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Introduction to Mortgages

What is a mortgage? Mortgages are financial instruments used to secure real property or real estate. Most people get a mortgage to purchase their home since we usually don't have the full purchase price in cash readily available. A mortgage gives us the ability to finance our home over a long period of time making it affordable on a month to month payment basis.

One of the common misconceptions is that the bank owns our home. Not true! You own the home but you owe the bank a lot of money. If you don't pay, the bank has the right to repossess what you put up in collateral to secure the loan. In the case of a mortgage that's your house.

The majority of mortgages are based on a fixed term and are amortized over that term. (amortization is a financial/mathematical term that refers to how a loan is repaid). Term refers to the length of the loan payback period. Amortization is the process of the loan balance declining over time as you make your payments.

For Example:

You purchase a home for $100,000 and make a down payment of 10% or $10,000. The amount you need to mortgage is $90,000. Let's say the interest rate is 7% and term is 30 years paid monthly 360 months. The monthly payment is determined by following an amortization schedule which determines the payment to be $598.77.

The payment stays fixed for the life of the loan but the amount of the payment that goes towards interest and the amount that goes towards principal constantly changes. This happens because interest is charged on the remaining balance each payment. Let's look at the above example's first monthly payment breakdown:

Payment = $598.77

Interest=$90,000*7%/12 or $90,000*.005833 = $525.00

Principal = Payment – Interest = $598.77 - $525.00 = $73.77

Remaining Principal = $90,000 - $73.77 = $89,926.23

The next month the interest portion will be a little less because the interest rate is applied against the remaining balance which is now a smaller value.

Your loan officer or real estate agent can provide you with a thirty year amortization schedule so you can see what happens to your mortgage each of the 360 months.

Types of Mortgages

Fixed Rate Mortgage

Fixed rate mortgages are probably the most common type of mortgage. “Fixed rate” refers to the fact that the interest rate is agreed upon initiation of the loan and never changes over the life of the loan. This also means that the principal and interest payment is fixed and will not change over the life of the loan. If you are required to escrow a portion of your real estate taxes and insurance, then your total payment may change due to any changes in taxes or insurance charges.

Adjustable Rate Mortgage (ARM)

Adjustable rate mortgages do just that: adjust their rate. Simply put, a loan that starts with an initial rate of 5% may be 7% the next year and 9% the 3rd year. Not to worry though, all adjustable have annual and lifetime rate caps. For example a 2/6 adjustable means that the rate cannot change by more than 2% up or down in any one year and cannot change more than 6% from the initial rate over the life of the loan.

Another parameter of the adjustable loan is the frequency at which it can change its rate. A 1 year adjustable can change its rate annually while a 3 year adjustable usually refers to a loan which remains at a fixed rate for 3 years and then can adjust annually thereafter. There are many variations available on the adjustable rate. Be sure to ask the lender to explain the terms.

Why adjustable? For the lender, they can borrow money on a short term basis to satisfy their obligations. If interest rates go up and you have a low interest long term fixed mortgage, the cost of the short term funds exceeds the profit they're making on your loan. The adjustable mortgage ties your interest rate to the market and gives the lender a more stable profit margin.

Does your payment change? In most cases, yes. When interest rates change, payments are re-calculated n the remaining principal balance for the remaining term at the new interest rate. Consider the following example:

$120,000 mortgage for 30 years @ 5% adjustable at 1 year increments with an annual cap of 2% and a lifetime cap of 6%.

Year 1

Rate = 5% Initial Principal = $120,000 term = 360 Months

Payment = $644.19

Year 2

Rate = 7% Initial Principal = $118,299.55 Term = 360 -12 = 348 months

Payment = $794.66

Year 3

Rate = 6% Initial Principal = $116,928.55 Term = 348-12 = 336 months

Payment = $719.26

Adjustable Rate Mortgages usually start at a lower rate than a fixed rate mortgage allowing the purchaser to qualify for a higher mortgage amount. They can also be fixed at a 1% adjustment for the first several years. The purchaser can make additional principal payments early in the loan to offset the prospect of higher interest rates in later years.


