Most people understand that a mortgage is a type of secured loan that a borrower takes out to pay for a home or another type of real estate property, which serves as the collateral. However, a mortgage can be a complicated debt instrument. The 2008 foreclosure crisis is evidence that borrowers often accept the terms of predatory mortgage loans without realizing what they’re getting into.
Understanding the terms of your mortgage and identifying potential pitfalls is critical to ensuring financial prosperity. This article takes an in-depth look at the mechanisms behind a mortgage, the different mortgage types, the macroeconomic determinants of mortgage rates, and more.
Secured vs. unsecured debt
Before diving into mortgages and how they work, understanding the difference between secured and unsecured loans is essential.
Secured loans require an asset with monetary value as collateral. In other words, the borrower pledges an asset as security for repayment of the loan. If the borrower fails to make the loan payments, the lender has the right to repossess the asset, sell it, and use the proceeds to pay off the debt.
Offering collateral reduces lenders’ risk and makes it easier for borrowers to obtain relatively large loan amounts. The interest rates of secured loans are generally lower than those of unsecured loans. The interest paid on some types of secured loans, such as mortgage loans and home equity loans, may also be tax-deductible.
Unsecured loans, such as credit cards, student loans, and personal loans, don’t involve collateral, so lenders have to rely heavily on borrowers’ creditworthiness to mitigate their risk. With an unsecured loan, you don’t have to worry about losing your property. However, failing to repay an unsecured loan will damage your credit.
The interest rates of unsecured loans are generally higher than the rates on secured loans. If you don’t have a positive credit history or steady income, an unsecured loan can also be challenging to obtain.
What is a mortgage loan?
A mortgage is a type of secured loan with a specified repayment schedule, with real property serving as collateral. This type of loan allows you to pay for a property over a predetermined mortgage length (10-30 years) at a fixed or adjustable interest rate instead of buying the property with cash.
If you fail to make your mortgage payments, the lender has the right to take your home with a legal proceeding known as foreclosure. If you sell the property before the mortgage term ends, the sale proceeds will cover the remainder of the mortgage debt.
Mortgage lenders include banks, credit unions, and some pension funds. If you want to apply for a mortgage, you can also approach various government agencies, including:
- Federal Housing Administration (FHA)
- Department of Veterans Affairs (VA)
- U.S. Department of Agriculture (USDA)
You can also work with a mortgage broker, who will help you connect with lenders and negotiate the best possible terms on your behalf.
The history of the modern mortgage
Before the Great Depression, home mortgages were loans that homeowners could take out for up to 50% of each property’s value with repayment periods of up to 10 years. At maturity, borrowers had to pay the principal as a balloon payment—a single, lump-sum payment.
During the Great Depression, house prices dropped, and the banks refused to allow refinancing. In other words, banks didn’t want to set up loans under new principal-and-interest payment terms that would make it easier for homeowners to repay their loans. Homeowners could no longer afford their balloon payments, resulting in large-scale foreclosures.
As part of President Franklin D. Roosevelt’s New Deal to reverse the downward economic spiral, the Home Owner’s Loan Corporation (HOLC) bought defaulted mortgages from banks, which it financed by issuing bonds. Then, the HOLC repurposed the loans as fixed-rate, long-term mortgages and reinstated them.
During this period, the Federal Housing Administration (FHA) also initiated a program to ease mortgages’ payment requirements. The FHA programs offered loan-to-value (LTV) ratios of 90% and higher, and they lengthened the loan periods – initially to 15 years and later to 30 years.
The FHA also started qualifying applicants according to their ability to pay back loans, and the properties they accepted as collateral had to meet various building quality standards. Commercial lenders, such as banks, had no choice but to implement the same lending practices as the FHA, practices that remain in effect to this day.
How do mortgage payments work?
When you close your home loan, you have to make a down payment, which is a percentage of your property’s purchase price that you pay upfront. The size of your down payment depends on the lender’s requirements, as well as how much cash you have at hand. Down payment percentages range from 5% to 20%, but you may find some programs requiring as little as 3%.
The monthly amount you have to pay towards your mortgage depends on your loan’s size (the total price after subtracting the down payment) and the loan term. The longer your repayment period, the lower your monthly mortgage payment, which is why most homeowners opt for 30-year mortgages. Four components (PITI) comprise your monthly mortgage payment:
Interest vs. principal
The mortgage principal is the amount you borrow to buy a property, and the principal portion of your monthly payment pays down your outstanding loan amount.
Interest is the cost that lenders charge to lend you money, and it is a percentage of the mortgage’s outstanding balance.
The gradual repayment of the principal amount and accumulated interest takes place according to amortization schedules.
- With a fixed-rate mortgage, your monthly payment remains the same for the duration of the loan.
- However, during the mortgage’s initial years, your monthly payment’s interest portion will be significantly higher than the principal portion.
