The Basics of Mortgages and Home Financing in 5 Minutes

Mary Rand Home Finance Editor

When it comes to financing or refinancing your home, most home buyers and existing home owners are simply bombarded with ambiguous interest rate information and high pressure process deadlines, making a decision simply impossible. If this sounds familiar, take 5 minutes to understand the basics.

A mortgage is simply a loan used to purchase a home. With every loan, the borrower must offer some form of collateral. In the case of a mortgage, the collateral is the home itself. If you don’t pay your mortgage bill, your lender can take your property (the collateral) to recover their loan. Interesting, during the housing collapse of 2008 to 2010, many of the foreclosed homes were seized by the lenders of the respective mortgages.

Deciding Between Fixed and Adjustable Rate Mortgages

There are basically two types of mortgages: fixed rate and variable/adjustable rate mortgages. They are different in the way the interest rate is determined. Just like it sounds, a fixed mortgage remains the same and your monthly mortgage bill never changes. This removes a lot of the risk and anxiety associated with changing interest rates. To the contrary, adjustable mortgages (also known as ARMs), have interest rates that can vary every six to 18 months. It’s a gamble: when interest rates rise, so will you mortgage payment. Of course, if interest rates fall, so does your mortgage.

Length of a Loan: How to Decide Between a 15-Year Mortgage and a 30-Year Mortgage

Regardless of a fixed or adjustable mortgage, you need to decide how long of a term you’d like to spread a loan across. If you’re buying a more expensive home, perhaps a bit above your financial ability, you will have to lower your payment by stretching the loan over more years, i.e. 30 years. The downside, is that over the life of the loan, you pay much more towards interest — money that could have otherwise gone towards other investments like college or retirement. The advantage of a 30-year over a 15-year mortgage though, is the lower monthly bill that allows a home owner to budget for other things in the short-term. In simple math, a fixed 30-year mortgage is about 25% lower than a 15-year mortgage.

Interest-Only Mortgages: What’s the Deal

Interest-only home loans were very popular during the housing boom between 2002 and 2006. Different from a traditional mortgage, they are attractive to a home buyer because they have a much lower mortgage payment in the early years of the loan term. A bit of “fool’s gold,” the payments are low because you’re only paying for the interest on the loan. That means that if the housing market is not on the rise, you’re not earning any equity in your home. This could very easily make your mortgage a very risky and expensive “rent” payment. The risk is that in the future, five to ten years down the road, the interest only loan will increase 20 to 30 times and change the financial lifestyle of the borrower immediately. Often times, interest-only mortgage borrowers purchase a home beyond their budget and are not prepared for the increased payment. Most financial experts and experienced home owners would recommend avoiding these risky loans.

Points: What Are They?

When it comes to mortgages, points are simply prepaid interest your pay to a lender for a cheaper loan. More specifically, points are the percentage points of the entire loan amount. For example, one point equals one percent of the loan. Continuing with this example, if you’re looking to purchase a $300,000 home, one point would cost an additional $3,000 at the time of the purchase. The immediate savings to a monthly mortgage bill, could be about $50 for a point depending on the interest rate. If you intend on living in the home for many years, say until your toddler is comfortably in college, it may be helpful to pay a point or two upfront if you can afford the additional cash at the time of the purchase in order to have a lower interest rate. Calculate the time it will take you to recover the savings of a point: $3,000/$50 = 60 months (5 years).

PMI (Private Mortgage Insurance): Why? Why? Why?

If you’re like most borrowers, you don’t have 20% of your home investment simply lying around. If you do, put it in a safe place like a bank! (LOL as my friends would say) If you are unable to come up with the 20% necessary for a down payment, your lender is going to require that you purchase private mortgage insurance. Simply put, PMI protects the lender against you defaulting on the loan. Private Mortgage Insurance can add an additional one-percent to the cost of your mortgage. Unfortunately, PMI’s are a necessary evil to securing a home loan.

5 Minute Budget Take-Away

There you have it: You gave me 5 minutes of your time, and hopefully I shall save you a thousand dollars here or there by simply bringing these simple mortgage concepts to your attention. By no means are my explanations and “highlights” the end all, be all. Use them as a starting point for discussions with your mortgage representative and see how they answer questions. Play dumb and ask, “What is PMI, and why do I need it?” You should be able to gauge if they can answer a simple question with a simple explanation and corresponding strategy. Most importantly, the key to selecting a mortgage within your budget is to make an informed and calculated decision.