How Does a Mortgage Work?

If you’re buying a place, you’re almost certain to need a mortgage. Here’s the lowdown on mortgages.

A mortgage is a loan. In the most basic sense, that’s all it is – it’s a loan that allows someone to buy real estate. Like all loans, mortgages have interest rates. In other words, if you take out a $100,000 loan, you don’t pay back just the $100,000. Instead, you pay back the amount you borrow, plus interest on the amount outstanding.

A mortgage is a loan secured by real property, in this case your condo. If you fail to make your mortgage payments, eventually the lender will foreclose on your loan – which means that the lender will take possession of your condo and sell it to get the money you owe them. If this happens, your credit rating will take a huge hit. Also, if the condo sells for less than the amount you owed on the loan, the difference may end up as “forgiveness of debt” on your next tax return, and may therefore be taxable income.

The interest rate isn’t a one-time fee. A quick thought experiment: say you get a five percent interest rate on a $100,000 loan. Five percent of 100,000 is 5,000, so you’re on the hook for an extra $5,000 to pay back the loan, right? Wrong. With a standard 30-year mortgage, your monthly payment would be roughly $536 and you’d end up paying $193,255 over 30 years, a whopping $93,255 in interest! (You can find mortgage calculators online to figure out your monthly payment for a given mortgage. Use different loan lengths and interest rates and figure out how much interest you’ll end up paying in total.)

How is that possible? The interest is usually stated as an annual rate, but it’s continuously applied. So, to put it in simple terms: after every payment you make, if haven’t paid back the entire loan, the remaining amount still owed continues to accrue interest. Over the course of 30 years, that really adds up.

A shorter loan term saves on interest, but makes monthly payments higher. If you elected a 15-year loan, your monthly payment on that same $100,000 loan at 5% would be about $791 and you’d pay a total of $142,342 over the course of the loan, of which $42,342 would be interest. This is clearly a much better deal if you can handle the payments.

Prevailing interest rates fluctuate with the economy. In the past several years, we’ve had very low mortgage rates. Since 2009, they’ve been around or below 5% for 30-year loans. In contrast, in the early 1980s, the interest rate was as high as 18% for a 30-year loan. To put that in perspective, at 18%, your monthly payment on $100,000 mortgage would have been $1,507 and you’d have paid over $400,000 in interest over the course of the loan!

Many banks and home loan websites publish their current interest rates and there are indexes of the “current” interest rate. So, while different banks offer slightly different rates, they should all hover around the same general number.

The interest rate you get is dependent on your credit rating. If your FICO score is low you’re deemed a higher risk to default, so you’ll have to pay a higher interest rate. A 700 or better FICO score is often the cut-off for best rates. If your score is below that, even by a few points, it can cost you literally thousands of dollars in extra interest. Therefore, only if you have a very good credit score can you expect to get the published rate, which is generally the lowest rate.

The interest rate also changes depending on the size of your down payment (the less you put down, the higher the rate you’ll pay), the length of the loan (the shorter the loan, the better the rate), and the amount of points you pay (see below).

Mortgages can also come with points, which is a fancy term for an upfront fee that reduces your interest rate. Basically, one point is equal to one percent of the loan amount. So if you pay two points on a $100,000 mortgage, you’re paying $2,000 upfront.

What do you get from this? Let’s say your lender offers to lower your interest rate from 5.0% to 4.5% if you pay two points. Over the life of the loan, you’ll pay less. An example: for a $100,000 mortgage, this is equal to a reduction of roughly $30 per month in interest. But, remember, you’re paying $2,000 upfront to have your monthly payment reduced. So, it would take a little over five years of monthly payments to save back the original $2,000 you paid. That said, after that, you’re saving money every month. For this strategy to work, then, you need to be committed to staying in your condo longterm.

The safest mortgage is the fixed-rate mortgage. If you want to know exactly what you’ll be paying every month for thirty years, get the most common mortgage type, the fixed-rate mortgage. This means that the interest rate will be the same for the life of the loan, as will the monthly payments.

There are also adjustable rate mortgages (ARMs), where the interest rate changes after a pre-determined time period, perhaps 3 years (3/1 ARM) or 5 years (5/1 ARM). After the fixed rate period, your new interest rate adjusts to the then prevailing market rate, and is re-assessed every year. This means that if interest rates go up, so does your monthly payment. Typically, ARMs do have both annual interest hike caps (1-2%) and lifetime caps (5-7%), so your risk is not unlimited, but over time this could make your payments hard to manage.

With an ARM, you need to carefully calculate whether you can afford the payments if the rates go up. Let’s say your rate resets (increases) 1% percentage point, from 5% to 6% on you $100,000 loan. Does your monthly payment increase by 1% or $5 to $541? Well, not quite! Your monthly payment jumps about $65 (or 12%) to $600. This is why the mortgage math is so tricky, and why so many people get into trouble with ARMs when the rates rise. With interest rates likely to increase in this economy, you need to be careful before you choose an adjustable rate mortgage.

Regardless, in certain situations ARMs can be advantageous: you get a lower initial rate than if you opted for a fixed rate mortgage. If you know that you’ll be moving within the fixed rate period or soon after, ARMs can save you money.

Author My First Apartment
Alex Starace

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Alex Starace and his wife own a condo in Chicago. Alex enjoys basketball, biking and jazz. His writing also appears regularly in My First Apartment, South Florida Opulence and TriQuarterly.

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