A balloon mortgage refers to a mortgage which has a set interest rate and set payments based on a term of 30 years. However, the entire remaining balance is due after a period of 3,5 or 7 years depending on the balloon program you chose.

This loan is attractive for someone who knows for certain that they will be moving or selling their home within the time period of the balloon and then can pay it off. The benefit to the consumer is that the balloon usually comes with an interest rate lower than the 15 or 30 year fixed rate loans.

What happens if you don't move or sell? Make sure the loan can be refinanced, i.e. Turned into a 15 or 30 year fixed loan at the then current market rate. This conversion typically carries a fee which should be stated in the original mortgage note.

Let's take an example:

5 Year Balloon

Rate = 6% Initial Principal $80,000

Monthly payment is calculated on a 30 year (360 MONTH) TERM: $479.64

You make these payments for 5 years and then the remaining balance of $74,443.49 is due in full. This can be paid off with cash form savings or through selling your home or it can be refinanced at current interest rates.


A step mortgage will normally have two pre-defined steps in the interest rate. For example, a 7/23 step loan means the interest rate is fixed for the first 7 years and then reverts to another rate for the remaining 23 years of the loan term. The second interest rate is dependent on market conditions at that time. ( Another common step loan is the 5/25) Example:

5/25 Step Mortgage

Rate = 6.5% Initial Principal = $90,000

Monthly Payment for 1st 5 year = $568.86

Principal balance after 5 years = $84,249.90

New rate = 10%

Monthly payment for next 23 years = $782.82

Mortgage Programs


A conventional loan refers to any mortgage that is neither insured or guaranteed by the government. The advantages and disadvantages of a conventional loan are as follows:


Lenders may be willing to keep the loan in their own lending portfolio, thus allowing more underwriting flexibility

Lenders may be willing to negotiate or eliminate certain loan fees

Many appraisals need meet only the guidelines of the lender's own board of directors' guidelines or the secondary market (if applicable) instead of strict appraisal standards of FHA and VA

If PMI (private mortgage insurance) is required, its premiums are usually less expensive than with ARM programs or FHA mortgage insurance.


Origination fees and other loan costs are determined by the individual guidelines and could therefore be higher than those of similar programs in the marketplace.

Most loans with greater than an 80 percent loan-to-value ratio generally will require the borrower to provide PMI (private mortgage insurance) if the loan is to be sold to the secondary market

Conventional loans may require larger down payments than those of government programs.

Private Mortgage Insurance (PMI) and Conventional Loans

Lender guidelines and the rules of the secondary market restrict the ability of enders to make high loan-to-value-mortgages without some guarantee against borrower default. Private mortgage insurance allows lender to increase their loan-to-value ratio and still sell their mortgages in the secondary market. If it approves the loan, the PMI company will issue a commitment to insure the lender. With this guarantee, the lender can increase the loan amount to as much as 100% of the property value (creating a zero down loan). The borrower pays the PMI premium and gets the benefit of a smaller down payment. The biggest challenge for most first-time home buyers is raising the money for the down payment. Private mortgage insurance is therefore one key to affordable housing, making the dream of home ownership possible for many.

80/20 Loans

Many lenders are offering 80/20 loans to eliminate the need for PMI. The 80% first lien will be fixed for 30 years at current rates and the 20% second lien at a slightly higher rate for 15 years. This works out to be close to the PMI fee but all of the interest is tax deductible. If you have a 5% or 10% down available the second lien will be for a lesser amount. Be sure to ask your loan officer about this option.

FHA ( Federal Housing Administration)

These loans are government backed by the Federal Housing Administration. Since they are backed by the government you can usually get a loan with as little as a 3% down payment on your home.

There are limits to the amount of the loan for this program and the limits depend on where you live. Also, some closing costs can be rolled into the mortgage. The basic idea of the FHA loan is to make housing more affordable to everyone.

