How Mortgages Work

In legal terms, a mortgage is "the pledging of property to a creditor as security for the payment of a debt" [source: YourDictionary.com]. In plain English, a mortgage is a loan. For many people, it's the biggest loan they will ever borrow. With a regular loan, there's no explicit collateral. The lender looks at your credit history, your income and your savings, and determines if you're a good risk. With a mortgage, the collateral for the loan is the house itself. If you don't pay back the loan (along with all of the fees and interest that are included with it), then the lender can take your house.

Banks are the traditional mortgage lender. You can either apply for a mortgage at the bank you use for your checking and savings accounts, or you can shop around to other banks for the best interest rates and terms. If you don't have the time to shop around yourself, you can work with a mortgage broker, who sifts though different lenders to negotiate the best deal for you. Banks aren't the only source of mortgages, though: Credit unions, some pension funds and various government agencies also offer mortgages.

Like other loans, mortgages carry an interest rate, either fixed or adjustable, and a length or "term" of the loan, anywhere from five to 30 years. Unlike most other loans, mortgages carry a lot of associated costs and fees. Some of those fees only happen once, such as closing costs, while others are tacked onto the mortgage payment every month.

You may think mortgages have been around for hundreds of years -- after all, how could anyone ever afford to pay for a house outright? It was only in the 1930s, however, that mortgages actually got their start. It may surprise you to learn that banks didn't forge ahead with this new idea; insurance companies did. These daring insurance companies did this not in the interest of making money through fees and interest charges, but in the hopes of gaining ownership of properties if borrowers failed to keep up with the payments.

It wasn't until 1934 that modern mortgages came into being. The Federal Housing Administration (FHA) played a critical role. In order to help pull the country out of the Great Depression, the FHA initiated a new type of mortgage aimed at the folks who couldn't get mortgages under the existing programs. At that time, only four in 10 households owned homes. Mortgage loan terms were limited to 50 percent of the property's market value, and the repayment schedule was spread over three to five years and ended with a balloon payment. An 80 percent loan at that time meant your down payment was 80 percent -- not the amount you financed! With loan terms like that, it's no wonder that most Americans were renters.

FHA started a program that lowered the down payment requirements. They set up programs that offered 80 percent loan-to-value (LTV), 90 percent LTV, and higher. This forced commercial banks and lenders to do the same, creating many more opportunities for average Americans to own homes.

The FHA also started the trend of qualifying people for loans based on their actual ability to pay back the loan, rather than the traditional way of simply "knowing someone." The FHA lengthened the loan terms. Rather than the traditional five- to seven-year loans, the FHA offered 15-year loans and eventually stretched that out to the 30-year loans we have today.

Another area that the FHA got involved in was the quality of home construction. Rather than simply financing any home, the FHA set quality standards that homes had to meet in order to qualify for the loan. That was a smart move; they wouldn't want the loan outlasting the building! This started another trend that commercial lenders eventually followed.

Before FHA, traditional mortgages were interest-only payments that ended with a balloon payment that amounted to the entire principal of the loan. That was one reason why foreclosures were so common. FHA established the amortization of loans, which meant that people got to pay an incremental amount of the loan's principal amount with each interest payment, reducing the loan gradually over the loan term until it was completely paid off.

On the next page, we'll break down the components of the modern monthly loan payment and explain the important concept of amortization.

The down payment on a mortgage is the lump sum you pay upfront that reduces the amount of money you have to borrow. You can put as much money down as you want. The traditional amount is 20 percent of the purchasing price, but it's possible to find mortgages that require as little as 3 to 5 percent. The more money you put down, though, the less you have to finance -- and the lower your monthly payment will be.

The monthly mortgage payment is composed of the following costs, appropriately known by the acronym PITI:

With a fixed-rate mortgage, your monthly payment remains roughly the same for the life of the loan. What changes from month to month and year to year is the portion of the mortgage payment that pays down the principal of the loan and the portion that is pure interest. The gradual repayment of both the original loan and the accumulated interest is called amortization.

If you look at the amortization schedule for a typical 30-year mortgage, the borrower pays much more interest than principal in the early years of the loan. For example, a $100,000 loan with a 6 percent interest rate carries a monthly mortgage payment of $599. During the first year of mortgage payments, roughly $500 each month goes to paying off the interest; only $99 chips away at the principal. Not until year 18 does the principal payment exceed the interest.

