What is a Mortgage, Mortgage Pre-Qualification to Closing

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Mortgages

I. Does the mortgage fit your budget
II. What is a Mortgage?
III. How much will it cost?
IV. Pre-Qualification to Closing

What is a Mortgage?

Basically, a mortgage is loan used to purchase a home or some other piece of property. The home purchased with the loan serves as collateral. A lien is placed on the home by the lender, which gives the lender the right to foreclose if the borrower does not live up to the repayment agreement.

To make it easier for borrowers to pay back mortgage loans, which are typically large, payments are made monthly and often stretched out over 15, 20, or 30 years. Each payment, when escrow is used, is often called a monthly PITI payment.

PITI stands for:

(P)rincipal is amount lent minus interest
(I)nterest owed on the loan amount
(T)axes owed (property taxes: the annual city/county taxes)
(I)nsurance coverage against fire, theft, and natural disasters

In order to make lending money that will be repayed over such a long period of time profitable, yearly interest charges are added to the amount owed. Throughout the life of the loan, you'll pay far more in interest than you will in principal. In some cases two or three times more. Because mortgages follow a repayment formula called amortization, in the initial years your monthly payments will, for the most part, pay down the interest owed. In the latter years, you'll be paying mostly principal.

The interest rate can either fixed, adjustable, or a combination of the two.

Fixed rate mortgages

Most borrowers prefer mortgages with fixed interest rates since they offer payment stability. Every month you know how much your mortgage payment will be, since interest rates do not change for the life of the loan. Typically, these fixed interest rate payments are made over the course of 15 or 30 years. With the 30 year payment option, your monthly payments will be lower than the 15 year plan, but the amount of interest you pay will be much higher due to the longer loan term. Fortunately, the interest is tax deductible for first and second homes.

Adjustable Rate mortgages

Adjustable rate mortgages (ARM) usually begin with a low fixed interest rate for a short period of time -- to make the ARM more attractive to borrowers -- and then, typically, begin to change yearly with market conditions. This initial fixed rate period can last from 1 to 10 years. Adjustable rate mortgages without fixed rate periods of more than a year are less common these days. Hybrid ARM's like the 3/1 are more likely to be available. The "3" in 3/1 represents the number of years the interest rate is fixed, while the "1" lets you know how many times per year the rate will be adjusted after the initial fixed period.

What determines whether an ARM's interest rate will be adjusted upward or downward after the fixed period has ended? An ARM is linked to the movement of either the U.S. Treasury Securities index, the London Interbank Offered Rate (LIBOR), or the 11th District Cost of Funds Index (COIF). During a period of falling interest rates, an ARM can be considerably cheaper than a fixed rate mortgage. However, in an environment with rising interest rates, they can double during the term of the loan. There are caps that prevent an ARM's interest rates from climbing to an extremely high level. The three types of caps are payment, lifetime, and periodic caps.

Adjustable rate mortgages can be tough for an inexperienced person to understand. Always ask that all of your options be explain by the broker or loan officer. Bear in mind that difference between the lowest available price and the highest price you are willing to pay is sometimes kept, in part, by the mortgage broker. In other words, it is in the mortgage brokers best interest to get you to pay more! So, it is up to you to make sure you negotiate for the options that provide the lowest costs.

Next: How much will it cost?

Updated: Nov 2005