- As the mortgage matures, the principal portion of the payment grows, and you will build equity in your home at an increasing rate.
Your monthly mortgage payments will likely include property taxes. Private lenders offering conventional loans don’t have a legal obligation to include property taxes into borrower’s monthly bills. However, the FHA rolls taxes into all mortgage bills.
The amount you’ll need to pay in taxes depends on your property’s assessed value and the local tax rate. Lenders typically calculate borrowers’ annual tax burden, which they divide by 12 and prorate in monthly billing.
If you pay property taxes with your monthly mortgage payment, the lender will deposit the property tax portion into an escrow account. The day your taxes become due to the county or another local authority, the lender will use the funds in your escrow account and make the tax payment on your behalf.
Most borrowers have to make certain insurance deposits with each mortgage payment, which the lender or mortgage servicer holds in escrow until the insurance bill is due. This may include one or both types of insurance: private mortgage insurance and homeowner’s insurance.
Homeowners’ insurance is a policy covering your property structure, personal property, and various living expenses. Some policies also include other structure coverage, which pays to restore structures separate from your home.
Lenders typically require homeowner’s insurance to ensure their investment has sufficient protection against losses resulting from storms, theft, fire, flooding, and other disasters. Generally, you set up your insurance policy with an insurance agent but then the lender pays it out of escrow and prorates the annual amount into your monthly payments.
Private mortgage insurance (PMI)
When borrowers can’t come up with a 20% down payment on a property, lenders will likely require them to take out private mortgage insurance (PMI). This type of insurance protects the lender and pays the mortgage if the borrower defaults or forecloses on their home.
If your down payment is less than 20%, you will likely have to pay PMI as part of your monthly mortgage payment. In some cases, you can pay PMI upfront as a one-time premium at closing. When the loan balance reaches 78% of the original home value (in other words, when you have paid 22% of the principal), you should contact the lender with a request to terminate the PMI.
PMI premiums’ annual cost typically ranges between 0.5% and 1% of the mortgage loan amount. For example, if you have to pay 1% on a loan amount of $100,000, that would be $1,000 per year, which increases your monthly mortgage payment by $83.33 per month.
Types of mortgages
A conventional loan is a type of mortgage the federal government doesn’t insure or guarantee. Instead, private lenders back conventional loans while borrowers pay for their insurance. Conventional loans are among the most popular financing options, and they accounted for 72% of all home sales during the third quarter of 2020.
The loan sizes of conforming loans are also less than the maximum amount set by the Federal Housing Finance Agency (FHFA), which oversees Freddie Mac and Fannie Mae. The baseline loan limit for a single-unit conforming loan in 2021 is $548,250 but differs from state to state. Other criteria a conforming loan must meet pertain to the following:
- Down payment size relative to the loan amount
- Type of property
- Borrower’s debt-to-income ratio
- Borrower’s credit score
A non-conforming loan uses underwriting standards that differ from the ones set by Freddie Mac and Fannie Mae, and its amount exceeds the FHFA loan limits. For example, a jumbo loan is a non-conforming loan exceeding the maximum loan limit for its area. Non-conforming loans may be a viable option for borrowers who have gone through bankruptcy in the past.
A fixed-rate mortgage offers an interest rate that remains the same for the loan’s entire repayment period. With this type of loan, your monthly mortgage payment also remains the same, provided there are no changes in the property tax and insurance portions of your payment. Fixed-rate loans are generally available in terms of 30 years, 20 years, and 15 years.
Fixed-rate mortgages offer stability over the long run and allow you to draw up precise monthly budgets for your other expenses. However, with this mortgage type, it takes a long time to build equity in your home, and you will also pay more interest over the long run. If you plan to stay in your home for at least ten years, a fixed-rate mortgage is the safest option.
Adjustable-rate mortgages (ARMs)
With an adjustable-rate mortgage, the interest rate on the outstanding balance changes at regular intervals, affecting the size of your monthly mortgage payments. How often the interest rate of an ARM adjusts depends on the mortgage. Most loans adjust once a year, but six-month and two-year ARMs also exist.
The initial interest rate of an ARM is fixed for a specific period, after which it resets periodically, based on an index plus a set margin.
The fixed-rate period and adjustment intervals are expressed as two numbers. For example, a 3/3 ARM has a fixed rate for three years before adjusting at three-year intervals. A 5/1 ARM has a fixed-rate period for five years, then it will adjust annually until maturity.
Indexes most ARM interest rates track include:
- The 11th District Cost of Funds Index (COFI)
- U.S. 1-Year Treasury Bills
- The London InterBank Offered Rate (LIBOR)
Many ARMs carry lifetime caps, which are limits on how high their interest rate can increase over the loan’s life. Periodic caps set limits to how much the interest rate may change with each adjustment. Before signing up for an ARM, make sure that its terms include lifetime and interim caps.
