Financing

How do mortgages work?
A mortgage is basically a long-term loan that you arrange through a bank or other financial institution, or even through the seller of the property. The house and/or property serve as collateral for the loan.

A home mortgage is most likely the largest debt you will assume. You typically pay off that debt in monthly payments over a long period of time, most often 15 to 30 years.
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What is in a mortgage payment?
A monthly mortgage payment typically includes the following, known as PITI:
  • Principal
  • Interest
  • Real estate Taxes
  • Property Insurance and, often, private mortgage insurance, known as PMI.
PMI gives the lender protection if the homeowner should default on the loan. The mortgage company charges insurance if the down payment is less than 20 percent of the sale price or appraised value. PMI usually can be eliminated once the principal balance of the mortgage reaches
80 percent of the sale price or appraised value, which is known as the loan-to-value (LTV) ratio.

The process of paying the principal takes years because mortgages are based on a repayment plan called amortization. During the years of the mortgage, a homeowner pays a lot of money toward interest in order to have manageable monthly payments on the huge house debt. During the first few years, most of the mortgage payments will be applied toward the interest. During the final years of the loan, the payments will be applied primarily to the remaining principal.
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What are the types of fixed rate mortgages?
Most lenders offer several types of mortgages; the most common are the fixed-rate mortgages for 30 years or 15 years.

30-year fixed rate
This mortgage is an industry standard, as total payments are spread over so many years that your monthly payments are lower than they would be on a shorter-term loan. The interest rate, which is set, or locked in, at the time of obtaining the mortgage, remains the same throughout the life of the loan. Check out the latest bankrate.com survey of interest rates on 30-year fixed mortgages.

On a 30-year loan, you end up paying thousands of dollars more in interest compared with a shorter-term obligation, but this interest is 100-percent tax deductible, which reduces your after-tax cost.

15-year fixed rate
This mortgage also is becoming a common loan because borrowers pay a lower interest rate in exchange for larger monthly payments. Note, however, that a smaller portion of your monthly payment goes for interest and therefore the tax deduction is smaller.
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What are the types of adjustable rate mortgages?
With a 15-year mortgage you could get an interest rate that is typically one-quarter to one-half percent lower than a 30-year mortgage. The shorter the term, generally the lower the interest. Yet, the main advantage is the fortune in interest you will be saving during the life of the loan. Check out the latest bankrate.com survey of interest rates on 15-year fixed mortgages.

Adjustable-rate mortgages, known as ARMs, differ from fixed-rate mortgages in that the interest rate moves up or down. ARMs are tied to a number of indexes, which usually are published interest rates. The margin is the amount a lender adds to the index , usually two percentage points or four percentage points, to set the actual interest rate of the ARM.

The most common index for ARM adjustments is the one-year U.S. Treasury bill. The one-year bill has a yield very near that offered by the 30-year Treasury bond, which is used to set rates on 30-year fixed mortgages.

The initial ARM rate is generally lower than the fixed mortgage rate, though in the current economy the one-year ARM rate has been only slightly lower, about one-quarter to one-third of a percentage point. Check out the latest bankrate.com survey of ARM interest rates.

Some ARMs adjust the interest rate every year, while others have an initial fixed rate period of 3, 5, 7 or even 10 years, after which the rate adjusts on an annual basis.
The more short term the index that your ARM is tied to, the more volatile your payments will be. That's good if interest rates fall, but it can cause trouble if interest rates rise.
Most ARMS offer built-in caps to protect against enormous increases in payments:

Lifetime cap - Limits how much the interest rate can rise during the life of the loan.
Periodic rate cap - Limits how much your payments can rise at one time.
Payment cap - Offered in some ARMs, it limits the amount the payment can rise over the life of the loan. So if the underlying index rises, your payment would increase only to the limit of the payment cap.
Keep in mind that rate caps work when the rates rise and when they fall. To get a better understanding of how ARMS work, we compare adjustable and fixed-rate mortgages in the next section.
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What other costs are associated with purchasing a home?
In addition to the down payment, there are many other typical closing costs. You need to have enough cash to cover these basic costs plus your down payment. Lenders estimate 3 percent to 6 percent of the loan amount in closing costs. On a $100,000 mortgage that would be $3,000 to $6,000.

Closing costs could include:
  • Loan application fees and credit report
  • Title search and insurance fees
  • Lender's attorney fees
  • Property appraisal
  • Inspections
  • Survey
  • Recording fees
  • Transfer taxes
  • Buyer's attorney
  • Documentary stamps on new note
  • Origination fees on mortgage
  • Condominium application fee
  • Escrow account balances/prepaids (for taxes, insurance)*
Real estate closing practices vary widely from state to state and even county to county. Where you live will determine exactly what you will have to pay. Even if you are not required to escrow money for taxes, you may want to set aside this amount to assure that you will be able to pay those tax bills when they fall due. You can get a good idea of what applies where you are buying by checking with a few real estate agents and lenders or title agents.

For more on closing costs, ask for the "Consumer's Guide to Mortgage Settlement Costs," Federal Reserve Bank of San Francisco, Public Information Department, P.O. Box 7702, San Francisco, CA 94120 or call (415) 974-2163.
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