The advantage of amortization is that you can slowly pay back the interest on the loan, rather than paying one huge balloon payment at the end. The downside of spreading the payments over 30 years is that you end up paying $215,838 for that original $100,000 loan. Also, it takes you longer to build up equity in the home, since you pay back so little principal for so long. Equity is the value of your home minus your remaining principal balance.

But that doesn't mean that fixed-rate, 30-year mortgages are a bad thing. Far from it. We'll look closer at fixed-rate mortgages on the next page.

Not that long ago, there was only one type of mortgage offered by lenders: the 30-year, fixed-rate mortgage. A fixed-rate mortgage offers an interest rate that will never change over the entire life of the loan. Not only does your interest rate never change, but your monthly mortgage payment remains the same for 15, 20 or 30 years, depending on the length of your mortgage. The only numbers that might change are property taxes and any insurance payments included in your monthly bill.

The interest rates tied to fixed-rate mortgages rise and fall with the larger economy. When the economy is growing, interest rates are higher than during a recession. Within those general trends, lenders offer borrowers specific rates based on their credit history and the length of the loan. Here are the benefits of 30, 20 and 15-year terms:

There is a long-term stability to fixed-rate mortgages that many borrowers find attractive-- especially those who plan on staying in their home for a decade or more. Other borrowers are more concerned with getting the lowest interest rate possible. This is part of the attraction of adjustable-rate mortgages, which we'll talk about next.

An adjustable-rate mortgage (ARM) has an interest rate that changes -- usually once a year -- according to changing market conditions. A changing interest rate affects the size of your monthly mortgage payment. ARMs are attractive to borrowers because the initial rate for most is significantly lower than a conventional 30-year fixed-rate mortgage. Even in 2010, with interest rates on the 30-year fixed mortgage at historic lows, the ARM rate is almost a full percentage point lower [source: Haviv]. ARMs also make sense to borrowers who believe they'll be selling their home within a few years.

If you're considering an ARM, one important thing to remember is that intentions don't always equal reality. Many ARM borrowers who intended to sell their homes quickly during the real estate boom were instead stuck with a "reset" mortgage they couldn't afford. Many of them never fully understood the terms of their ARM agreement. Here are the key numbers to look for:

Now let's look at some of the less common mortgage options, like government-sponsored loans, balloon mortgages and reverse mortgages.

Let's start with a risky type of mortgage called a balloon mortgage. A balloon mortgage is a short-term mortgage (five to seven years) that's amortized as if it's a 30-year mortgage. The advantage is that you end up making relatively low monthly payments for five years, but here's the kicker. At the end of those five years, you owe the bank the remaining balance on the principal, which is going to be awfully close to the original loan amount. This "balloon" payment can be a killer. If you can't flip or refinance the home in five years, you're out of luck.

Reverse mortgages actually pay you as long as you live in your home. These loans are designed for homeowners age 62 and older who need an inflow of cash, either as a monthly check or a line of credit. Essentially, these homeowners borrow against the equity in their homes, but they don't have to pay the loan back as long as they don't sell their homes or move. The downside is that the closing costs can be very high, and you still have to pay taxes and mortgage insurance [source: Moore].

Three agencies of the federal government work with lenders to offer discounted rates and loan terms for qualifying borrowers: Federal Housing Administration (FHA), which is part of the U.S. Department of Housing and Urban Development, the Veterans Administration (VA) and the Rural Housing Service (RHS), which is a branch of the U.S. Department of Agriculture.

These agencies don't directly lend money to borrowers. Rather, they insure the loans made by approved mortgage lenders. This includes the refinancing of mortgages that have become unaffordable. Borrowers with bad credit histories might find it easier to secure a loan from an FHA-approved lender, since the lender knows that if the borrower fails to pay back the loan, the government will pick up the bill. FHA loans only require a 3 percent down payment, all of which can come from a family member, employer or charitable organization [source: HUD]. Commercial mortgages wouldn't allow that.

Veterans Administration loans, like FHA loans, are guaranteed by the agency, not lent directly to borrowers.VA-backed loans offer generous terms and relaxed requirements to qualified veterans. Vets can pay no money down as long as the home price doesn't exceed the loan limits for the county.