ARMs often carry lower interest rates than fixed-rate mortgages, which means you’ll cover your principle within a shorter time. If you don’t plan to live at the property for more than six or seven years, an ARM may be your most cost-effective option.
Annual percentage rate (apr)
Comparing loans with different costs and interest rates can be difficult. When shopping for loans, you want to ensure that you take out the option with the lowest expense over the life of the mortgage.
Let’s look at an example of two loan options:
Present Value (loan amount): $200,000
Interest rate: 4%
Present Value (loan amount): $200,000
Interest rate: 4.80%
Which loan option is best? To ensure that you compare apples with apples, you need to use the annual percentage rate (APR), representing the actual loan costs you have to pay annually as a percentage of your loan amount.
A loan’s APR is generally higher than its interest rate because it includes the interest and all loan costs, including the origination fee, insurance premiums, and points. When comparing loans, you have to consider the APR, not just the interest rate, to determine which loan carries the lowest actual cost. The Federal Truth in Lending Act requires lenders to disclose the APR and finance charges on all loan offers.
The APR of a loan will increase as the following increase:
- Loan amount
- Interest rate
- Repayment term
The relationship between a loan’s monthly payment and APR is inverse. In other words, the higher your monthly payment, the lower the APR.
Factors determining mortgage rates
To successfully apply for a loan, borrowers must meet specific income requirements. When calculating a mortgage rate, lenders also consider borrowers’ credit score, the loan amount, down payment size, and the property condition and location.
While lenders are free to determine the interest rates they charge for loans, they must adhere to market conditions. Below, we look at the macroeconomic factors affecting the market levels of interest rates.
Economic growth is when the production of goods and services increases for a specific period. During economic growth, stock prices rise, employment rates increase, and households earn a higher income.
An increase in the gross domestic product (GDP) raises the demand for money to conduct transactions, including the demand for home loans. When real money demand exceeds real money supply, the interest rate increases.
An economic downturn has the opposite effect on the interest rate. As household income declines, the demand for home loans decreases, which reduces the interest rates that mortgage lenders offer.
Inflation is the steady increase in the prices of goods and services. In other words, a dollar has more buying power today than it will have tomorrow. Lenders know that inflation will erode the value of the loan amount over the life of the loan, so they increase interest rates to compensate for their projected loss.
Federal reserve monetary policy
Through policy tools, the Federal Reserve conducts monetary policy to influence employment, inflation, and the supply and cost of credit in the economy.
The federal fund rate is among the Federal Reserve’s most influential policy tools, which is the rate that commercial banks have to pay for borrowing in the federal funds market. A federal rate adjustment will affect other interest rates and the borrowing costs for businesses and households.
Lenders’ expectations of monetary policy in the future have a significant effect on long-term interest rates. For example, suppose lenders believe that the Federal Reserve is not currently focusing on containing inflation. In that case, they will add a risk premium to their long-term rates, protecting themselves against losses due to rising inflation.
Mortgage securitization (mortgage-backed securities)
Banks and other lenders sell mortgage-backed securities (MBSs) on the secondary market as investment products. In other words, banks act as middlemen between MBS investors and borrowers, and the investors effectively lend money to property buyers.
These private firms compete with corporate and government bonds, which also offer mortgage-backed securities as fixed-income, long-term investments. To attract buyers for their investment products in a competitive market, banks have to ensure high yields by increasing the interest rates they charge borrowers.
Conditions in the housing market
Like economic growth, conditions and trends in the housing market also affect the demand and supply for home loans, influencing mortgage rates. Various factors can influence the demand for properties, including taxation influences, such as capital gains discounts and the price of renting properties.
Mortgage servicers are companies taking care of all the administrative tasks regarding mortgage loans. After you close on your mortgage, the servicer is responsible for sending you monthly statements, receiving your mortgage payments, and managing the escrow accounts for your tax and insurance payments. The mortgage servicer is also your point of contact for all matters relating to your mortgage.
The mortgage servicer doesn’t necessarily have to be the same entity as the lender. You can find out who your mortgage servicer is by checking your loan statement or payment coupon book. A change of servicers often occurs during the loan’s life, and the lender must inform you of such a transition.
For most people, it is impossible to buy a home with cash. However, with a mortgage, you can spread the repayments on your home over many years, making homeownership affordable. Mortgages are secured loans, and the interest rates they carry are relatively low, making them one of the most cost-effective loan types.
If you plan on living in your new home for the rest of your life and don’t want to deal with the uncertainty of fluctuating interest rates, a fixed-rate mortgage is the best option for you. However, if you don’t intend to live in your home for longer than five to seven years, it’s advisable to stick with an adjustable-rate loan that has acceptable lifetime and periodic caps.