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The Anatomy of a Mortgage

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What exactly is a mortgage? Simply put, it's a loan from a financial institution to you. In return, you pay interest on the amount loaned. The lender also has first dibs on your house in case you neglect to pay back the loan.

Francophiles and wordsmiths will recognize the root word "mort" in there. No, that's not your Uncle Mort; that's the French word for "dead." The idea is that you're going to kill off that loan, by paying back the money you borrowed. You amortize the loan, over time. Yes, it's a slow death, but it must be carried out.

A loan has three facets:

  1. size (how many dollars you need to borrow)
  2. interest (the percentage rate you pay on the loan)
  3. term (how long it will take to pay off the loan)

The first one is self-explanatory (although there are choices you can make with regard to the down payment, which we'll investigate in a little while).

The other two are more complicated. Let's look first at the interest rate.

The Calculation of APR (Annual Percentage Rate)

The annual percentage rate is a method developed under federal law to disclose to loan applicants the actual amount of interest that will be paid on a given loan, over the life of that loan. It makes it easy to compare one mortgage to another by making it an apples-to-apples comparison. You should, however, use the APR as just one tool in evaluating a loan, not as the sole factor in making your decision.

To understand APR, you must first understand the concept of points. A point is 1% of the loan amount. If the loan is for $100,000, one point is $1,000.

There are two types of points: origination and discount. Origination points are the fees normally charged by a lender, and sometimes by a mortgage broker, for originating, or starting up, your loan. Discount points are charged to lower your interest rate, and this lowers your payments. In other words, if you pay some more money up front, the bank will let you pay less over time.

Both types of points should be considered interest that you pay up front. Therefore, you must figure points into the cost of your loan repayment. If you take out a loan for $120,000 at 9% interest for 30 years, and you pay one origination point and one discount point, you're paying a total of two points, or $2,400. Your payment will be $965.55 per month.

To get the proper APR on your loan, then, you have to add that $2,400 to your starting balance, since (remember?) it is interest, albeit prepaid interest. This makes your total loan $122,400. Figure the new payment on that balance, which works out to $984.00. Now return to the original loan amount and (ready, mathematicians?) compute the polynomial backwards to reach the interest rate it would take to equal the payment on the total loan. It works out to roughly 9.23%.

In paying points to lower your rate, a good rule of thumb is that it will take you about five years to make up the additional point(s) paid; then you will begin saving money over the remaining term of the loan.

By federal law, lenders are required to send you a TIL (no, that's not something you get your hand caught in when you're stealing -- it stands for Truth in Lending) statement within three days of applying for a loan.

The Term

The most common term for a fixed-rate mortgage is 30 years, with 15 years the next most common.

A 30-year vs. 15-year mortgage debate rages, but one thing is sure: You will pay much more interest over the term of the loan (in most cases double) on a 30-year mortgage. On the flip side, a 30-year mortgage will offer lower monthly payments. You'll be getting a tax write-off for the interest portion of your payments, which could be substantial. On the other hand, in the first 15 years of your loan, you will be unFoolishly lining someone else's pocket with interest, while not building up significant principal for yourself.

Example: Let's say you buy a $150,000 home. You put down 20%, or $30,000, which leaves you $120,000 to finance. If you get a 30-year loan at 8.5%, your payments are $922.70. After five years of payments, your balance owed is $114,588. If, on the other hand, you obtain a 15-year mortgage at 8.00% (rates are lower with shorter-term loans), your payments are $1,146.00 ($224.00 more each month). After five years in this loan, however, your balance is only $94,000. That's quite a difference when it comes time to sell.

In sum, a 30-year loan is good for long-term stability. If you can afford a 15-year mortgage, you will build principal faster. Another option would be to pay what would be equal to the 15-year payment on a 30-year loan, enabling you to pay it off in about 15 years (slightly longer due to the higher interest rate), while still having the cushion of the lower payment should money problems arise.

Details...

There's one other loan categorization that has to do with size. A conforming loan is less than the Federal National Mortgage Association's legislated mortgage amount limit, which is currently $322,700 for a single-family home. A jumbo loan, also known as a nonconforming loan, exceeds that amount. Since such jumbo loans cannot be funded by the agency, they usually carry a higher interest rate.