financing programs. Among the first novel concepts was a loan for up to 80% of the property’s value which, by definition, only required only a 20% down payment. The FHA also considerably lengthened loan terms, beginning with 5- to 7-year terms, and eventually extending loans all the way up to a 30-year term. FHA also introduced the concept of amortization, where instead of just making interest payments on the loan, borrowers repaid principal plus interest, and in doing so gained equity in their property over the course of the loan. FHA is also credited with establishing a set of quality standards to ensure that properties met certain criteria before they could be financed.
As the nation gradually climbed out of its economic depression, private retail banks soon realized that the terms being offered by FHA for home purchases were highly attractive to consumers, and soon were forced to adjust their product offerings and marketing techniques in order to remain competitive and take their rightful slice of the growing pie. Today, private lenders represent the overwhelming majority of mortgage underwriters, and the FHA has been relegated to its primary role of providing insurance on mortgages made by FHA-approved lenders. The FHA became part of the U.S. Government’s Department of Housing and Urban Development in 1965.
Other legislation was enacted in later years to protect borrowers against fraudulent practices in the mortgage business. The Truth in Lending Act of 1968 and the Real Estate Settlement Procedures Act of 1974, both of which require lenders to disclose specific information about their loan pricing and methods of operation, represented major advances in consumer rights. The Federal Homeowners Protection Act of 1998 helped to establish standards regarding a consumer’s right to cancel private mortgage insurance on a residence.
Today’s Mortgages: More Variety Than Ever
Once upon a time, there was just a single type of mortgage available to consumers: a fixed-rate installment loan, with a term of either 15 or 30 years. Due to both the rapid expansion of the nation’s housing market in the years following World War II and an increasing variety of different home types available for purchase including condominiums and co-ops, lenders have been forced to diversify their offerings to keep pace with the times.
Today’s homebuyer can choose from a dizzying array of different mortgage types to meet his or her particular needs: fixed; adjustable; hybrid; 2-step; interest only; jumbo; graduated payment; and reverse mortgages are only a small sample of the many options available.A variety of repayment terms are also available from most lenders. While at one point, the 30-year term was the maximum term offered, some lenders offer a 40-year term in some circumstances. Provided that a consumer can qualify for a mortgage, he or she is highly likely to find a number of different suitable options.
Depending on the prevailing direction of interest rates, many homeowners find it advantageous to refinance their mortgages at some point. Refinancing can be just as exhausting as obtaining an original purchase mortgage. What appears to be a short-term savings can often turn into a long-term loss, and the decision must be made with care. In fact, refinancing is so common in some markets that mortgage bankers have coined the term “refi junkies” to refer to homeowners who frequently refinance their homes in an attempt to realize the tiniest of monthly savings.
Real estate agents can often serve as valued advisors regarding financing options, but smart homebuyers do their homework ahead of time to avoid making rash decisions when they fall in love with a particular home. No bank or agent can tell you how much mortgage you can afford – only you can make that decision for yourself, and it’s usually best to determine that figure long before you begin house hunting.
Outlook: Where Is The Mortgage Industry Going?
While many financial professionals are convinced that the notorious real estate “bubble” of 2004-2005 has already burst – or at the least, is deflating rapidly – the mortgage business still shows signs of robust health. Even with interest rates slowly creeping upward and the inventories of unsold houses growing daily, millions of Americans are still buying homes. As baby boomers begin to enter their retirement years in growing numbers, there has also been a marked resurgence in the popularity of second homes and secluded vacation retreats, which is in turn creating even more demand for residential financing. Other recent industry trends include:
Interest Only Mortgages
The interest-only – or IO – mortgage is a relatively new product which combines elements of a fixed-rate and an adjustable-rate loans which allows homebuyers to pay only the interest on their mortgage for an initial period of time before beginning to repay interest and principal. In theory, the interest-only mortgage allows homebuyers to purchase properties that they might otherwise be unable to afford, and for this reason, some underwriters have drawn criticism for promoting these mortgages to first-time homebuyers.
Reverse Mortgages
In recent years, a product known as the “reverse mortgage” – also known as a “reverse equity mortgage” or a “home equity conversion mortgage” – has begun to gain popularity. Designed primarily for older people on a fixed income who want to access the equity they’ve built up while still living in their homes, the reverse mortgage essentially provides a means of converting this equity into cash. The mortgage can be paid off in full to restore a previous equity position, or if the home is left to the owner’s heirs, the heirs will be required to either pay off the mortgage or sell the property. As the United States’ population continues to age and the long-term outlook for Social Security looking rather dim, some industry experts believe that the reverse mortgage may become even more popular over the next 20-30 years as more retirees seek new ways to supplement their incomes.
Reselling or Assigning
The practice of financial institutions selling entire mortgage portfolios to other institutions has been going on now for decades. Buried in the fine print of most mortgage contracts is a paragraph that entitles the originating lender to sell or assign the mortgage to another company at any point prior to full repayment. There is a growing trend in the United States for mortgage underwriters to sell mortgages long before maturity, and sales sometimes take place within months of the closing date. A homebuyer will frequently find that the lender who originated their loan subsequently sold it to another institution, necessitating that subsequent payments be made to an entirely new entity. Additionally, the rapid consolidation of the financial services industry in the United States has resulted in smaller banks being swallowed up by larger institutions, and subject to anti-trust regulation by federal authorities, this trend is expected to continue in coming years.
