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What Is a Mortgage?
A “mortgage” is an agreement between a borrower and lender to pledge property as collateral for a loan. It’s a typical practice to use the terms “mortgage” and “home loan” interchangeably. But a mortgage is the legal agreement that makes a loan possible, not the loan itself.
By definition, a borrower must use a home loan to buy or develop a property, home or apartment. But a mortgage can serve other purposes. Apart from buying property, a mortgage can be used to consolidate debt, finance a business, pay for a wedding, or even a vacation.
When someone wants to buy a home, they need to pledge the property as collateral, unless they can pay in cash.
When someone takes out a loan to buy a house, she/he agrees the lender has the right to collect on the payments. The lender could ultimately take the property in foreclosure if the borrower fails to pay. Since most people don’t make large purchases in cash, lenders need mechanisms like mortgages to protect themselves.
Conventional mortgages typically require a down payment of at least 5% percent and then a payment schedule. Percentage of down payment will have an impact on your mortgage rate.
The Types of Mortgages
There are several types of mortgages. It is important to educate yourself on all the options so you will make the best financial choice:
Fixed Rate Mortgages
With fixed rate mortgages, interest remains the same for the duration of the loan. There can be some variation in the ratios of interest to principal each month. However, when interest rates are low (like right now), it makes sense to take out a fixed rate mortgage. Fixed rate mortgages are the most popular and simple option due to the predictable monthly payments.
Total interest paid on a fixed rate mortgage depends on the loan term, which can be 10, 15, 20, 30 years. 15 and 30-year mortgage terms are the most common. Fixed rate mortgages are either “conventional,” or guaranteed by various government or private entities.
The longer the term of the loan, the lower the payments. Shorter-term mortgages mean higher monthly payments, but less interest over time. Longer terms make it easier to manage multiple financial obligations.
Benefits of Fixed-rate mortgage:
- Easier to understand.
- Simple for budgeting monthly household expenses.
- No change in the principle and interest portion of the payment over the life of the loan.
’Variable’ or Adjustable Rate Mortgages
Variable or adjustable rate mortgages (ARMs) have an interest rate that fluctuates together with market conditions. Fluctuating rates can then lead to either higher or lower monthly payments. The terms ‘adjustable’ and ‘variable’ are usually used synonymously.
Adjustable mortgages change rates on a set schedule, in most cases, annually. Many ARMs cap the maximum interest a borrower can pay. A 7/1 ARM, for instance, has a fixed rate for the first seven years. After that, it fluctuates annually. Other options include 3/1 ARM, 5/1 ARM, and 10/1 ARM.
The introductory rate is often called a “teaser rate.” Teaser rates are usually very attractive compared to most other fixed rates available in the market. Variable rate mortgages do fluctuate but there are rate caps that limit the amount of fluctuation. It’s smart to look for an ARM that caps how much your rate can rise.
Benefits of ARMs
- Lower fixed rate for a set period.
- Good for those comfortable with some level of risk.
- A solid choice for people planning a move after a few years.
Interest-only agreements allow borrowers to pay much lower monthly payments for a set period of five to 10 years. After this is over though, they will be required to start paying on the principal. Since the borrower isn’t paying on the principle at first, he/she will then have to pay more against the principal than he/she would have with a fixed rate mortgage when the interest only period ends.
Benefits of Interest-Only Mortgages
- Low monthly payments during the interest-only period.
- Entire amount may be tax-deductible during the interest-only period. (Consult your tax professional)
- A sensible choice for those confident they will be able to handle larger payments in the future.
Balloon mortgages usually have a short term of around 10 years or less. The full balance is then due at the end of the term. Interest rates are comparable to a standard fixed-rate mortgage. If a borrower finds herself/himself unable to pay off the balance at the end of the term, it is possible to apply to refinance. The lender will apply prevailing market rates, however.
Benefits of Balloon Mortgages
- Affordable initial payment.
- Good option for buying land.
- In many cases, balance can be refinanced.
Reverse mortgages are for people aged 62 and over. They are backed by the Federal Housing Administration (FHA). They allow homeowners to convert equity in their homes into cash. This means borrowing against a property that is already owned.
The cash will be granted in a lump sum or a revolving credit line. Homeowners are not required to make monthly payments. When one takes out a second mortgage, he/she is still required to pay property taxes and keep the home insured.
Benefits of a Reverse Mortgage
- Can help some people to live a comfortable retirement.
- Borrowers can collect funds as a lump sum or line of credit, or combination of the two.
- No mortgage payments needed if borrowers remain at home, pay property taxes, insurance and maintain the property.
- Closing costs and fees can be financed with the reverse mortgage.
- Proceeds from the loan are generally not taxable income.
- Will not likely affect Social Security or Medicare.
- Remaining equity belongs to borrower and heirs after the loan is paid off.
When a homeowner has built up some equity, he/she can take out a home equity loan or revolving line of credit. This is also known as a second mortgage. Such loans typically have higher interest rates than first mortgages. They can be good options for financing home renovations, paying educational expenses, etc.
Benefits of a Second Mortgage
- Tax deductions may be available for interest paid. (Check with your tax advisor)
If you are looking at mortgages, whether to buy a home or cover other expenses, make sure you educate yourself on all available options for your budget and the market. Make an appointment to speak with a finance and banking professional today.