The Skeleton of a Mortgage: All the Parts and What They Do

August 18, 2010 No Comments »

A mortgage is not a simple instrument.  It contains many working parts, most of which are adjustable and all of which are significant.  No two mortgage deals turn out the same way, and the final form that a mortgage takes is entirely dependent on the financial needs and capabilities of the borrower.

That said, much of what goes into a mortgage is consistent across the board.  There are essentially seven different pieces of the mortgage puzzle, and the size and role of each of these pieces affects the roles of the others.

Mortgage Type

You’ve heard the terminology before—fixed-rated, jumbo, ARM, VA, FHA, and so on.  The mortgage type determines the range of interest rates available to the borrowers as well as the loan term length and other stipulations.  A few of the more common mortgage types are outlined here.

  • Adjustable-rate mortgages.  These come at comparatively low interest rates, but these low rates are tied to the market index.  If rates as a whole increase, then ARM rates increase.  ARMs are easy to get into, but they may have negative consequences if mortgage rates rise.
  • Fixed-rate mortgages.  Unlike ARMs, fixed-rate mortgages remain at a steady rate over the entire course of the loan term.  Regardless of the market, interest rates on a fixed-rate mortgage will never increase.  They’ll be higher at the outset, however, to account for this.  Fixed-rate mortgages are therefore not as cheap out of the gate.
  • FHA mortgages.  These mortgages are insured by the Federal Housing Administration, which enables lenders to offer them to high-risk borrowers.  FHA mortgages are intended to allow homeowners with low cash reserves or poor credit scores to purchase homes.  FHA mortgage require minimal down payments.
  • VA mortgages.  VA mortgages are offered to veterans only.  These mortgages require no down payment and come at highly agreeable rates.
  • Balloon mortgages.  A balloon mortgage comes at a fixed interest rate for a very short period—often only five years.  At the end of the period, the full amount of the purchase price is due.  These mortgages can be highly useful if the borrower plans to sell the home soon after buying.

Interest Rate

The mortgage interest rate is arguably the most significant part of the mortgage deal.  The higher the rate, the greater the overall interest accrued.  Even a minor adjustment to a mortgage rate can cost a borrower tens of thousands of dollars over the ensuing 30 years.  Pay close attention to mortgage rates.

Loan Term

The length of the loan itself is almost as important as the interest rate.  A mortgage that is paid off in 15 years will likely cost a borrower less money than a loan at a lower rate paid off in 30 years.  The shorter the term, the lower the cost of interest.

Related: 5 things to ask your lender before opening a home loan.

Down Payment

Different mortgage types require different down payment amounts, though all of this depends upon the exact terms negotiated between the borrower and the lender.  The down payment is the cash that is paid up front upon purchase of the home.  If the down payment accounts for less than 20% of the purchase price, lenders will often require the borrower to take out private mortgage insurance to mitigate the risk of the high-capital loan.

Points

Points are like miniature down payments.  A point is equivalent to 1% of the purchase price of the home.  Many lenders allow borrowers to pay one or more points—in addition to the down payment—in exchange for a lower interest rate over the course of the loan.

Mortgage Insurance

As discussed above, lenders often require that borrowers take out mortgage insurance if the mortgage is opened with a minimal down payment.  Mortgage insurance is paid for by the borrower and can create a significant additional monthly expense.  The borrower continues to pay the premiums until he or she has gained at least 20% equity in the home.

Closing Costs

A closing cost is any upfront cost associated with the closure of the mortgage deal.  This may include origination fees, broker’s commissions, application fees, appraisal fees, and other miscellaneous costs.  All of these costs are paid by the borrower.  Many borrowers overlook closing costs and fail to retain adequate funding to cover these expenses when budgeting for a mortgage.

Related: Understanding how much you should pay in closing costs.

When comparing all of these elements, recognize that they work together as a unit.  Altering one may alter others.  The pieces of the skeleton balance with each other, and as a result, you can often customize your mortgage to meet your unique needs.  But don’t expect perfection across the board.  If you want a lower interest rate, it will require a higher down payment.  If you want a shorter loan term, it will require a higher interest rate.  Identify your financial capabilities and your long term goals, and then work with your lender to craft a mortgage that meets your needs.

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