If you live in a rural area or small town, you may qualify for a low-interest loan through the Rural Housing Service. RHS offers both guaranteed loans through approved lenders and direct loans that are government funded. Theyenable low-income families to get loans for homes.

On the next page, learn all about interest. What do all these percentages mean, anyway?

Probably one of the most confusing things about mortgages and other loans is the calculation of interest. With variations in compounding, terms and other factors, it's hard to compare apples to apples when comparing mortgages. Sometimes it seems like we're comparing apples to grapefruits.

For example, what if you want to compare a 30-year fixed-rate mortgage at 7 percent with one point to a 15-year fixed-rate mortgage at 6 percent with one-and-a-half points? First, you have to remember to also consider the fees and other costs associated with each loan. How can you accurately compare the two? Luckily, there's a way to do that. Lenders are required by the Federal Truth in Lending Act to disclose the effective percentage rate, as well as the total finance charge in dollars.

The annual percentage rate (APR) that you hear so much about allows you to make true comparisons of the actual costs of loans. The APR is the average annual finance charge (which includes fees and other loan costs) divided by the amount borrowed. It is expressed as an annual percentage rate -- hence the name. The APR will be slightly higher than the interest rate the lender is charging because it includes all (or most) of the other fees that the loan carries with it, such as the origination fee, points and PMI premiums.

Here's an example of how the APR works. You see an advertisement offering a 30-year fixed-rate mortgage at 7 percent with one point. You see another advertisement offering a 30-year fixed-rate mortgage at 7 percent with no points. Easy choice, right? Actually, it isn't. Fortunately, the APR considers all of the fine print.

Say you need to borrow $100,000. With either lender, that means that your monthly payment is $665.30. If the point is 1 percent of $100,000 ($1,000), the application fee is $25, the processing fee is $250, and the other closing fees total $750, then the total of those fees ($2,025) is deducted from the actual loan amount of $100,000 ($100,000 - $2,025 = $97,975). This means that $97,975 is the new loan amount used to figure the true cost of the loan. To find the APR, you determine the interest rate that would equate to a monthly payment of $665.30 for a loan of $97,975. In this case, it's really 7.2 percent.

So the second lender is the better deal, right? Not so fast. Keep reading to learn about the relation between APR and origination fees.

The origination fee is how lenders make money up front on your mortgage loan. Origination fees are calculated as a percentage of the total loan, usually between 0.5 and 1 percent on U.S. mortgages [source: Investopedia]. Going back to our APR example, let's say that the second lender charges a 3 percent origination fee, plus an application fee and other costs totaling $3,820 at closing. That brings the new loan amount down to $96,180, which yields an APR of 7.39 percent. So there you have it: Although the second lender advertised no points, it ended up with a higher APR because of its steep origination fee.

The take home message is simple: Don't just look at the interest rate. Ask for the APR and compare it with other lenders. Also, make sure you know which fees are being included in the APR calculation. Typically, these include origination fees, points, buydown fees, prepaid mortgage interest, mortgage insurance premiums, application fees and underwriting costs. But note that some fees are charged by all lenders and are non-negotiable, such as title insurance and appraisals.

Luckily, you don't have to calculate the APR on your own. The lender will give it to you when it gives you the Federal Truth in Lending Disclosure; you just have to understand its importance.

Here are some other things to take into account when you examine the APR:

In order to qualify for a mortgage, most lenders require that you have a debt-to-income ratio of 28/36 (this can vary depending on the down payment and the type of loan you're getting, however). This means that no more than 28 percent of your total monthly income (from all sources and before taxes) can go toward housing, and no more than 36 percent of your monthly income can go toward your total monthly debt (this includes your mortgage payment). The debt they look at includes any longer-term loans like car loans, student loans, credit cards or any other debts that will take a while to pay off.

Here's an example of how the debt-to-income ratio works: Suppose you earn $35,000 per year and are looking at a house that would require a mortgage of $800 per month. According to the 28 percent limit for your housing, you could afford a payment of $816 per month, so the $800 per month this house will cost is fine (27 percent of your gross income). Suppose, however, you also have a $200 monthly car payment and a $115 monthly student loan payment. You have to add those to the $800 mortgage to find out your total debt. These total $1,115, which is roughly 38 percent of your gross income. That makes your housing-to-debt ratio 27/38. Lenders typically use the lesser of the two numbers, in this case the 28 percent $816 limit, but you may have to come up with a bigger down payment or negotiate with the lender.