One of the drawbacks of this loan type is something called a mortgage insurance premium (MIP). This is a lump sum at closing followed by a monthly surcharge on your mortgage payment. This money goes into a national fund which covers defaults on outstanding loans. At the time of this writing, this lump sum is currently 2.25% of the mortgage amount which is typically rolled into your mortgage balance and financed as part of the loan. Then, a monthly surcharge of .5% of the mortgage amount is added to your required payment. This charge in addition to the tax and insurance escrow payment and the principal and interest payment makes up your total payment.

Other advantages and disadvantages of using FHA financing are described below:


There is a low down payment requirement, as low as 3%

The entire down payment can be "gifted", or given to the borrower by a relative

Closing costs can be financed into the loan

A seller or other third party is allowed to participate in paying the buyer's closing costs

FHA loans have no prepayment penalty

Qualifying guidelines assist the average buyer in the marketplace, some underwriting guidelines are actually less restrictive than those of conventional fixed-rate loans. 


Sellers may object to paying discount points or other closing costs attributed to FHA financing

Since a seller may be requested to pay fairly heavy costs to assist a buyer, the cost of the home may be higher

A mortgage insurance premium (MIP) is required up front, or can be financed into the loan, and an annual renewal premium is charged, payable in the monthly payment for the life of the loans

Appraisal guidelines for FHA loans may be more stringent than those of conventional mortgage appraisals

A 1% origination fee is charged on FHA loan

Loan processing for FHA loans may take longer than it does for conventional loans.

Mortgage Insurance Premiums and FHA loans

As discussed earlier, there are two kinds of mortgage insurance premiums with FHA loans; initial premiums and renewal premiums. The borrower either must pay the initial premium in cash at closing or finance it into the loan. To calculate MIP, consider the following example. To finance the initial MIP on a $70,000 loan, the purchaser would add 3% or $2,100 to the loan amount. In addition, the annual renewal premium for a minimum down payment loan would add one-half of 1% annually on to the payment ($350 annually) paid monthly, or $29.17 on to the payment. This monthly premium would remain in effect for 30 years, the life of the loan.

The maximum loan amount can be exceeded by the amount of the MIP if it's added to the loan amount and financed into the loan. In addition, a third party (seller, relatives or employer) may pay part or all of the MIP in cash at closing.

VA (Veterans Administration)

This type of loan is also government backed and is only available to veterans. Some of the features are:

No down payment required

Increased qualifying ratios 

Similar to the FHA loan, the VA loan has an up front requirement of a funding fee (FF). This funding fee is a one time charge which can be rolled into the mortgage amount.

Qualifying for a Mortgage

When shopping for a new home, typically the first question you will have is "how much can I afford?" Lenders refer to it as qualification and most real estate agents will work with you to determine your range. There are two ratios that lenders will use to qualify you for a loan amount.

Front ratio

The front ratio is your total gross monthly income (i.e. Before tax) divided by your mortgage obligation (mortgage obligation consists of the principal and interest payment plus tax escrows, if required and private mortgage insurance (if required). Each lender will establish what this number should be but it typically is between 28% and 44%.

Back ratio

This ratio is your total gross monthly income divided by your mortgage obligation plus any long term debts. Long term debts are things like car loans other mortgages, home equity loans, school loans, credit cards, alimony and child support. This number will be between 33% and 48%, again depending on the lender's policies.

Other issues to qualifying will be:

Employment history

Cash available for closing costs and the source of those funds.

Credit History

Most financial advisors caution that the amount of loan that you qualify for is not necessarily what you can afford. Lenders simply use an equation that will satisfy the sources of their funds and also look attractive when the loan is packaged for  sale on the mortgage backed securities market.

For example, the lender will not take into consideration your lifestyle in terms of dining out or vacations, pending income changes such as a job change or leave of absence, a child going off to college or a new car.

Therefore, say financial advisors, take a realistic look at that proposed mortgage payment and decide how it will fit into your financial life. Remember that payment will be around for quite some time.

Applying For A Mortgage

There is a lot of information you will be required to supply the lender during the application process. This information assures the lender that you can indeed pay the loan back. Also, in most cases your loan will be packaged with others as part of a mortgage backed securities investment.

The following is a checklist of some of the information you may be required to supply your lender. Having this information available for your application will impress your lender and greatly speed your loan process.

