Let’s start with the ultra basic: “What is a mortgage?”
You’ve undoubtedly heard the word “mortgage” thrown around a million times.
A mortgage can be referred to in a variety of different ways, with the most common being a “home loan.” Some may refer to a mortgage as a “lien”, which is the amount of money a borrower owes on a property. Whatever is left over from the original loan amount is referred to as the existing lien.
Others might refer to the mortgage as a trust deed, or deed of trust, which is a legal document that outlines the terms of the agreement.
Regardless of the many terms and variations, a mortgage is essentially an agreement between a bank and a borrower to lend money in exchange for a piece of property.
Bank/Mortgage Lender —> Mortgage —> Borrower/Homeowner
A bank, otherwise known as a mortgage lender, will loan you a specific amount of money that will need to be repaid in “X” amount of years at “X” interest rate. Assuming you qualify for a mortgage, the bank will grant you a loan and you will go into contract with that bank and begin making regular monthly payments until your mortgage is paid in full.
The property acts as collateral in exchange for the mortgage. So if you don’t make your mortgage payments on time and pay off your loan in full, the issuing bank has the right to take your home. This is known as foreclosure.
There are four main types of mortgage transactions:
- Purchase Money Mortgage
- Rate and Term Refinance
- Cash-out Refinance
- Home Equity Line of Credit
While you’re here, you may also want to learn more about how refinancing works.
Most Mortgages Have 30-Year Terms
Most mortgages are due in full in 30-years and also based on a 30-year amortization. That is, the total loan amount, or lien(s) will need to be paid off in 30 years, or in 360 months.
Amortization refers to how the mortgage is paid off. It is essentially the way your mortgage payments are distributed on a monthly basis, detailing how much interest and principal will be paid off each month for the duration of the mortgage term.
If it’s a 30-year fixed mortgage with 30-year amortization, the mortgage is paid off in equal amounts every month until the mortgage balance is zero. At that point, you would have full ownership in the associated property. The value of the property would also be the amount of home equity you have available to tap into, either via sale, refinance, or home equity line of credit.
Also note that there are other less common loan terms such as 15 year, 20 year, and even 50 year loan programs. But for the sake of simplicity, let’s focus on the 30-year amortization type.
Plenty of Mortgage Options
When searching for a loan program, you will be presented with a variety of options from a six-month product to a 30 year fixed product. Both are based on 30-year amortization, but they differ greatly in rate. The 30 year fixed product is pretty clear.
It’s simply a fixed rate for the entire 30 years of the loan. It never changes, and the rate you pay the first month is also the rate you will pay the last month, or the 360th month to be exact. Learn more about fixed-rate mortgages.
The six-month product is a bit more complicated. For the first six months, the interest rate will not change. But after those initial six months, the rate will become variable (adjustable), though still based on a 30-year amortization. The loan program will be tied to a mortgage index, such as the LIBOR (London Interbank Offered Rate) and will also contain a margin agreed upon by the bank or lender.
When you combine the two, you will find your monthly rate. The margin doesn’t adjust, but the index will do so on a daily basis, which will affect the rate you pay monthly.
[Which mortgage is right for me?]
Mortgage Caps
The only saving grace to this type of program are the caps, which limit the amount a mortgage rate can change. They tend in come in three types:
Initial: The amount the rate can change at the time of the first variable period. In this case, after the first six months.
Periodic: The amount the rate can change during each period, which in this case is every six months.
Lifetime: The amount the rate can change during the life of loan. So throughout the full 30 years, it can’t exceed this amount.
The caps at the company I used to work for were 6/2/6, meaning after the first six months is up, the rate you initially paid can move up or down 6%, although the rate will never go to 0%, and will likely have a floor rate, which is either the original start rate, or something determined by the lender such as 2% below the original start rate.
Then each six months, it can go up or down 2%, and throughout the life of the loan it can go up 6% TOTAL from where it initially started. So if you’re start rate was 6%, after six months it could rise to 12%, which is also the life cap, so it couldn’t go beyond that, but it could potentially drop 2% to 10% after another six months. Yes, the caps work both ways, in case rates happen to improve. Learn more about adjustable-rate mortgages.
If you’re looking for quick definitions to other mortgage-related terms, check out my mortgage glossary.
