A mortgage is likely to be the largest, longest-term loan you’ll ever take out to buy the biggest asset you’ll ever own — your home. The more you understand how a mortgage works, the better equipped you should be to select the mortgage that’s right for you.

WHAT IS A MORTGAGE?

A mortgage, also referred to as a mortgage loan, is an agreement between you (the borrower) and a mortgage lender to buy or refinance a home without having all the cash upfront. This agreement gives lenders the legal rights to repossess a property if you fail to meet the terms of your mortgage by not repaying the money you’ve borrowed plus interest. To see the full details of how to apply for a mortgage.

WHO GETS A MORTGAGE?

Most people who buy a home do so with a mortgage. A mortgage is a necessity if you can’t pay the full cost of a home out of pocket. There are some cases where it makes sense to have a mortgage on your home even though you have the money to pay it off. For example, investors sometimes mortgage properties to free up funds for other investments. 

HOW A MORTGAGE WORKS?

Every month you make a mortgage payment, it gets split into at least four different buckets that make up principal, interest, taxes and insurance or PITI for short. Here is how each bucket works:

1. Principal. This is the portion of your loan balance that’s paid down with each payment.
2. Interest. This is the interest rate charged monthly by your lender for the mortgage you chose.
3. Taxes. You’ll pay 1/12th of your yearly property tax bill each month based on how much is assessed each year in your neighborhood.
4. Insurance. Lenders require homeowners insurance to cover your home against hazards like fire, theft or accidents. You may have an additional, separate monthly payment for mortgage insurance based on your down payment or loan type.

In the early years of your mortgage, interest makes up a greater part of your overall payment, but as time goes on, you start paying more principal than interest until the loan is paid off. Your lender will provide an amortization schedule (a table showing the breakdown of each payment). This schedule will show you how your loan balance drops over time, as well as how much principal you’re paying versus interest.

COMMON MORTGAGE TERMS

§  Amortization

Part of each monthly mortgage payment will go toward paying interest to your lender, while another part goes toward paying down your loan balance (also known as your loan’s principal). Amortization refers to how those payments are broken up over the life of the loan. During the earlier years, a higher portion of your payment goes toward interest. As time goes on, more of your payment goes toward paying down the balance of your loan.

§  Escrow

Part of owning a home is paying for property taxes and homeowners insurance. To make it easy for you, lenders set up an escrow account to pay these expenses. Your escrow account is managed by your lender and functions kind of like a checking account. No one earns interest on the funds held there, but the account is used to collect money so your lender can send payments for your taxes and insurance on your behalf. To fund your account, escrow payments are added to your monthly mortgage payment.

§  Promissory Note

The promissory note, or “note” as it is more commonly labeled, outlines how you will repay the loan, with details including:

• Your interest rate
• Your total loan amount
• The term of the loan (30 years or 15 years are common examples)
• When the loan is considered late
• Your monthly principal and interest payment
• Closing Costs

These are expenses charged by a lender to make or originate your loan.  They typically include origination fees, discount points, fees related to underwriting, processing, document preparation and funding of your loan. However, your total closing costs include appraisal and title fees, title insurance, surveys, recording fees and more. While fees vary widely by the type of mortgage you get and by location, they typically total 2% to 6% of the loan amount.

§  Discount Points

Also called “mortgage points,” this is money paid to your lender in exchange for a lower interest rate. A point is equal to 1 percent of your loan. The lender may offer to sell you points in exchange for a lower interest rate. Note: A point does not equal a percentage rate drop in interest rate. The lender will tell you how much a point will drop the rate. You can usually buy points in one-quarter increments.

So when does it make sense to buy points? How long you plan to keep the mortgage will determine this. If you plan on moving in a few years, buying points to get a better interest rate may not make sense because you won’t recoup the initial investment.

If you plan on staying in the home without refinancing anytime soon, points might make sense. You have to make the choice between lower interest rates over the life of the loan or no points up front. Compare offers to see what makes sense to you.

§  Note Rate

This is the actual interest rate you pay each year based on the loan amount you borrow, expressed as a percentage rate. It doesn’t reflect any of the costs or charges for the mortgage, and should not be confused with the annual percentage rate, which we’ll explain next.

§  Annual Percentage Rate (APR)

The annual percentage rate (APR) includes fees and points to arrive at an effective annual rate. Because different lenders charge different fees and structure loans differently, the APR is the best way to compare what each lender is offering. For example, Lender A may offer you an astounding 2% interest rate that sounds far better than Lender B’s 3.5%. But Lender A is including points and exorbitant fees. So the APR, or what you’ll really be paying could be higher for Lender A even though the interest rate is lower. APR helps you compare apples to apples.

The APR was created to make it easier for consumers to compare loans with different interest rates and costs, and federal law requires it to be disclosed in all advertising.

§  Private Mortgage Insurance

Private mortgage insurance is a fee you pay to protect your lender in case you default on your conventional loan. In most cases, you’ll need to pay PMI if your down payment is less than 20%. The cost of PMI can be added to your monthly mortgage payment, covered via a one-time upfront payment at closing or a combination of both. There’s also a lender-paid PMI, in which you pay a slightly higher interest rate on the mortgage instead of paying the monthly fee.

To understand how much you can afford and what loans you might be eligible for, contact Rising Sun Lending. Our experienced and professional team will customize the best suitable financing tools that fit into your needs.