Full address for all places of residence during the last 3 years  

Name, full address, account number and phone number for all landlords ad mortgage lenders for the last 3 years

Copies of the front and back of your last 12 months cancelled rent checks or mortgage payments (Bank statements may be used if cancelled checks are not available from your bank)  Name and full address of all employers for the last 3 years  Clear, readable photocopies of all pay stubs received in the last 30 days   

Clear photocopies of all W-2's for all jobs worked during the last 2 years
Copies of the past 3 months statements for:
Checking Accounts
Savings Accounts
CD Accounts
Money market Accounts, etc
Copies of any statements showing the value and last 3 month history of any assets and investments you will be using to complete the purchase or refinance

Auto loans   

Personal loans   

Student loans 


 Credit cards you currently use or have balances due   

Any obligations for which you are a co-owner or co-signer.
Also, the following additional information will be required if: 
You have young children requiring child care while you work:
Name, address and monthly cost of the person(s) providing this service.
You are divorced or recently separated:
Copy of the divorce decree or separation agreement.
You are paying a receiving alimony or child support:
Copy of court order or divorce decree showing amount paid or received.  
Self-employed or a commissioned salesperson:
Copies of full tax returns for the last two years  
A homeowner or owner of any other real estate
Copy of the sales agreement or listing on your present home being sold  
Copy of deed and title insurance on your home being refinanced
Taxes, insurance costs and copies of leases on rental properties
You have been previously bankrupt
Full petition and discharge papers 

What About Points?

 Most borrowers are confused about points. Simply state a point is 1% of the mortgage amount and is essentially up font or pre-paid interest. You may have noticed that the more points are quoted, the lower the associated interest rate. This is because the lender is asking for interest up front in lieu of a long term revenue stream of interest over the course of the loan being repaid.

The concept of points started with the emergence of the market for mortgage backed securities. What happens with the majority of mortgages is that they are packaged and sold as an investment within a few weeks or months of their origination. Therefore, the lender that originated the mortgage does not collect the mortgage payment over the life of the loan. They in turn collect some of that interest revenue up front in the form of points.

Points is a common practice of all lenders. You can't escape it but you can understand how to evaluate different point/rate packages when analyzing different options. When you see an advertisement by a lender and they're quoting a 7% loan with 2.5 points, this is merely one rate/point option they offer. Typically they will advertise an attractive rate that carries 0 to 3 points. In reality, that lender can also offer you a 7 ¼% loan with 1 ½ points (remember this is just an example and there is no implied relationship between rates and points). Therefore, you will need to make a decision between these packages. Typically, this decision will be influenced by the expected length pf stay in the home and how much cash you have for closing costs on the mortgage. Please see the next section (Comparing Various Loan Options) for a closer look at analyzing this decision.

Comparing Various Loan Options

The previous section (What About Points) explained a bit about the nature of "points". This section will help you analyze and decide between various rate/point loan choices you are faced with.

Your loan officer can produce a loan summary for all the loan choices you are considering. Typically they will only differ in the number of points and/or the loan term. Sometimes, the closing costs (besides the points) may be different for different loan options.

Now we need to analyze the differences between these options. Basically, the loan with the lower monthly payment will have the higher points and therefore higher total closing costs. The simple answer to deciding the best deal is to take the difference in closing costs and divide by the difference in monthly payment . The result of this calculation is the number of months it takes in order for the higher initial cost loan (i.e. Lower interest rate) to become the better deal.

Let's take an example:

Mortgage Amount = $100,000

Term = 30 years

Closing Costs = $3,000

Option 1: Interest Rate = 7.00% and 2 points ($2,000)

Payment = $665.30/month

Option 2: Interest Rate = 6.625% and 3 points ($3,000)

Payment = $640.31/month

The difference in monthly payments is $24.99 and the difference in upfront payments is $1,000. therefore it will take just over 40 months (3 years and 4 months) for the higher initial cost/lower payment loan to become the better deal. You need to judge how long you plan to be in the mortgage to determine if that's the right move. Also, another factor is whether you can afford the extra cash up front at closing ($1,000 in this example).

