WHAT IS MORTGAGE?

Mortgage

I

INTRODUCTION

Mortgage, legal instrument that pledges a house or other real estate as security for repayment of a loan. By providing a guarantee that the loan will be paid back, a mortgage enables a person to buy property without having the funds to pay for it outright. If the borrower fails to repay the loan, the lender may foreclose on the property—that is, force the sale of the house to recover the amount of the loan (see Foreclosure).

The mortgage lending process has two instruments, a note and a mortgage. The note specifies the financial terms of a loan agreement. The mortgage contains a legal description of the property and a statement that pledges the property as security for the loan. However, the word mortgage commonly refers to both parts of the loan agreement as a whole.

II

GETTING A MORTGAGE

A borrower can obtain a mortgage from a bank, credit union, or other lender. Most lenders require the borrower to have a certain amount of money to use as a down payment toward the purchase of the house. For example, if an individual wants to buy a home priced at $100,000 and the lender requires a down payment of $5000, the individual will apply for a loan of $95,000 to pay for the difference.

A lender requires detailed information about borrowers to assess their ability and willingness to repay a loan. For example, a borrower will be asked about income, employment history, and credit history. The lender will also inquire about any debts, such as a car loan or credit card balances.

Before the lender agrees to a loan, an appraisal of the property by a qualified third party is required. The appraisal provides an estimate of the property's value. The lender wants to be certain that the property is worth at least as much as the loan in case of foreclosure.

If all requirements are met, the lender agrees to the loan. The loan agreement specifies the current interest rate and the loan's repayment terms. The terms of repayment specify how much the regular payments will be, how frequently they will be made, and over how many years. The interest rate and the duration, or life, of the mortgage determine the amount of the payment. Payments are usually made monthly. The life of the mortgage can be 15, 20, 30, or even 40 years.

To accept the loan the borrowers must sign a promissory note that obligates them to repay the mortgage debt. The borrower also promises to keep the property insured against fire and other hazards, and to pay any property taxes that may be owed. If the borrower fails to keep any of these obligations, the loan is considered to be in default, and subject to foreclosure.

The actual transfer of funds and property takes place at the closing. At the closing the lender transfers money to the borrower for buying the house and the borrower signs the mortgage documents. The borrower also pays the lender any fees associated with borrowing the money. These might include origination costs for creating and processing the loan, fees for obtaining reports on credit history, and fees for obtaining an appraisal.

III

REPAYING A MORTGAGE

Mortgage payments consist of two parts: payments for interest and for principal. Interest is the fee for using the lender's money. Principal is the amount of the loan still owed. A portion of each payment pays interest and the remaining portion reduces the principal. The process of paying off the principal while paying interest is called amortization.

When a homeowner begins to repay his or her mortgage almost all of each monthly payment pays for interest. This changes as the loan ages, even though the amount paid each month may not change. Each month's payment reduces the principal by a small amount, therefore less interest is owed the next month. Since less interest is owed, more of the payment can be used to reduce the principal. Gradually less of each month's payment is needed to pay interest, and more goes to reduce the principal.

For example, if a person borrows $80,000 at 8.0 percent for 20 years to buy a home, he or she will make monthly payments of about $669.15. Out of the first month's payment, about $533.33 pays interest on the principal ($80,000 × 8 percent interest per year ÷ 12 months per year = $533.33). The balance of the monthly payment, $135.82, reduces the principal. The second month's payment is based on the new principal of $79,864.18. This time, $532.43 goes toward interest ($79,864.18 × 8 percent ÷ 12 months) and $136.72 reduces the principal. The relationship between the amount of each monthly payment that goes to interest and principal changes over time. The first 13 years of a 20-year mortgage—or about two-thirds its life—pays back half the principal. During the last seven years, more and more of the monthly payment goes to reduce the principal until the debt is completely paid. At the end of the 20-year, $80,000 mortgage, the borrower will have made 240 monthly payments totaling about $160,500.

IV

KINDS OF MORTGAGES

The two most common mortgages in the United States are the fixed-rate mortgage and the adjustable-rate mortgage. With a fixed-rate mortgage, the interest rate stays the same over the life of the loan. With an adjustable-rate mortgage (ARM), the interest rate can change at the end of pre-determined intervals, such as every six months or every year. The interest rate is tied to changes in a published index that reflects the current interest rate. One widely-used index is the interest rate of United States Treasury bonds. If the index has gone up at the end of the adjustment period, the mortgage rate goes up, and thus the borrower's payment also goes up. Conversely, if the index has gone down, the mortgage rate goes down, and the mortgage payment goes down. Neither the lender nor the borrower can influence or predict in which direction the index will move. Most ARMs have a maximum interest rate cap.

Other, less common mortgages include the balloon mortgage and the graduated payment mortgage. A balloon mortgage is a short-term loan. The borrower makes payments for some period of time and then makes one large payment at the end. The graduated payment mortgage starts out with low monthly payments, which gradually increase over time before stabilizing.

In the United States certain government programs make it easier for borrowers to obtain a mortgage by lessening the risks for the lenders. Programs administered by the Federal Housing Administration (FHA) help low- and moderate-income borrowers obtain loans for housing by providing insurance for lenders against borrower default. The borrower pays for the mortgage insurance by paying a fee to the FHA. If the borrower defaults, the FHA will compensate the lender should the house sell for less than the amount of the mortgage debt. The Veterans Administration (VA) administers programs that guarantee loans made to qualified veterans. If the borrower defaults, the VA repays the lender a specified part of the mortgage loan. Other agencies buy mortgages from lenders and sell them to investors. The money the lender receives from the sale can be used to issue additional mortgages. These agencies include the Federal National Mortgage Association (FNMA or “Fannie Mae”), the Federal Home Loan Mortgage Corporation (FHLMC or “Freddie Mac”), and the Government National Mortgage Association (GNMA or “Ginnie Mae”).