Evan Sachs
A mortgage is a fancy bank loan that helps you buy a house. They’re meant for those of us who don’t have hundreds of thousands of dollars lying around, ready to be spent when that nice four-bedroom Colonial across town hits the market.
A mortgage is also an agreement between you and the bank that you’ll repay the loan plus interest. If you stop paying your monthly payments, the bank has the right to take your home (foreclose) and kick you out.
The Reality
You really don’t own the house until your mortgage is paid off — it’s owned by the bank.
Most American homeowners have mortgages, but many mismanage them. A mortgage, for most of us, is the largest, longest-term loan we will ever take out. Many can’t keep up because they borrow over their heads and eventually fall behind on their payments.
However, if done right, your mortgage doesn’t have to be a burden.
How Does a Mortgage Work?
Before you attempt to find a mortgage, you need to understand that mortgages work in a two-part process: The bank pre-approves an applicant (you, based on your income and credit history) so you can make an official bid on a house.
No one will sell you a house if don’t have a mortgage lender lined up.
If the seller accepts your bid, the bank will give you a detailed monthly payment schedule spread out over years or decades.
And then you go to the closing, in which reams of forms and other important documents are signed and you’re handed the keys to your new home. Just keep making your monthly payments, and you won’t have any problems.
What’s cool about mortgages, unlike car loans, is that with each payment, you’re building equity. You’re slowly and methodically taking ownership of your home, which is hopefully appreciating in value, from the bank.
How Do Mortgage Payments Work?
After your purchase offer is accepted by the home seller, your mortgage lender will lay out the schedule terms of your monthly mortgage payment. This consists of four essential parts: principal, interest, taxes, and insurance.
1. Principal
This is the total amount you borrow from the bank or lender, and it’s usually the biggest part of the monthly payment. When you pay the principal each month, you’re building equity in your home.
2. Interest
This is the fee or price you must pay to borrow the money. There are actually two interest rates.
One is the simple rate expressed as a percentage of the principal loan amount. The other is the “real” interest rate, called the annual percentage rate (APR).
This reflects the entire cost of borrowing the money, based on a combination of interest, fees, and loan terms.
3. Taxes
You must pay property taxes to the city or county government. Your mortgage lender typically includes these taxes in your payments.
The amounts vary around the country. In the Northeast, for example, property taxes can be so high that the monthly payment could exceed the interest and principal payment combined!
4. Insurance
There are two types: homeowners insurance and private mortgage insurance (PMI). You can’t purchase your new home without having homeowners insurance, which covers damage to or destruction of your house or property. It also protects you if someone gets hurt on your property.
PMI is necessary only if you can’t meet the 20 percent down payment threshold set by the banks. The added insurance protects the bank if you default, and it could cost you as much as 1.5 percent of the principal every year.
Other Key Terms to Know
If you want to fully understand how a mortgage works, you should know what all the jargon means. Here are a the key terms that you’ll need to be familiar with.
1. Amortization
One of the most interesting aspects of the mortgage payment schedule is its structure, including amortization. With amortization, in the mortgage’s early years, interest makes up a bigger part of each monthly payment (front-loading) than the principal. But as the years go by, the principal becomes a larger portion of the monthly payment than the interest.
This system works well when it comes to your federal taxes, since you can deduct your annual interest payments. You get to deduct most of the (concentrated) interest in the mortgage’s early years.
2. Closing Costs
These are expenses over and above the sales price. You’re basically paying for the parasites you can’t shake from your mortgage, like title insurance (including appraisal), attorney, title fees, recording fees, and so on.
Closing costs vary from state to state. New York has some of the highest.
I paid $18,000 in closing costs when I bought a home several years ago. It was painful to write that check. Some of that money went to the parasites, some to the bank, and the rest to what is called “escrow.”
3. Escrow
Think of escrow as a slush fund. Your lender uses it to pay your local and state property taxes.
At my closing in June 2014, the bank wanted me to place around $6,000 in an escrow account just to cover any unpaid property taxes left over by the seller and to pay upcoming tax bills for the year.
4. Points
You can lower your APR by “buying” points from the bank. Say, for an extra $2,000 in cash, you could lower your APR from 4.5 percent to 4.3 percent. That might seem like a tiny difference, but over decades, it can add up to thousands of dollars in savings.
What Types of Mortgages Are Available?
Most homebuyers go with a fixed-rate mortgage or an adjustable-rate mortgage (ARM). I have a 30-year fixed-rate mortgage, the most common, but you can get terms of 10, 15, or 20 years. The trade-off with a shorter-duration mortgage is you get a lower interest rate, but will need to make bigger monthly payments.
ARM loans carry a variable interest rate, which can go up or down.
What makes ARMs attractive is a lower interest rate than you’d get with a fixed-rate mortgage.
And many of them offer a fixed rate for the first five or seven years, followed by a flexible rate, which works for people who plan to stay a short while in their homes.
Also, banks aren’t the only ones that offer mortgages. The federal government offers them to first-time homebuyers, veterans, and low-income Americans, among others.
How Do You Qualify for a Mortgage?
Banks, credit unions, other financial lenders, and Uncle Sam offer mortgages. You can compare rates online or use a mortgage broker, who can help you find the best offer and guide you through the whole paperwork process.
After you apply, you must undergo and pass an extensive credit and income check. Your credit score comes first. You must have a minimum score of 620.
Next is your debt-to-income ratio, or the total of your monthly debt payments (credit cards, student loans, etc.) divided by your monthly income. This ratio must be consistently stable and reliable. It helps the bank calculate your ability to meet your monthly mortgage payment obligations and determine whether you’re a safe bet (risk). Most lenders require a ratio of 36 percent or less.
The last step is the credit score. Most lenders want 20 percent of the purchase price. A mortgage offered by the Federal Housing Administration, the U.S. Department of Veterans Affairs, or the U.S. Department of Agriculture might require only 3 percent. But in most cases, if you can’t come up with 20 percent, you’ll have to purchase PMI.
Benefits and Drawbacks of a Mortgage
Having to take out a mortgage isn’t a pleasant experience. I had to produce and sign piles of documents, and raid my savings and taxable brokerages accounts to finance the $80,000 down payment (my dad gifted me $10,000). I had to borrow $18,000 from my 401(k) just to pay the outrageously high closing costs.
And don’t get me going about how much cash my wife and I have had to spend on rehabbing and updating the house — it never ends. I think I need a new roof.
However, there are a number of benefits to homeownership. Sure, the bank could take my house. Or it may lose value. Yet it’s my house, and I get to enjoy all the benefits a mortgage offers.
Taking out a mortgage can also boost your credit score. You can deduct the interest you pay annually as well as your private mortgage insurance premiums, points, and certain fees. And you can deduct your property taxes up to $10,000.
But a mortgage’s biggest benefit is access to cash — or to the equity you’ve been building with each monthly payment. After a couple of years, as your home value increases and your mortgage principal shrinks, you will have more equity in your home — and you can borrow against that equity with a home equity loan or line of credit.
Additional reporting by Connor Beckett McInerney.
