Financial Literacy for Everyone

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If you're going to be responsible for paying a mortgage for the next 30 years, you should know exactly what a mortgage is. A mortgage has three basic parts: a down payment, monthly payments and fees. Since mortgages usually involve a long-term payment plan, it's important to understand how they work.

Understanding Mortgages

A mortgage has three parts: a down payment, monthly payments and fees.

  • The monthly payment is the amount needed to pay off the mortgage over the length of the loan and includes a payment on the principal of the loan as well as interest. There are often property taxes and other fees included in the monthly bill.
  • The fees are various costs you have to pay up front to get the loan.
  • The down payment is the up-front amount you pay to secure a mortgage. The larger your down payment, the better your financing deal will be. You'll get a lower mortgage interest rate, pay fewer fees and gain equity in your home more rapidly.

Have a lot of questions about mortgages? Check out the Consumer Financial Protection Bureau's answers to frequently asked questions.

Types of Mortgages
There are two main types of mortgages: a conventional loan, guaranteed by a private lender or banking institution and a government-backed loan. Within these categories, these less common payment options may also be available:

  • Pledged Asset Mortgages – In a pledged asset mortgage, you can use assets such as stocks, bonds and other property as collateral on your loan. This eliminates the need for a down payment and also avoids the need for PMI (private mortgage insurance) requirements.
  • Mortgage Help Programs – There are programs that will assist you in obtaining and financing a mortgage. Check with your bank, city development office or a knowledgeable real estate agent to find out more.

Most government-backed mortgages come in one of three forms:

  • Veterans Administration (VA) LoansThe U.S. Department of Veterans Affairs offers loan benefits to veterans who served in the armed forces on active duty during times of conflict (as long as they were not discharged dishonorably). The first step to receive a VA loan is to obtain a certificate of eligibility, then submit it with your most recent discharge or separation release papers to a VA eligibility center.
  • Federal Housing Administration (FHA) LoansThe FHA was created to help people obtain affordable housing. FHA loans are actually made by a lending institution, such as a bank, but the federal government insures the loan. This is often the least costly loan that non-veterans can get.
  • U.S. Department of Agriculture (USDA) Loans – Backed by the U.S. Department of Agriculture, USDA loans are for rural property buyers who are without “decent, safe and sanitary housing,” are unable to secure a home loan from traditional sources and have an adjusted income at or below the low-income threshold for the area where they live.

After you choose your loan, you'll decide whether you want a fixed or an adjustable rate. Your choice determines the interest you'll be charged.

Fixed Rate
A fixed rate mortgage requires a monthly payment that is the same amount throughout the term of the loan. When you sign the loan papers, you agree on an interest rate and that rate never changes. This is the best type of loan if interest rates are low when you get a mortgage.

Adjustable Rate
An adjustable rate mortgage allows the interest rate on your loan to vary with prevailing interest rates. If rates go up, so will your mortgage rate and monthly payment. If rates increase a lot, you could be in big trouble. If rates go down, your mortgage rate will drop and so will your monthly payment. It is generally safest to stick with a fixed rate loan to safeguard against rising interest rates. If rates drop, refinance your mortgage to take advantage of lower rates.

Conforming and Nonconforming Loans
The amount of money you borrow affects your interest rate. Home loan sizes fall into two main size categories: conforming and nonconforming. Conforming loans meet the loan limit guidelines set by government-sponsored mortgage associations Fannie Mae and Freddie Mac. Non-conforming loans include those made to borrowers with poor credit, high debt or recent bankruptcies. If you want to stay within conforming loan limits so you get a lower interest rate, you'll need to narrow down your home search to properties priced below the loan limit for your area. If you want a house that's priced above your local limit, you can still qualify for a conforming loan if you have a big enough down payment to bring the loan amount down below the limit.

Mortgage Points
You can reduce the interest rate on your mortgage loan by paying an up-front fee, known as mortgage points, which subsequently reduce your monthly payment. One point equals 1 percent of the cost of your mortgage and purchasing one point typically lowers your interest rate by 0.125 percent. In this way, buying points is said to be “buying down the rate.” Points can also be tax-deductible if the purchase is for your primary residence. If you plan on living in your next home for at least a decade, then points might be a good option for you. Paying points will cost you more than just initially paying a higher interest rate on the loan if you plan to sell the property within only the next few years.

Good-Faith Estimate
Within three days after receiving your loan application, a mortgage provider is required to give you a good-faith estimate (GFE) that outlines all the charges, fees and terms associated with your home loan. Your GFE also includes an estimate of the total you can expect to pay when you close on your home. A GFE helps you compare loan offers from different lenders; it's not a binding contract, so if you decide to decline the loan, you won't have to pay any of the fees listed. If your loan is denied within three days, then you are not guaranteed a GFE, but you do have the right to ask for and receive the specific reasons your loan was denied.

Rate Lock
The interest rate that you are quoted at the time of your mortgage application can change by the time you sign your home loan. If you want to avoid any surprises, you can pay for a rate lock, which commits the lender to giving you the original interest rate. This guarantee of a fixed interest rate on a mortgage is only possible if a loan is closed in a specified time period, typically 30 to 60 days. The longer you keep your rate lock past 60 days, the more it will cost you. Rate locks come in various forms – a percentage of your mortgage amount, a flat one-time fee, or simply an amount figured into your interest rate. You can lock in a rate when you see one you want – when you first apply for the loan or later in the process. While rate locks typically prevent your interest rate from rising, they can also keep it from going down. You can seek out loans that offer a “float down” policy where your rate can fall with the market, but not rise. A rate lock is worthwhile if an unexpected increase in the interest rate will put your mortgage out of reach.

Private Mortgage Insurance
If your down payment on the purchase of a home is less than 20 percent, then a lender may require you to pay for private mortgage insurance, or PMI, because it is accepting a lower amount of up-front money toward the purchase. The PMI protects the lender's liability if you default, allowing them to issue mortgages to someone with lower down payments. The cost of PMI is based on the size of the loan you are applying for, your down payment and your credit score.

For example, if you put down 5 percent to purchase a home, PMI might cover the additional 15 percent. If you stop making payments on your loan, the PMI triggers the policy payout as well as foreclosure proceedings, so that the lender can repossess the home and sell it in an attempt to regain the balance of what is owed.

Once your mortgage principal balance is less than 80 percent of the original appraised value or the current market value of your home, whichever is less, you can generally cancel the PMI. Your PMI can also end if you reach the midpoint of your payoff – for example, if you take out a 30-year loan and you complete 15 years of payments.

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