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The Dream of Home Ownership

The Dream of Home Ownership

Owning a home is a powerful dream and goal for many people. Owning a home is not only an important step to the financial security of many families, it is also an integral part of the American dream. Why? Home ownership represents freedom, security and financial stability.

Most potential homebuyers can only achieve this dream with the help of a mortgage loan. Few have enough cash available to pay the full amount. With national home prices averaging between the high $160,000's to upward of $220,000 depending on region and market, obtaining a mortgage to purchase a home is a must.

The first step? Determining an affordable mortgage amount and finding a house or condo in your price range.

What is a Mortgage Loan?

What is a Mortgage Loan?

A mortgage loan is a loan made between two parties and is most commonly used when purchasing a house, condominium or other real estate. This type of loan allows the borrower to make a large real estate purchase by securing the loan with the property being purchased. The borrower gains ownership from the lender by making payments in accordance with an agreed upon repayment schedule. This payment schedule depends on the type of mortgage used.

The two parts of a mortgage

Most mortgages are made of these components:

  • Promissory note - Held by the borrower. Obligates the holder of the note to make payments to the holder of the mortgage note based on an agreed upon payment schedule. The payment schedule is also known as the amortization schedule.
  • Mortgage note - Held by the lender. Gives the lender the right to foreclose or take ownership of the property if the owner of the promissory note does not make the agreed upon payments in accordance with the amortization schedule.

Qualification Factors

Several factors determine someone's eligibility for the type and the amount of mortgage he or she will be approved for. These factors also determine the interest rate and size of the loan. Factors include the value and condition of the property, credit score, income, debt-to-income ratio and loan terms.

Two Types of Mortgage Loans

Two Types of Mortgage Loans

There are two basic types of mortgages: fixed-rate mortgages and adjustable-rate mortgages (ARM). Both have multiple variations.

Fixed-rate mortgage

The fixed-rate mortgage is what most people consider the traditional mortgage. The mortgage is usually for 30-years, and as the name suggests, has a fixed interest rate. This was once the only mortgage available. The fixed interest rate allows borrowers and lenders a measure of predictability.

The 15-year fixed-rate mortgage is similar except the term is shorter, making this mortgage popular with those who want to pay off the loan in 15 years and pay less in total interest. The downside? Monthly payment amounts are higher that a longer term mortgage.

Adjustable-rate mortgage (ARM)

The major difference between the ARM and the fixed-rate mortgage is the interest rate calculation. The interest rate can change over time, either increasing or decreasing, rather than staying constant.

Risks: With ARM's, the borrower assumes the risk of interest rate increases in exchange for lower initial rates and lower initial mortgage payments. The lender takes a risk as well by offering loans knowing that the borrower may not be able to make future payments if the rates go up. Should this happen, the lender is forced to foreclose and to resell the house at a potential loss.

Thanks to the subprime housing crises, (of which ARM's share a large part of the responsibility); these may not be available to everyone.

Loan variations

Other types of mortgage loans have limited availability but may be appropriate in specific circumstances.

Interest-only loan

This type of loan requires the borrower to pay only the interest. These lower payments appeal to homebuyers because of the lower monthly payments. However with no money going toward the principal, no equity is created. The interest only term is usually for a limited time; once that term expires, a lump sum payment, refinance or higher monthly payments are required.

The most common reason for these is to allow borrowers, who plan to move in a short amount of time or are expecting their income level to increase sharply, to purchase property.

Reverse mortgage

These are only available to homeowners age 62 or older. A reverse mortgage creates an income stream from the equity of the house. As with other mortgages, the property is the collateral. However, a reverse mortgage does not need to be paid back until the homeowner dies, sells the property or moves out the home.

Reverse mortgage income is advertised as a way to supplement a fixed income. However, the AARP warns seniors that reverse mortgages tend to be more costly than other mortgages. The AARP advises seniors to look into home equity loans or home equity lines of credit as alternatives if income is needed.

What a Mortgage Costs

What a Mortgage Costs

The costs of a mortgage are more complex than some realize. For starters, mortgage rates, much like stocks or bonds, can fluctuate throughout the day. This becomes challenging when trying to plan because a rate quoted in the morning may change by the afternoon. The good news is that once the rate is locked-in, it remains the same.

Interest Rates

The biggest impact on the cost of a mortgage, outside of the property cost, is the interest rate. Forbes reports that "a one-percentage point difference in mortgage rates translates into at least a 10 percent difference in the monthly mortgage payment." In other words, a 3 percent interest rate can save 10 percent per month on a 30 year fixed rate loan.

Annual Percentage Rate

The Annual Percentage Rate (APR) is a measure of how much will actually be paid on a loan throughout the calendar year. This not only applies to mortgages, but also to credit cards and other loans. The APR takes into effect the cost and interest, as well as origination fees, closing costs and mortgage points.

Quick tip: Although the housing industry is regulated, there are no regulations setting a standard fee or rate on a mortgage. Shopping for lenders can reduce costs and potentially save thousands of dollars.

Closing costs

Most mortgages have closing costs, although who pays them can be negotiated between the buyer and seller. These are the costs needed to close the deal on purchasing property and can vary depending on the state of residence and property being purchased.