You also have to think about what you can afford. The lender will tell you what you can afford based on the lower number in the debt-to-income ratio, but that's not taking any of your regular expenses (like food) into account. What if you have an expensive hobby or have plans for something that will require a lot of money in five years? Your lender doesn't know about that, so the $1,400 mortgage it says you qualify for today may not fit your actual budget in five years -- particularly if you don't see your income increasing too much over that period. Take a look at this calculator to see how much house you can afford based on your current income.

In general, it's more difficult to qualify for a mortgage now than it was during the housing boom, when just about any motivated homebuyer could find credit -- even many who couldn't afford to buy a house. In the next section, we'll explain what kind of credit history and income capacity you'll need to pass the lender's background check.

A lender will look at your employment history and credit history as indicators of how likely you are to pay back your loan. Lenders want to see stability, which means they will look closely any late payments during the last two years of your credit history. They will pay particular attention to any rent or mortgage payments that were more than 30 days past due. They'll also look at late payments for credit cards during the last six months.

Stable income is also important. Lenders look for steady employment with a single employer for the past two years (or at least employment in the same field). Other income -- such as earnings from part-time or freelance work, overtime, bonuses or self-employment -- is also acceptable if it has a two-year history. If you don't meet the minimum requirements, that doesn't mean you'll never quality for a mortgage. You may just have to talk to more lenders or settle for a higher interest rate.

The entire credit market has been tight for several years now. Mortgage lenders give the best interest rates to borrowers with high credit scores (760 to 850) who can make a big down payment (10 to 20 percent) [source: Esswein].

Here is a typical list of the documents you need when applying for a mortgage:

A more detailed list can be found here. Your lender and closing attorney will also tell you what paperwork and documents you will need to present at the loan closing. We'll delve into the closing process on the next page.

The total cost of a home mortgage is much more than just the monthly mortgage payments. Once a sales contract is signed, the closing process begins. As part of the closing, the deed and title are transferred to the buyer, title insurance and financing documents are exchanged and copies are delivered to the county recorder. Since the closing is a legal process, it often involves an attorney or at least a third-party escrow holder. All of these processes and professionals cost money, adding up to a surprisingly large sum known as the closing costs.

The amount of money you'll have to pay in closing costs varies a lot by region. If you live in a highly taxed area, for example, your closing costs will be higher. Also, realtors, lenders and attorneys have differing fee scales depending on the markets they work in. Typically, you will pay anywhere from 3 to 6 percent of your total loan amount in closing costs -- that means $3,000 to $6,000 if you get a $100,000 loan.

Of course, you can and should shop around and negotiate the fees. The Real Estate Settlement Procedures Act requires lenders to provide you with a good faith estimate of closing costs within three days of receiving your application. As you can see from the list covering the next few pages, there are a lot of fees that you might be able to convince the lender to lower or drop. You may also be able to negotiate for the seller to pay some of the closing costs.

The fees for services involved in closing a mortgage fall into three categories: the actual cost of getting the loan, the fees involved in transferring ownership of the property and the taxes paid to state and local governments.

On the next three pages, we'll break down each and every fee that can possibly be included in closing on a home purchase.

Here are some of the major fees included closing costs:

If you thought you were done with closing costs, think again:

Can you believe that we still have more closing costs to discuss? You'll find them on the next page.

Yes, there are more:

Now that you've finally closed the sale -- yes, you may actually have to pay for something else. Find out what on the next page.

Private mortgage insurance (PMI) can help you snag the mortgage you want with a down payment of 20 percent or less. This is particularly helpful for younger buyers who haven't had the years to save but want to enjoy the tax benefits and investment aspects of home ownership. PMI is insurance that pays the mortgage in case you can't. It's protection for the lender, who is taking a greater risk with a borrower who has less equity. Lenders have discovered through experience and research that there is a definite correlation between the amount of money a borrower has put into the home and the rate of default on loans. The more equity in the home, the lower the rate of default.

Here is an example of how it works: If a couple has $10,000 in the bank, then they can buy a $50,000 home if they have to pay a 20 percent down payment. If they don't have to pay 20 percent, then that same $10,000 can be a 10 percent down payment on a $100,000 house or a 5 percent down payment on a $200,000 house. If they opt for the more expensive house, however, they have to pay for PMI. The costs for PMI are based on the loan amount. For a $100,000 loan with a 10 percent down payment, the average cost of PMI might be $40 per month.

