A mortgage is a loan secured by real property in which the lender obtains the legal right to liquidate (sell) the property to recover its funds in the event the borrower fails to make payment on the loan. The purchase of a home is often a consumer’s single largest purchase in his or her life. Generally mortgage lenders will lend an amount two to three times the annual household INCOME, depending on a borrower’s savings and other debts. Mortgage payments usually should not exceed 30 percent of a household’s monthly disposable income. Mortgage payments include three components: payment on the principal of the loan (the amount borrowed); payment on the interest owed; and payments to special accounts (called an escrow account) for payment of INSURANCE, PROPERTY TAXES, and other recurring charges. Combined, this is called PITI (Principal, Interest, Taxes, Insurance). One major question in securing a mortgage is how much the borrower will “put down.” The down payment reduces the amount of the mortgage and acts as security for the lender against the possibility that the value of the house might decline. Most mortgage lenders require at least 5 percent of the value of the property as down payment, though there are special programs for veterans, active members of the military, and first-time home buyers that allow 0 percent down. Borrowers who put at least 20 percent down can often avoid certain mortgage-related costs, such as principal mortgage insurance (PMI). There are two general types of mortgages: fixed rate and adjustable rate. Fixed-rate mortgages retain the same interest rate over the life of the mortgage. They are typically 30 years or 15 years in length, though some are as short as 10 years. Many homebuyers choose a mortgage length to coincide with when they expect to retire. Shorter length mortgages significantly reduce the total amount of interest paid but result in higher monthly payments. One way to shorten a mortgage is to agree to biweekly payments of half the monthly amount, rather than monthly payments. Biweekly payments result in 13 equivalent payments per year (26 ½ payments equals 13 “months” worth of payments). Adjustable-rate mortgages (ARMs) allow the interest rate to change over the life of the mortgage. In the late 1990s, with falling mortgage rates, many households saw their INTEREST RATES and monthly payments decline. In the early 1990s, when interest rates rose, adjustable-rate mortgage payments also rose. There are many different kinds of ARMs. The most common type combines a fixed rate for a specified period of time with an annual cap (limit) on how much the rate can change after the initial time period and a life of the mortgage cap on how high the rate could go. For example, a 1/2/6 ARM would hold the interest rate fixed for the one year, then have a 2 percent annual limit to how much the interest rate could change and a 6 percent limit on how high the rate could go from the initial rate charged. The advantage of an ARM to a borrower is that the initial rate is usually 2–3 percent lower than the fixed-rate mortgage, which lowers the initial payments for the borrower. The advantage to the lender is that it has transferred interest rate risk to the borrower. Therefore if interest rates go up in the future, the lender will get a higher return. Pre- 1980, almost all mortgages in the United States were fixedrate mortgages. In the late 1970s and early 1980s, INFLATION increased, and interest rates increased with it. Lenders, particularly, SAVINGS AND LOAN ASSOCIATIONS, found that, like BONDS, when interest rates rise, the value of a fixed-payment security (a fixed-rate mortgage) declines. For example, an 8 percent $100,000 mortgage generates $8,000 interest income the first year. If mortgage interest rates rise to 16 percent (which they did in 1980), then an investor would only be willing to pay $50,000 for a mortgage paying $8,000 per year ($8,000 ÷ $50,000 = 16 percent return). They would not pay $100,000 for the mortgage, because they could also purchase a new mortgage yeilding 16 percent. Another confusing issue for consumers seeking mortgages is “points”—fees charged by lenders, expressed as a percentage of the amount being borrowed. Many lenders charge a 1 percent initiation fee (in addition to a loan application fee). Borrowers can also reduce their interest rate by paying more points; this is known as a “buy-down discount.” By paying a higher fee, the borrower reduces his or her interest rate and therefore the monthly payment. Whether to pay the higher points depends on how much lower the interest rate will be and how long the homebuyer thinks he/she will own the property. Whether to choose a fixed-rate or variable-rate mortgage depends on a variety of factors, including
• the borrowers’ current financial situation
• how the borrower expects his or her finances to change in the future
• how long the borrower expects to own the home
• the borrower’s willingness to risk higher payments in the future
Households where one family member is temporarily not working may choose a variable-rate mortgage for the lower current payment, knowing they will probably have more income in the future. Similarly, borrowers who are in the process of paying off student loans or other short-term payments will know when those payments end and be able to make higher payments in the future, should interest rates rise. Borrowers who expect to move in a few years will probably benefit from an adjustable-rate mortgage. Borrowers who think they will stay in a home a longer period of time or who are uncomfortable with the risk of rising mortgage payments would likely choose a fixed-rate mortgage. The mortgage process can be quite daunting to firsttime homebuyers. There are now many websites where monthly payment schedules can be calculated and where borrowers can shop for a mortgage lender. Before starting the mortgage process, usually homebuyers find a home they wish to purchase and sign a real-estate sales CONTRACT. This is the most critical stage in the buying process and should not be entered into without independent expert advice. One part of a real-estate sales contract stipulates the mortgage financing the buyer will secure. When signing a contract, buyers often attempt to “lock in” a specified interest rate with a mortgage lender, contingent on the sale going through.