Closing costs can include (but are not limited to) the following:

  • Attorney fees - for legal reviews. (While not required in all states, having an attorney review the documents can help avoid future issues.)
  • Appraisal fees - cost to determine market value of the property.
  • Inspection fees - covers property inspections that may be required by the lender.
  • Origination fees - lender fee for completing paperwork.
  • Title search and insurance - covers this cost. (A title search is done to make sure the property does not have any unresolved issues such as unpaid taxes, liens or mortgage payments due. The insurance protects the lender in case there's a problem or dispute with the title.)
  • Discount points - fee which may be paid in order to get a lower interest rate.
  • Underwriting - the cost of evaluating the mortgage application and buyers credit worthiness.
  • Credit check - fee for running a credit report.
  • Escrow deposit - prepayment of taxes and homeowners insurance. Typically covers a few months.

Credit Score

How much does a borrower's credit score factor into the overall cost of a mortgage loan? Credit scores reflect the risk that a borrower represents to a lender. A good credit score represents low risk, while a low score represents higher risk. Once the lender knows the credit score or risk (a mortgage underwriter will review the details), an interest rate is offered. And the best rates? They are offered to those with the best credit scores.

Anatomy of a Mortgage Payment

Anatomy of a Mortgage Payment

Mortgage payments are made up of the principal plus the loan interest. Most lenders also require an escrow account to be set up to pay for property taxes and homeowners insurance, these are also factored into the monthly payment amount.

  • Principal - the amount borrowed from the lender in order to purchase the property.
  • Interest - percentage agreed upon to pay the lender in order to borrow the money.

Payment calculation details

Mortgage interest can be simple interest or compounded interest (interest is added to the principal and compounded on periodic basis). This is another factor to consider when shopping for a loan. A monthly compounding loan will cost more than a weekly compounding loan but more than a simple interest loan.

Principal and interest are calculated over the life of the loan and used to create an amortization schedule. Borrowers pay interest first and then the principal. Even after 10 years of a typical 30 year mortgage, the principal amount appears to have moved little.

For example, a 30 year loan for $200,000 at a 4.7 percent interest rate has a total interest paid amount of $173,417. The total amount paid on the mortgage equals $373,417. While this is typical, making extra principal payments can reduce the principal faster.

Quick tip: Use our mortgage loan calculator to see the monthly amortization schedule for yourself.

Escrow

Most lenders require a borrower to have a separate escrow account. This account is used to pay property taxes and homeowners insurance. Not paying either of these can result in problems or losses to both the homeowner and the lender. Borrowers pay the necessary amounts to cover both insurance and taxes and the lender pays the insurance and taxes from the escrow account when they come due.

About Home Equity

About Home Equity

Equity is the market value of a house, condo or other real estate e at a given time. It is calculated by determining the current market value of the property minus outstanding mortgage debt. This amount changes over time and can increase or decrease based on the housing market.

For example, a house purchased for $100,000 may be appraised at a higher amount when the housing marking is growing. If that house is now appraised at $150,000, the available equity is $50,000.

Home values do not always increase. This same house, in a declining market, might have a current appraisal value of $80,000. This means there is negative equity and the borrower owes more on the property than it is worth. The borrower is "upside down" or "underwater" on his or her mortgage.

Refinance

Having equity offers the ability to refinance, replacing the existing mortgage for a new one. Refinancing is generally done to lock in a lower interest rate and reduce long term costs. Refinancing can also be used as a means of debt consolidation. Sometimes it can accomplish both.

For example, a homeowner with $20,000 in equity might consider refinancing at a lower interest rate for the full market value of that home. This provides an additional $20,000 in cash to consolidate debts or make a major purchase.

Before refinancing, consider the following:

  • Refinancing is not free. Refinancing a home may seem great, but factor in the fees and calculate the long term cost before signing.
  • Consolidating debt isn't for everyone. Refinancing for the full market value of the home to get pay debt may seem beneficial, but make sure the total amount of debt isn't increasing. Refinancing at a higher market value may cause payments to increase even if the interest rate is lower.

Preventing Foreclosure

Preventing Foreclosure

Foreclosure happens when the borrower either stops paying the mortgage or falls far enough behind that the lender deems it necessary to take ownership of the property. Borrowers facing financial challenges need to communicate frequently with the lender to help avoid foreclosure.

Loan modification

A loan modification is a change to one or more terms of the mortgage loan that results in payments the borrower can afford.

According to the US Department of Housing and Urban Development there are specific calculations done to determine eligibility. The lender may require an interior inspection of the home. All accrued late fees are waived. The lender will conduct an escrow analysis and financial review of the borrowers' individual situation to help determine eligibility.

Ask for help

Many lenders have programs to assist borrowers and help avoid foreclosure - but borrowers have to ask for help. Programs are available through the Federal government and many state and local agencies as well.

Comparing Mortgage Rates

The Mortgage Mosaic (Infographic)

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More About Mortgages

For First Time Home Buyers

National Mortgage Resources

  • FHA Options: Loans from the Federal Housing Authority offer lower interest rates for first time buyers, fixer-uppers, seniors and others.
  • Find FHA Lenders: Take advantage of great FHA discounts and programs by insuring that your lender is FHA approved.
  • VA Loans: Active duty service members, Veterans and eligible surviving spouses can find help from The Department of Veteran Affairs.
  • Fannie Mae: Homeowner options and resources.
  • Freddie Mac: Homeowner and business information.

Facing Foreclosure?

  • Avoid Scams: Making Home Affordable provides this resource so you know what to look out for.
  • Mortgage Relief: Federal program designed to help homeowners who are struggling to keep their homes.
  • Upside down mortgage: Three ways to turn your mortgage around

Calculators to Use

More Resources