That's the simple analysis and in most cases all that is necessary. True economists would not ignore the time value of money nor any tax implications as this example does.

Questions To Ask

The following are some additional questions you may ask to clarify your loan choice:

Is the loan assumable? If so, under what circumstances and would the interest rate change? How would that be determined?

Can the private mortgage insurance (PMI) on the conventional loan be removed? If so, what are the current requirements? Remember, if the removal guidelines are strict now, they probably won't get any better with time!

Can the buyer pay taxes and insurance outside of the loan payments? This is determined by the type of loan and lender requirements.

Is there any prepayment penalty on the loan? Is there any minimum amount of prepayments required?

Paying Your Mortgage

Your mortgage is probably your biggest debt obligation. Paying your mortgage on time will help keep your credit record clean. Not paying your mortgage on time can result in significant late charges, a black mark on your credit report, and possibly result in the loss of your home.

Pre-paying your Mortgage

Your mortgage can also be viewed as an investment. Making extra principal payments on your mortgage is an option that should be considered along with putting money in the bank or investing in a stock or mutual fund.

Your agent can calculate the effective annual yield on an extra principal payment. For example, if you decide to make a $50 extra principal payment on your next payment and your next payment only, your agent can calculate: 1) the overall interest savings from that one time extra principal payment, 2) the effective remaining term of your loan, and 3) the effective annual yield on that $50 investment.

Where do these savings come from? Each mortgage payment, the required payment is fixed but the principal and interest portions vary. The interest portion is computed by multiplying the effective periodic interest rate against the remaining principal balance. The principal portion is then the difference between the required payment and the interest portion. When you apply extra principal to your payment, the remaining principal balance is a little less than it would have been. This effect continues to snowball as the loan matures and the final effect is less interest paid and a shorter loan payback period. This holds true whether you make only one extra principal payment during the life of the loan, vary the amount of extra principal applied, or consistently apply the same extra principal payment to each payment.

Some important points to consider when investing in your mortgage:

Make sure your lender allows pre-payment of your mortgage without penalty.

Be certain that the extra principal payment is applied to reduce the loan balance immediately as opposed to applying it to the "back-end" of the loan.

Be sure to follow the lender's instructions on how to send in your extra principal payment. If you do not clearly specify tat the extra payment is for principal, the lender may apply it to your escrow balance instead.

As opposed to investing money in a savings account or mutual fund, investing in your mortgage is not liquid. You only become liquid when the loan is paid off. Therefore, extra principal payments should be considered a long term investment that cannot be touched. As far as tax implications go, some would argue that you lose interest deductions on your home mortgage if you prepay the principal and pay less in interest. On the other hand, however, the effective yield on your extra principal investment is currently a tax free investment. If you're worried about not having so much mortgage interest to claim on your tax returns, ask yourself if it makes sense to spend a dollar to save 28 cents (using an example of someone in a 28% tax bracket.

What To Expect At Closing

Closing refers to the settlement of the mortgage loan. At settlement, the involved parties come together to settle the paperwork and exchange moneys associated with the deal. In the case of a new mortgage for the home you're buying, the parties are the buyer, seller and lender. In the case of a refinance, the parties are the borrower and lender.

If your loan application process went smoothly there should be no surprises at settlement. However, last minute problems may crop up. For example. A termite inspection report may be missing or the loan applicant may have forgotten to bring a one year paid homeowner's insurance policy. Depending on the parties involved, these instances may postpone settlement.

You will be presented with a settlement or closing sheet ( HUD 1) which will reflect all the applicable details of the transaction. The settlement sheet details the amount of money due from various parties and the amount of money due to various parties. Check this document carefully! If you were fully disclosed by your lender before settlement (as required by law) there should not be any charges you do not recognize. Also, bring along a calculator and add up the charges. Although they are totaled on the settlement sheet, errors are common. Your realtor will review these documents with you and verify their accuracy.

