Mortgages Explained: Your Guide to Home Loans & Financing

A mortgage is a loan – provided by a mortgage lender or a bankTop Banks in the USAAccording to the US Federal Deposit Insurance Corporation, there were 6,799 FDIC-insured commercial banks in the USA as of February 2014.  – that enables an individual to purchase a home or property. While it’s possible to take out loans to cover the entire cost of a home, it’s more common to secure a loan for about 80% of the home’s value.

The loan must be paid back over time. The home purchased acts as collateralTangible AssetsTangible assets are assets with a physical form and that hold value. Examples include property, plant, and equipment. Tangible assets are on the money an individual is lent to purchase the home.

Types of Mortgages

The two most common types of mortgages are fixed-rate and adjustable-rate (also known as variable rate) mortgages.

Fixed-Rate Mortgages

Fixed-rate mortgages provide borrowers with an established interest rateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. over a set term of typically 15, 20, or 30 years. With a fixed interest rate, the shorter the term over which the borrower pays, the higher the monthly payment. Conversely, the longer the borrower takes to pay, the smaller the monthly repayment amount. However, the longer it takes to repay the loan, the more the borrower ultimately pays in interest charges.

The greatest advantage of a fixed-rate mortgage is that the borrower can count on their monthly mortgage payments being the same every month throughout the life of their mortgage, making it easier to set household budgets and avoid any unexpected additional charges from one month to the next. Even if market rates increase significantly, the borrower doesn’t have to make higher monthly payments.

Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) come with interest rates that can – and usually, do – change over the life of the loan. Increases in market rates and other factors cause interest rates to fluctuate, which changes the amount of interest the borrower must pay, and, therefore, changes the total monthly payment due. With adjustable rate mortgages, the interest rate is set to be reviewed and adjusted at specific times. For example, the rate may be adjusted once a year or once every six months.

One of the most popular adjustable-rate mortgages is the 5/1 ARM, which offers a fixed rate for the first five years of the repayment period, with the interest rate for the remainder of the loan’s life subject to being adjusted annually.

While ARMs make it more difficult for the borrower to gauge spending and establish their monthly budgets, they are popular because they typically come with lower starting interest rates than fixed-rate mortgages. Borrowers, assuming their income will grow over time, may seek an ARM in order to lock in a low fixed-rate in the beginning, when they are earning less.

The primary risk with an ARM is that interest rates may increase significantly over the life of the loan, to a point where the mortgage payments become so high that they are difficult for the borrower to meet. Significant rate increases may even lead to default and the borrower losing the home through foreclosure.

Mortgages are major financial commitments, locking borrowers into decades of payments that must be made on a consistent basis. However, most people believe that the long-term benefits of home ownership make committing to a mortgage worthwhile.

Mortgage Payments

Mortgage payments usually occur on a monthly basis and consist of four main parts:

1. Principal

The principal is the total amount of the loan given. For example, if an individual takes out a $250,000 mortgage to purchase a home, then the principal loan amount is $250,000. LendersKey Players in the Capital MarketsIn this article, we provide a general overview of the key players and their respective roles in the capital markets. The capital markets consist of two types of markets: primary and secondary. This guide will provide an overview of all the major companies and careers across the capital markets. typically like to see a 20% down payment on the purchase of a home. So, if the $250,000 mortgage represents 80% of the home’s appraised value, then the homebuyers would be making a down payment of $62,500, and the total purchase price of the home would be $312,500.

2. Interest

The interest is the monthly percentage added to each mortgage payment. Lenders and banks don’t simply loan individuals money without expecting to get something in return. Interest is the money a lender or bank earns or charges on the money they loaned to homebuyers.

3. Taxes

In most cases, mortgage payments will include the property tax the individual must pay as a homeowner. The municipal taxes are calculated based on the value of the home.

4. Insurance

Mortgages also include homeowner’s insurance, which is required by lenders to cover damage to the home (which acts as collateral), as well as the property inside of it. It also covers specific mortgage insurance, which is generally required if an individual makes a down payment that is less than 20% of the home’s cost. That insurance is designed to protect the lender or bank if the borrower defaults on his or her loan.

Additional Resources

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• Cost of DebtCost of DebtThe cost of debt is the return that a company provides to its debtholders and creditors. Cost of debt is used in WACC calculations for valuation analysis.
• Floating Interest RateFloating Interest RateA floating interest rate refers to a variable interest rate that changes over the duration of the debt obligation. It is the opposite of a fixed rate.
• Interest PayableInterest PayableInterest Payable is a liability account shown on a company’s balance sheet that represents the amount of interest expense that has accrued
• Real EstateReal EstateReal estate is real property that consists of land and improvements, which include buildings, fixtures, roads, structures, and utility systems. Property rights give a title of ownership to the land, improvements, and natural resources such as minerals, plants, animals, water, etc.