Nationalization
Over the past decade, the mortgage business has been rapidly transforming itself from a localized business into a nationalized one. The local savings & loan institution was once the most popular location to apply for a mortgage. Nowadays, a typical mortgage underwriter is likely to be located thousands of miles away from the actual property being financed. For example, Wells Fargo, a San Francisco, CA-based financial services company, now transacts a significant portion of its mortgage business in East Coast states where it has no bank branches. Technological advances in underwriting have also helped to expedite most transactions, though much to the dismay of most homebuyers, it seems that residential mortgages will always involve a tall stack of intimidating paperwork.
Consolidation
While the number of mortgage bankers in the United States has increased slightly over the past few years, the vast majority of new home loans are currently being handled by a relatively small pool of large lenders. This is another result of rapid consolidation in the U.S. financial services industry, where large institutions have been able to achieve tremendous efficiencies of scale in mortgage underwriting and servicing. While most creditworthy homebuyers will always be assured of having access to wide range of mortgage providers, competition amongst underwriters is becoming more intense than ever, and this fact is driving many of the smaller companies to merge their portfolios and operations.
Subprime Lending
This category of lending involves borrowers with less-than-perfect credit who are willing to pay higher interest rates and points in exchange for getting a mortgage that they might otherwise not be able to secure. Subprime lending has shown steady growth over the past five years, though it has drawn some regulatory criticism for alleged “predatory lending.” While lenders assume significantly more risk when underwriting these types of loans, subprime mortgages also generate significantly higher profit margins for most lenders.
Overview of Mortgage Articles Available
15–year versus 30–year mortgage terms
There are many variables to take into consideration when considering loan terms, and the right answer isn’t always clear. Two of the most popular terms for fixed–rate and adjustable–rate mortgages are the 15–year and the 30–year. Which one should a borrower consider for their loan? Read a detailed explanation about the benefits and drawbacks of each type.
adjustable–rate mortgage
A high interest rate on a term loan is costly, especially when prevailing interest rates fall below what a borrower currently pays to a lender. Refinancing to take advantage of a new interest rate is often expensive. An adjustable rate mortgage, or “ARM,”offers the flexibility of an interest that changes along with marketplace conditions, an option which a lot of homebuyers prefer over the rigidity of a fixed rate. Learn more about the ups and downs of ARMs.
amortization
A borrower should understand the basics of loan amortization. With any type of mortgage, the borrower is making installment payments to a lender in order to reduce the outstanding balance on the loan. If they opt for an adjustable rate mortgage, there is a chance that the payments may not keep pace with the loan’s interest, resulting in interest payments on top of interest, and the total amount of the mortgage can actually increase instead of decrease. Learn more about the concept of mortgage amortization.
Federal Housing Administration loan
The U.S. Federal Housing Administration offers a unique mortgage program that is designed to help buyers get into a home at a lower cos. There are some special conditions that must be met by borrowers. The money comes from private lenders rather than from the government itself presenting new obstacles. Learn more about the requirements to qualify for an FHA Loan.
fixed–rate mortgage
Historically, the fixed rate mortgage was the only game in town. Homebuyers chose from two “flavors”of fixed–rate mortgages: either a 15–year term or a 30–year term. Today, there is a wide variety of fixed–rate terms from which to choose. Locking in a specific interest rate for the life of loan is a desirable budgeting tactic that helps homeowners to avoid unexpected surprises, but it can also cost more. Find out more about the advantages and disadvantages of fixed rate mortgages.
hybrid mortgage
An alternative available from many lenders is the hybrid mortgage. It is devised to offer a fixed rate for a set period of time before converting to an adjustable rate. Hhybrid loans, also known as intermediate ARMs, can be a smart choice for some borrowers. Learn more about the various types of hybrid mortgages.
interest–only mortgage
Some borrowers dislike paying a home loan where their payments are concentrated on interest, instead of paying the interest and the principal. The initial lower monthly payments on interest–only mortgages provide a way to purchase a home at a lower cost, and to defer payments of interest and principle to a point in time when household income increases. Learn more about the pros and cons of an interest–only mortgage.
jumbo loan
The term “jumbo loan” actually refers to a mortgage that exceeds a predetermined size, and it is a fairly common occurrence in some areas where expensive real estate markets prevail. Borrowing large sums of money directly from a lender or from a third party brings its own unique benefits and challenges. Learn more about the Jumbo loan to see if it's an appropriate choice.
two–step mortgage
A unique type of hybrid mortgage, the two–step mortgage offers an initial fixed rate for a short term, and converts to an adjusted fixed rate for the balance of the loan. The two–step mortgage is an excellent choice for first–time homebuyers who anticipate that their earnings will increase at a later point in time. Learn more about the necessary involvement to obtain a two–step mortgage.
Veterans Administration loan
Many Americans choose career training and life experiences by serving their country in a branch of the U.S. armed services. To help servicemen and servicewomen become homeowners, the Veterans Administration offers special mortgage programs designed exclusively for current and former members of the military. The VA is not a bank, but rather it works with various lending institutions to offer lower interest rates to veterans, and then guarantees repayment of those loans. Learn more about what qualified veterans can expect from a VA Loan.