After everything has been agreed upon, you will be required to produce a cashier's check for the amount you owe and sign a lot of papers. Probably the most important document is the mortgage note. This is the binding contract between you and the lender. A copy of it will be filed in your County's courthouse and the original mailed to you in a few days to a few weeks. It is recommended you store this safely with any other important documentation.


Refinancing has been a hot topic since the early 1990's due to falling interest rates. Many books and articles have been dedicated to this topic and therefore only some of the major points will be covered here.

Refinancing your home mortgage is almost the same as getting a new mortgage, you will most likely need to go through the application and settlement processes again. Granted this enough to keep some people from refinancing. You may simply want to refinance the balance of your mortgage or you may want to refinance the balance plus some extra money (if there is equity in your home) for a variety of reasons.

There are lots of rules of thumb quoted about refinancing but the most definitive way to make a decision is to calculate the details of each option. The basic components of the analysis are:

Determine the remaining principal balance to be refinanced

Estimate the current value of your home

Add in any extra cash to be taken out of your home equity

Set the parameters of the new loan: type, interest rate, term

Estimate the closing costs for the new loans

Determine what portion of these closing costs will be rolled into the loan or paid out of pocket at closing

Calculate the new required payments

 Your loan officer can produce a report for you that shows:

The difference in required principal and interest payments

The amount of term reduction (only applicable if the new loan has a term less than the remaining term on the loan being refinanced)

Interest savings when comparing the interest that would have been paid on the current loan (without refinancing) to the total interest that will be paid with the new loan (with normal required loan payments). If the interest savings reflects a negative number, then more interest will actually be paid by refinancing. This can occur for two reasons:

The refinanced loan's term is significantly longer than the remaining term of the old loan. For example, a $100,000, 30 year, 9% loan that has 20 years remaining on its term (10 years of payments have been made) is being considered to be refinanced. If a fixed rate 7%, 30 year, $90,000 loan is obtained and regular required payments are made for 30 years, then interest charges would be approximately $18,600 more than if the old loan was kept for the remaining 20 years. This is due to the fact that although the interest rate is lower the loan term has been extended for another 10 ears. A prudent to do in this case is to refinance the loan and apply some or all of the savings in required payments as extra principal payments to the new loan, thus reducing the effective term or refinance the loan with a shorter term.

The new loan amount is significantly more than the remaining principal on the old loan because cash is being taken out of the equity of the home.

Loan Disclosure

A mortgage lender is required to make certain disclosures to a borrower at application or within three days after application. The disclosures describe costs incurred with the loan, the effective interest rate being charged and the possibility that the lender will sell the loan.

Good Faith Estimate

The Real Estate Settlement Procedures Act (RESPA) requires disclosure of estimated settlement costs to homebuyers based on the parameters of the loan. Settlement costs, itemized on the Department of Housing and Urban Development's (HUD's) settlement statement, includes fees to be paid at closing: these fees can vary based on changes in the loan that occurs between the time of application and closing. A final version of the HUD statement will be provided to you before closing.

Truth In Lending

The purpose of the Federal Truth-in-Lending Law and Regulations is to ensure that borrowers are aware of the terms and cost of credit so that they can knowledgeably compare loan programs and lenders. For example, the lender must disclose the annual percentage rat (APR) of the loan, defined as the cost of credit to the borrower expressed as a yearly rate/ The finance charge disclosed includes any charge paid directly or indirectly by the borrower and imposed by the lender as a condition of extending credit.

Where to Start

Shopping for a loan is a lot like buying a car – it has to be priced right, comfortable and be able to last as long as needed! That's why it's increasingly important to shop not only for the actual loan, but for the lender as well. A good loan officer not only will provide all the information the borrower needs to make an informed decision about which loan to choose, but will do everything possible to troubleshoot potential obstacles to bring the transaction to a speedy and successful closing.

After you have an executed contract (an accepted offer on a house), your lender will provide you a Good Faith Estimate and a Truth in Lending statement. You can then contact other lenders and shop for a better deal. It is extremely important that you use a reputable lender who can close on time. Friends and family members are great sources of referrals.

Note: We recommend you talk with a loan officer before you begin your home search. Getting pre-qualified/pre-approved turns you into a cash buyer!

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