Mortgage Basics

A mortgage is a long-term loan that uses real estate as collateral. A mortgage loan is commonly used for buying a home. Mortgage loans are usually fully-amortizing, which means that the monthly principal and interest payment will pay off the loan in the number of payments stipulated on the note. Mortgage loans are also described by the length of time for repayment, such as 15, 30 or 40 years, and whether the interest rate is fixed or adjustable. A mortgage loan where the downpayment is less than 20% usually requires private mortgage insurance (PMI) or government insurance or guarantee.

Most mortgage loans require monthly payments of principal and interest plus additional payments that are set-aside in escrow accounts to pay property taxes, homeowners (hazard) insurance, and any condominium or homeowner association assessments. Monthly mortgage insurance premiums for loans that have private or government mortgage insurance are generally included as part of the regular monthly principal and interest payment.
Some lenders offer "nontraditional" mortgage loans such as interest-only loans, in which case the borrower pays only the accrued interest and none of the payment is used to reduce the principal balance, or loans where the borrower chooses each month whether to make a minimum payment, pay the accrued interest only, or pay the accrued interest and a portion of the principal.

Home buyers who opt for a nontraditional mortgage should be aware that, depending on the terms of the loan, sudden and significant changes can occur in the monthly payment due to changes in the interest rate and/or payment terms. It is the home buyer's obligation to fully understand the terms of their loan.

Some lenders offer bi-weekly mortgages, which call for 26 payments per year. The details of bi-weekly mortgages can differ, so it's best to ask the lender to outline the details of how these programs work. A word of caution regarding bi-weekly mortgages. A number of companies offer bi-weekly mortgage programs that require the borrower to send their mortgage payment to a party that is not the lender. Borrowers should exercise caution to ensure that these payments will be sent to the lender on a timely basis and that the borrower, not the third party, receives the benefit of making bi-weekly payments.

Homebuyers who can afford the higher monthly payment sometimes prefer a 15-year mortgage to a 30-year mortgage. Interest rates on 15-year mortgages usually are slightly lower than 30-year rates. In addition, a homebuyer financing a home purchase with a 15-year mortgage will repay principal substantially faster and will pay far less total interest over the term of the loan.

Conventional Mortgages
A conventional mortgage is one that is not insured or guaranteed by the government. Conventional loans with a downpayment of less than 20% typically require private mortgage insurance (PMI), which protects the lender if the homeowner defaults on the loan. For more information about conventional loans, please check the Web sites of Fannie Mae and Freddie Mac, the two primary puchasers of conventional loans. Please note that Fannie Mae and Freddie Mac do not lend money to home buyers, rather, these organizations and other investors purchase loans that have been made to home buyers by mortgage lenders.

FHA-Insured Loans
The Federal Housing Administration (FHA), which is a part of the US Department of Housing & Urban Development (HUD), operates several low-downpayment mortgage insurance programs that buyers can use to purchase a home. FHA-insured loans generally require the buyer to make a three percent cash contribution to the downpayment and closing costs. FHA-insured loans are available from most of the same lenders who offer conventional loans.

The maximum FHA-insured loan amount for a one-family home ranges from $200,160 to $362,790 depending on local area median home prices and other factors. The Economic Stimulus Act of 2008, which was signed into law by President Bush on February 13, will temporarily raise FHA loan limits. Under the provisions of this law, FHA limits will range from $271,050 to $729,750 for loans approved through December 31, 2008. These limits will be effective when published by HUD in March. Your lender can provide more details about FHA-insured mortgages and the maximum loan amount in your area, or find information on FHA’s loan limits directly from HUD’s Web site.

VA-Guaranteed Loans
If you are a veteran of military service, reservist, or on active military duty, you may be able to obtain a loan guaranteed by the Department of Veterans Affairs (VA), which requires little or no downpayment. Get more information about the VA Loan Guaranty program.

Rural Housing Service Loans
The Rural Housing Service (RHS), which is a part of the US Department of Agriculture, offers Section 502 Direct and Guaranteed Rural Housing loans to homebuyers located in rural areas. Section 502 Direct loans offer reduced interest rates to lower-income borrowers who qualify, and are arranged directly through local USDA County Agents or through USDA Rural Development state offices.

A limited amount of funding is available for Section 502 Direct loans, so some lenders also offer “Leveraged Loan” programs. Leveraged loans combine a Section 502 Direct loan that carries a low interest rate with a conventional, market-rate loan. The “blended” interest rate on the resulting loan is lower than the current market rate as a result of the combination of the rates on the two loans.

The Section 502 Guaranteed Rural Housing Loans are arranged through participating local lenders and are available to a broader range of borrowers. Click here to find out more about RHS loan programs.

State Housing Finance Agency Loans
State Housing Finance Agencies (HFA) provide loans to first-time homebuyers and veterans of military service who have not previously received a loan through an HFA, often at below-market interest rates. Program availability and eligibility requirements vary from state to state. You should check with your state HFA for programs that are currently available. Find a link to your state’s HFA from the National Council of State Housing Agencies' Web site.

Adjustable Rate Mortgages (ARMs)
With a fixed-rate mortgage, the interest rate stays the same during the life of the loan. But with an ARM, the interest rate changes periodically, usually in relation to a specific index such as a cost of funds rate or the Treasury bill rate. Payments may go up or down accordingly. Adjustable-rate mortgages (ARMs) are characterized by the time frame for adjustment, such as 1 year, or 3, 5, 7, or 10 years. Hybrid ARMs have grown in popularity because they may offer a favorable fixed rate of interest for a time, such as 3, 5, 7, or 10 years, after which the loan becomes a 1-year ARM.

Lenders generally charge lower initial interest rates for ARMs and Hybrid ARMs than for fixed-rate mortgages. This makes the ARM easier on your pocketbook at first than a fixed-rate mortgage for the same amount. It also means that you might qualify for a larger loan because lenders sometimes make this decision on the basis of your current income and the anticipated monthly payments for the few year or two. Moreover, if interest rates remain steady or move lower, your ARM could be less expensive over a long period than a fixed-rate mortgage.
Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It's a trade-off: you get a lower rate with an ARM in exchange for assuming more risk.

Here are some things to consider with an ARM or a Hybrid ARM:

• Is my income likely to increase enough to cover higher mortgage payments if interest rates go up?
  
• How long do I plan to own this home? (If you plan to sell soon, rising interest rates may not present the risk they do if you plan to own the house for a long time.)
  
• Can my payments increase even if interest rates generally do not increase?
  
• What index will be used to adjust the mortgage rate? Ask the lender for a table showing movements in the index over the previous 10 years to see how your mortgage payments would have changed.
  
• How often will the interest rate be adjusted? Every year? Three years? Five years? The longer the adjustment period, the better you will be able to plan your future loan cost.
  What is the initial mortgage interest rate? Does it include a special discount or “teaser?” If so, you could face a large increase in your monthly payments when the interest rate is adjusted for the first time.
  
• What is the margin on the interest rate? The margin is the amount that the lender adds to the index rate to calculate your mortgage rate. For instance, if the index rate is 7 percent and the margin is 2 percent, your overall interest rate would be 9 percent.
  
• What limits or caps have been placed on the adjustments? One of the most important items to discuss with your lender is the maximum amount that your mortgage rate can increase in any single adjustment period and over the life of the loan. Find out the "worst case" situation in the event of a sharp increase in your index rate.
  
• Is the loan convertible? If so, is there a cost to convert? Convertibility allows you to change your ARM to a fixed-rate loan at some designated time in the future.
  Is there a prepayment penalty? If you refinance your loan with a new loan, you may be assessed a fee. .