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Mortgage Basics

A mortgage is a long-term loan acquired from a bank, an independent mortgage broker or the property seller. It is normally used to purchase a home. Due to the large size of the mortgage loan, a borrower will often pay it off over a long period of 15 to 30 years. When purchasing a home you would typically go through the following stages:

• You choose the home you wish to buy.
• You agree with the home seller on the price.
• You contact the mortgage provider for prequalification.
• You apply for the mortgage.
• The lender verifies the information in your application.
• You select suitable mortgage terms such as the loan amount type of mortgage (ARM or FRM) and th loan term.

• The lender or lenders agent inspects the conditions of the house.
• You arrange a homeowner's insurance.

On your moving date:

• You pay the down payment and the closing costs.
• You sign an agreement detailing the terms and conditions of the mortgage.
• You sign an agreement transferring the ownership of the home to you.
• You move into your new home.

• You repay money to the lender at regular intervals, usually monthly or bi-weekly.
• For ARM-type mortgages, rate adjustments may occur which will affect your regular repayments.
• You continue the repayments until the mortgage is completely paid off.

What is in a Payment?

A monthly mortgage repayment is often called a PITI payment. PITI stands for Principal, Interest, Taxes and Insurance. As the name suggests, this payment consists of four parts:

1. Principal: The repayment of some of the original loan amount.
2. Interest: The cost of borrowing the principal.
3. Taxes: RET (Real Estate Taxes) paid to your local government.
4. Insurance: Homeowner's insurance on the home. This item may also include PMI – private mortgage insurance – that protects the lender in case the down payment is too low.

Sometimes borrowers can choose to pay the RET and insurance as periodic lump sums rather than as supplements to their monthly repayments.

What is Amortization?

Amortization is a system of repaying a mortgage loan where the monthly payment remains fixed during the whole loan term. The principle and interest proportions making up these payments gradually change through the term.

The lender cannot expect the borrower to pay the entire sum at once and so the interest is spread over the full term of the loan. During the early years of the loan, most of the payment goes towards interest with a smaller amount paying off the principal. To keep each monthly payment fixed over the loan period a repayment formula is applied so that the principal proportion of the payment gradually increases over time while the interest proportion decreases.

Here is an example:

A 30-year $200,000 mortgage with a fixed rate of 6 percent will require the homeowner to pay a total of $224,347 in interest. At the start of the repayment period $1179 will be paid each month. Only $205 will go toward reducing the principal, while the other $974 will go toward interest on the loan. At the end of the repayment period $1179 will still be paid but $1173 will conclude the principal repayments and only $6 will go toward interest.

Types of Mortgages

Here are the two most frequently used mortgage types:

• Fixed Rate Mortgage (FRM): The interest rate and the loan term are fixed. The monthly payment does not change during the term of the mortgage. This type of mortgage is best if you do not want to risk an increase in your monthly repayments and are planning to stay in your current home for a long period.
  
• Adjustable Rate Mortgage (ARM): The interest rate on your mortgage will alter up or down according to current interest rate levels and so your monthly payments will follow these rate changes. However, the initial rate is considerably lower than that of FRMs. You would prefer an ARM when current interest rates are high or if you are planning to move home in a few years.

To read more on mortgage types, see ARM vs. FRM.

How much money do I need to apply for a mortgage?

On closing day (the day you move into the home), you typically need to have enough money for the down payment and the closing costs. The down payment is usually 5-15% of the loan amount, although this may vary with your personal circumstances. The closing costs can be up to 4% of the loan amount.

How much money will I pay in total?

For a 30-year $200,000 mortgage with a fixed rate of 6 percent, the borrower will be required to repay $200,000 of the principal and $224,347 of interest.

What is Prequalification?

Prequalification is the first step in applying for a mortgage. The lender will analyze your income, debt and credit history in order to determine your maximum loan amount. Prequalification does not impose any obligations on the lender or the borrower. Information submitted during prequalification is verified when you are applying to purchase your selected home.