There is a mind-numbing amount of information about mortgages online. For instance, the word itself is said to be taken from 'law French' and first codified into common law by English barristers in the Middle Ages. It's actual meaning is 'death pledge', meaning the pledge dies when the obligation is fulfilled. Loans to control property in various forms have existed since ancient times. They have also been subject to restrictions and abuse throughout time and sometimes influenced by various theologies. You can learn more about the history of mortgages with a simple query on your favorite search engine.
In order to avoid your eyes glazing over, our intent here will be to explain the most common loans in use today and their components. We'll also acknowledge that it's sometimes hard to improve on what other have already done. We will, therefore, share some of the information already compiled in this article by our friends at Wikipedia.
Let's start with some definitions pertaining to mortgages:
- Property: The physical residence being financed. The exact form of ownership will vary from country to country, and may restrict the types of lending that are possible.
- Mortgage: The security interest of the lender in the property, which may entail restrictions on the use or disposal of the property. Restrictions may include requirements to purchase home insurance and mortgage insurance, or pay off outstanding debt before selling the property.
- Borrower (Mortgagor): The person borrowing who either has or is creating an ownership interest in the property.
- Lender (Mortgagee): Any lender, but usually a bank or other financial institution. (In some countries, particularly the United States, Lenders may also be investors who own an interest in the mortgage through a mortgage-backed security. In such a situation, the initial lender is known as the mortgage originator, which then packages and sells the loan to investors. The payments from the borrower are thereafter collected by a loan servicer.)
- Principal: The original size of the loan, which may or may not include certain other costs; as any principal is repaid, the principal will go down in size.
- Interest: A financial charge for use of the lender's money.
- Foreclosure or repossession: The possibility that the lender has to foreclose, repossess or seize the property under certain circumstances is essential to a mortgage loan; without this aspect, the loan is arguably no different from any other type of loan.
- Completion: Legal completion of the mortgage deed, and hence the start of the mortgage.
- Redemption: Final repayment of the amount outstanding, which may be a "natural redemption" at the end of the scheduled term or a lump sum redemption, typically when the borrower decides to sell the property. A closed mortgage account is said to be "redeemed".
Next, we'll examine the characteristics of mortgage loans:
- Interest: Interest may be fixed for the life of the loan or variable, and change at certain predefined periods; the interest rate can also, of course, be higher or lower.
- Term: Mortgage loans generally have a maximum term, that is, the number of years after which an amortizing loan will be repaid. Some mortgage loans may have no amortization, or require full repayment of any remaining balance at a certain date, or even negative amortization.
- Payment amount and frequency: The amount paid per period and the frequency of payments; in some cases, the amount paid per period may change or the borrower may have the option to increase or decrease the amount paid.
- Prepayment: Some types of mortgages may limit or restrict prepayment of all or a portion of the loan, or require payment of a penalty to the lender for prepayment.
The two basic types of amortized loans are the fixed rate mortgage (FRM) and adjustable-rate mortgage (ARM - also known as a floating rate or variable rate mortgage). In some countries, such as the United States, fixed rate mortgages are the norm, but floating rate mortgages are relatively common. Combinations of fixed and floating rate mortgages are also common, whereby a mortgage loan will have a fixed rate for some period, for example the first five years, and vary after the end of that period.
- In a fixed rate mortgage, the interest rate remains fixed for the life (or term) of the loan. In case of an annuity repayment scheme, the periodic payment remains the same amount throughout the loan. In case of linear payback, the periodic payment will gradually decrease.
- In an adjustable rate mortgage, the interest rate is generally fixed for a period of time, after which it will periodically (for example, annually or monthly) adjust up or down to some market index. Adjustable rates transfer part of the interest rate risk from the lender to the borrower and thus are widely used where fixed rate funding is difficult to obtain or prohibitively expensive. Since the risk is transferred to the borrower, the initial interest rate may be, for example, 0.5% to 2% lower than the average 30-year fixed rate; the size of the price differential will be related to debt market conditions, including the yield curve.
The charge to the borrower depends upon the credit risk in addition to the interest rate risk. The mortgage origination and underwriting process involves checking credit scores, debt-to-income, down payments, and assets. Jumbo mortgages and sub-prime lending are not supported by government guarantees and face higher interest rates.
Other Mortgage Considerations
Other considerations in establishing a mortgage loan are:
- Loan to value ratio: An example would be purchasing a home for $200,000 with a down payment of $40,000 (20%) leaving a loan of $160,000 (80%). Your loan to value ratio, in commonly expressed terms, would be 80/20.
- Value: This is generally established by an appraisal arranged by the lender. It is not necessarily your purchase price, but given prudent analysis prior to purchase, the two should closely align.
- Payment and debt ratios: An example of this would be having a monthly household income of $6,667 ($80,000 annually) with a house payment of $1,667 giving you a payment to income ratio of 25%. Adding other monthly household debt obligations of $733 to the house payment of $1,667 for total debt of $2,400 would give you a debt to income ratio of 36%. As you can see these ratios are commonly expressed as percentages.
Still with us? There are three types of mortgages predominant in the USA. These are commonly known as conventional, FHA and VA loans.
Conventional loans are the most common. These differ from FHA and VA loans in that they are not insured by the government and follow guidelines issued by the Federal National Mortgage Association and Federal Home Loan Mortgage Association. These two entities are commonly referred to as Fannie Mae and Freddie Mac. The guidelines generally limits loan size to $510,400 in 2020 although this can vary by region of the country. Loans that meet this limit are known as conforming loans although loans can exceed the limit and still be called conventional loans. Those that exceed the limit are known as non-conforming conventional loans, or sometimes, jumbo loans.
The Federal Housing Administration (FHA) is part of the U.S. Department of Housing and Urban Development (HUD). It does not lend money, but rather, backs lenders in the event the borrower defaults. FHA loans require a minimum down payment of 3.5% and are generally limited to $765,600, but can be higher in more expensive regions of the country. They also, generally allow for higher payment and debt to income ratios.
Active duty and military veterans may qualify for loans administered by the U.S. Department of Veterans Affairs. An appealing advantage to a VA loan is that there is no down payment required as long as the purchase price meets the appraised price and the seller is willing to pay closing costs. As with FHA, the VA does not loan money, but rather, backs lenders making loans to qualified veterans. An eligible veteran's basic entitlement is no longer capped at $144,000 and the VA may guarantee up to 25% of conforming loan guidelines as laid out by Fannie Mae and Freddie Mac and explained above. This exception does not apply to refinancing.
Preparing To Apply
As explained on our Buyers Information page, preparing to apply for a mortgage loan begins with analyzing your personal financial situation. You'll need to review your credit scores, examine your overall budget and assess your ability to meet ratios explained above.
Be aware that there are many options for rates, payment frequency, durations and types of loans, depending on your qualifications. Gather your information, do your analysis, and if you you don't already have a preferred lender, consult your Daugherty Group real estate professional for assistance.