In 1998, the Homeowners Protection Act established rules for mortgages signed on or after July 29, 1999, that require the automatic termination of PMI after you have reached 22 percent equity in the home, based on the original property value. You can also request that the PMI be dropped when you reach 20 percent if your mortgage was signed after that date. If your mortgage was signed prior to that date, you can request the cancellation of PMI once you've reached the magic 20 percent mark, but your lender isn't required by law to cancel it.

There are certain conditions that may make your loan an exception to this rule -- for example, if you haven't kept your payments current, if your loan is considered high-risk or if you have other liens on the property. Note that there are some states that have laws regarding early termination of PMI for those who signed mortgages before July 29, 1998.

Getting a mortgage is a lot harder than it used to be. Why is that? We'll examine two lenders and what led to the housing crisis on the next page.

Contrary to what you may think, mortgage lenders don't make their money on interest. They cash in your mortgage by selling it on the secondary investment market. If a lender had to wait 30 years to receive full payment on its mortgage loans, it wouldn't have enough liquidity to make loans to other borrowers.

The largest purchasers of mortgages on the secondary market are two government-sponsored enterprises (GSEs): the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). These large public/private entities were created by Congress in order to make mortgages available to more people with low and moderate incomes.

For Freddie and Fannie (as they're commonly known) to purchase a mortgage, it must conform to their loan limits, which for 2010 were $417,000 for a single-family home in a "general" area and up to $1.8 million for high-cost areas like parts of Hawaii [source: Fannie Mae]. After Freddie and Fannie purchase mortgages from lenders, they sell them as securities in the bond market. This provides lenders with the liquidity to fund more mortgages, and until 2006, the mortgage-backed securities (MBS) sold by Freddie and Fannie were considered solid investments. But when hundreds of thousands of people began to default on their mortgages, those securities plummeted in value. Because so many large international investment banks had bet heavily on MBSs, the rising mortgage default rates in the U.S. sent shockwaves throughout the global economy.

In 2008, Fannie and Freddie were taken over by the Federal Housing Finance Agency, (technically, the FHFA became a "conservator" of the struggling mortgage backers) and as of June 2010 had received $145 billion in bailout funds from the U.S. Treasury to inject emergency liquidity into the credit market. Even after the government takeover, Fannie and Freddie were still publically traded companies until their share prices dipped below the minimum price requirements and were dropped from the New York Stock Exchange in 2010 [source: Reuters].

Even with all of their problems, Fannie and Freddie are still the largest purchasers of mortgages on the secondary market and an essential component of the nation's credit system.

On the next page, we'll talk about the "F" word -- foreclosure -- and how the government is helping beleaguered borrowers avoid a credit catastrophe.

Missing mortgage payments could lead to the loss of your property. Foreclosure is the legal process by which a lender takes possession of your home and sells it in order to get its money back.

The U.S. has never seen a foreclosure crisis like the one that began in 2008. In that year alone, lenders filed 2 million foreclosure proceedings and 1 million mortgage borrowers lost their homes [source: Palmeri]. Experts from housing database RealtyTrac say that as many as 4 million households could receive foreclosure notices in 2010 [source: Glink]. Just because you receive a foreclosure notice, however, it doesn't mean you will necessarily lose your home.

The Federal government has instituted a number of refinancing and loan modification programs to help homeowners avoid the credit-crushing experience of foreclosure. At the website MakingHomeAffordable.gov, borrowers can see if they qualify for one of four key programs:

One important thing to remember is that foreclosures are lousy for lenders, too. According to the Mortgage Bankers Association, it costs lenders more than $50,000 per home just to process the claim [source: MBA]. Then the bank has to sell the home, which will likely go for a fraction of the original loan amount.

One last note on foreclosures: In today's mortgage climate, there is no reason to pay for mortgage counseling or loan modification services. In fact, the government warns that many of these services are scams. The Housing and Urban Development office runs the HOPE Hotline (888-995-HOPE), a toll-free number for any struggling homeowner who wants to avoid foreclosure.

If you'd like to stave off foreclosure by saving money on your mortgage, head over to the next page for pointers.

Here are few things to remember that can help you save money on your mortgage:

For more information on mortgages and related topics, please see the links on the next page.