Today, we will talk about mortgages. Since buying a home is the biggest purchase most of Americans do in their life, I think we can spend a few minutes to get a good grasp of what mortgages are. Even if it is not your first purchase or you want to invest in real estate to be a landlord, you should learn a thing or two by reading this post.
Before we start, I am not a lender, nor an attorney, nor a CPA. Everything I say is my opinion, and you should seek the advice of a professional before acting on anything. Please keep in mind that investing in real estate is for most you guys the most significant purchase of your life. So do talk to an attorney, a lender, or a CPA about your unique goals and circumstances. You will get advice tailored to your unique situation.
First of all, who give a mortgage? Does a lender give you a mortgage? Or do you provide a mortgage to your lender? Can you guess?
You may be surprised, but you give the mortgage to your lender! Yes, you are the mortgagor; the “or” suffix means giving, and the lender is the mortgagee, the “ee” suffix means receiving.
How is it possible? What we usually call a mortgage is, in fact, two separate instruments. A note, which is the debt you contract and it defines how you will repay it, and the mortgage which is a hypothecation instrument. “Hypothecation” means you pledge collateral to secure a debt, here it will be the house you buy as collateral, to secure the note. So to borrow money to buy a house you sign two different documents. Usually, we call both of them, together, a mortgage. And later, in this post, I will call both of the two instruments, together, a mortgage, so do not be confused.
When you buy a house, you will see the two documents to sign, and you will say, “aha, I know why they ask me for two signatures.” If you have already a mortgage, look in your papers, and you will see: you have two different instruments: the note, which is the debt, and the mortgage were you promise to give your property to the lender in case you default on a term of the contract.
Now you understand what is what we usually call a mortgage. What kind of mortgage can you get?
The majority of you will get a fully amortized loan. What is an amortized loan? An amortized loan means you pay it off gradually by periodic payments of principal, the money you owe, and interest (the rent you pay on that money). And fully amortized means that at the end, you will owe nothing, all the borrowed money would have been paid off.
So you see, if you have a monthly mortgage of $1,000, and say the split between interest and principal repayment is $700 and $300, the cost for you each month is the interest part, $700. The principal repayment is like saving money. Your net worth increases by $300. It is something to keep in mind when you compare the cost of buying to renting. With a mortgage, you are required each month to save money, which in my opinion is great.
Fun fact, the term amortization literally means “kill it off.” Amortize comes from Vulgar Latin “admortire,” meaning “to kill.” You kill your debt each month, slowly but surely.
So we talked about fully amortized loans. Some mortgages are not fully amortized. They can be partially amortized, or not amortized at all. You pay the interest and only a part of the principal required to fully amortize the loan, or only the interest. What does it mean? It means that at the end of the loan period, you have to pay a large lump sum to pay off your debt. It is called a balloon payment. Even if those kinds of loans may be useful because they lower the monthly payment, as an ordinary individual, you should avoid them, unless you know what you are doing.
In 2008, a lot of people were caught by a balloon payment due but not able to pay it, nor refinance it. So borrower beware!
You may encounter that kind of loans, especially for home improvement and second mortgages. They are not common in residential first mortgage loans. You may see the name “straight loan” or “straight term loan” when you pay only the interest, and you pay the principal at the end of the loan term. It is also called a “straight payment plan.” So if you see “straight,” it means interest-only plus a big balloon payment in the end.
The other significant feature you should be aware of is the kind of interest rate. Is it fixed, or is it floating?
As a rule of thumb, you should favor the fixed-interest rate even if it is slightly more expensive than the adjustable-rate mortgage.
Why is it more expensive? Because the lender has to cover himself against an adverse move in interest rates, and naturally, it has a cost for him. Since your lender does not run a charity, you have to compensate him by a slightly higher interest rate at inception. As a borrower, I happily take that deal. And you should too, especially if you take a mortgage to buy an investment property because no matter what, you know how much you have to pay for that loan for the next 20 or 30 years. It is also true if it is your home and not a rental you are buying. You take enough risk when you buy a property, so why increase it by insuring your lender against an interest rate that could hurt him?
As I said in my previous post, “Leverage Demystified” (and my video “Leverage demystified!” on my YouTube’s channel), you and I, we don’t know where interest rates will be in 5 or 10 years. And you know guys, banks buy and sell everyday futures on treasury notes, T-Bills, and T-Bonds. They have access to financial instruments you can’t dream of, like forward-rate agreements with other banks, swaps, swaptions, and a lot of other exotic stuff. Never forget that banks are very sophisticated players that can protect themselves against an adverse move in interest rates. You can’t. I do believe it is not our place, as ordinary people and ordinary investors, to take that kind of risks.
Keep in mind that in 2008, a lot of people got caught in the nightmare of adjustable-rate mortgages even if the Federal Reserve cut the interest rates after the banking sector meltdown in the most significant financial collapse since 1929.
Before I talk more about adjustable-rate mortgages, do you know there is a way to pay off faster your mortgage? Yes, with a biweekly mortgage payment.
Let’s say you have a monthly mortgage of $1,000. Instead of paying $1,000 once a month, you may elect to pay $500 every two weeks if your mortgage lender offers this payment option. Do you see how it will speed up your mortgage repayment? If you guessed that biweekly is not the same as twice a month, you were right! A year has 52 weeks, hence 26 biweekly payments. You pay the equivalent of thirteen monthly payments (26 divided by 2 is 13) instead of twelve. The trick works because you are paying more. You could achieve the same by deciding to prepay your mortgage once a year by a full monthly payment. Overall, depending on the interest rates, you could pay off your mortgage in 25 or 26 years, instead of 30.
By the way, if your mortgage lender does not offer the biweekly payment option, and you wish to do that anyway, some third-party services may allow you to do that. If you choose to follow that path, especially if you have been contacted by one of those company claiming you will save a lot of money by using their services, be very careful. Try to understand what are the costs; it may be very costly. So be cautious!
Finally, let’s come back to the adjustable-rate mortgage. You know I do not like those kinds of loans, and if you consider one, be careful. They have a lot of traps.
An ARM shifts the risks of interest rates going up to you guys.
It may start with a low teaser rate. It is an artificially low interest rate for a short period, for example, the first year, or the first adjustment period which may be longer than a year. Why is it artificially low? To entice you to choose it, instead of a safe fixed-rate mortgage. Some borrowers, with meager payment capabilities, may find that loans the only ones available. The loan will be approved based on this first, artificially low, monthly payment. I let you imagine what will happen when the regular interest rate kicks in, increasing the payments sharply. It is, in essence, a predictable financial disaster.
So in an adjustable-rate mortgage, the interest rate and by consequence, monthly payments can go up and down. They do not change every month. Instead adjustments are made at predetermined dates. Adjustment periods are usually one year, though they can be shorter or longer, like three, five, or even ten years.
To know by how much your monthly payment will change, your lender will look at the value of an index. Your loan agreement specifies the index to use; it is a benchmark that shows the level of the current interest rates. Once the index value is known, your lender adds a margin to it, for example, 2%. So the index is floating, the margin is constant during the life of your adjustable-rate mortgage. And you have now your new monthly payment, or not.
If you find it complicated, sadly we are not done yet.
We have to talk about the cap, the ceiling, and the floor.
You see, mortgages’ interest rate given by the index plus margin can be very different from the previous interest rate charged. You can have a considerable change in your monthly payment. To mitigate that risk your loan agreement may set up a cap on the size of the adjustment, for example, 2%. Even if the change required by the benchmark is a 3% increase, your lender will only apply 2% as required by the cap. Do you think when that happens the cap shielded you from the difference between 3% and 2%? Do you escape 1% of the interest rate increase?
Not so fast! You may have escaped 1% of the interest rate rise. Some loan agreements provide that the lender absorbs the difference between the calculated change and the cap. However, it is not always the case. Your lender may be allowed to apply the 1% in the following adjustment period, even if the benchmark did not change. Or worse, the unpaid 1% interest rate is considered as a shortfall, and added to your principal, extending the term of your loan. Even worst, you may end up in negative amortization. The shortfall is larger than the principal you pay back every month, and instead of killing your mortgage slowly, you have a bigger and bigger debt each month.
Finally, the ceiling is the maximum interest rate you can pay during the loan. It is also known as a lifetime cap. No matter what, you will never be charged a higher interest rate. It protects you from a dramatic increase in interest rates. On the flip side, a floor, if you have one, is the minimum interest rate you will be charged, even if the benchmark plus margin are lower. The floor protects the lender.
How do you like adjustable-rate mortgages now?
Now, one advantage of adjustable-rate mortgages is if the benchmark interest rate fall, you may end up paying less than the fixed-rate mortgage, which stays fixed. Some ARMs allow you, for a fee, to convert them to a fixed-rate mortgage. It may be done at some predetermined points in time, or for others ARMs at any time. You may choose a favorable moment to do that. I do not believe that convertibility is a strong argument in favor of adjustable-rate mortgages. Why? If the interest rates fall, you may also refinance your fixed-rate mortgage. It costs too, but you never had the risk of rising interest rates in the first place.
I do believe that the winner between adjustable-rate mortgages and fixed-rate mortgages is the fixed-rate mortgage due to its inherent security and you can always refinance it if the interest rates are lower, locking the lower interest rate.
This concludes the first part of this mortgage primer. There is a lot of information, but I hope it is useful for you, and it helps you to get a good grasp of the different aspects of mortgages. Do not hesitate to ask questions in the comments below. The comments are also a great place to tell me what do you think!
In the second part, I will talk about rate locks, the points, and both the front-end and back-end ratios.
As always, to have more details about mortgages and to get specific information about your situation, talk to a lender.