How Mortgages Work

Are you in the market for a new house? That probably puts you in the market for a mortgage, too. See more real estate pictures.

Buying a home is the embodiment of the American dream. However, that wasn’t always the case: In fact, before the 1930s, only four in 10 American families owned their own home. That’s because very few people had enough cash to buy a home in one lump sum. And until the 1930s, there was no such thing as a bank loan specifically designed to purchase a home, something we now know as a mortgage.

In simple terms, a mortgage is a loan in which your house functions as the collateral. The bank or mortgage lender loans you a large chunk of money (typically 80 percent of the price of the home), which you must pay back -- with interest -- over a set period of time. If you fail to pay back the loan, the lender can take your home through a legal process known as foreclosure.


For decades, the only type of mortgage available was a fixed-interest loan repaid over 30 years. It offers the stability of regular -- and relatively low -- monthly payments. In the 1980s came adjustable rate mortgages (ARMs), loans with an even lower initial interest rate that adjusts or “resets” every year for the life of the mortgage. At the peak of the recent housing boom, when lenders were trying to squeeze even unqualified borrowers into a mortgage, they began offering “creative” ARMs with shorter reset periods, tantalizingly low “teaser” rates and no limits on rate increases.

When you couple bad loans with a bad economy, you get rampant foreclosures. Since 2007, more than 250,000 Americans have entered foreclosure proceedings every month [source: Levy]. Now those foreclosures are turning into full-on repossessions, which are expected to reach 1 million homes in 2010 [source: Veiga].

Looking back at the flood of foreclosures since the housing crash, it’s clear that many borrowers didn't fully understand the terms of the mortgages they signed. According to one study, 35 percent of ARM borrowers did not know if there was a cap on how much their interest rate could rise [source: Pence]. This is why it’s essential to understand the terms of your mortgage, particularly the pitfalls of “nontraditional” loans.

In this article, we'll look at each of the many different types of mortgages, explain all of those confusing terms like escrow and amortization, and break down the hidden costs, taxes and fees that can add up each month. We’ll start with the most basic question: What is a mortgage?


What Are Mortgages?

In legal terms, a mortgage is "the pledging of property to a creditor as security for the payment of a debt" [source:]. 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.

History of Mortgages

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 Mortgage Payment

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:


  • Principal - The total amount of money you are borrowing from the lender (after your down payment)
  • Interest - The money the lender charges you for the loan. It's a percentage of the total amount of money you're borrowing.
  • Taxes - Money to pay your property taxes is often put into an escrow account, a third-party entity that holds accumulated property taxes until they're due.
  • Insurance - Most mortgages require the purchase of hazard insurance to protect against losses from fire, storms, theft, floods and other potential catastrophes. If you own less than 20 percent of the equity in your home, you may also have to buy private mortgage insurance, which we'll talk more about later.

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.


Fixed-rate Mortgages

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:


  • 30-year fixed-rate -- Since this is the longest loan, you'll end up paying the most in interest. While that might not seem like a good thing, it also allows you to deduct the most in interest payments from your taxes. This long-term loan also locks in the lowest monthly payments.
  • 20-year fixed-rate -- These are harder to find, but the shorter term will allow you to build up more equity in your home sooner. And since you'll be making larger monthly payments, the interest rate is generally lower than a 30-year fixed mortgage.
  • 15-year fixed-rate -- This loan term has the same benefits as the 20-year term (quicker payoff, higher equity and lower interest rate), but you'll have an even higher monthly payment.

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.


Adjustable-rate Mortgages

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:


  • How often your interest rate adjusts -- A conventional ARM adjusts every year, but there are also six-month ARMs, one-year ARMs, two-year ARMs and so on. A popular "hybrid" ARM is the 5/1 year ARM, which carries a fixed rate for five years, then adjusts annually for the life of the loan. A 3/3 year ARM has a fixed rate for the first three years, then adjusts every three years.
  • There will also be caps, or limits, to how high your interest rate can go over the life of the loan and how much it may change with each adjustment. Interim or periodic caps dictate how much the interest rate may rise with each adjustment and lifetime caps specify how high the rate can go over the life of the loan. Never sign up for an ARM without any caps!
  • The interest rates for ARMs can be tied to one-year U.S. Treasury bills, certificates of deposit (CDs), the London Inter-Bank Offer Rate (LIBOR) or other indexes. When mortgage lenders come up with their ARM rates, they look at the index and add a margin of two to four percentage points. Being tied to these index rates means that when those rates go up, your interest goes up with it. The catch? If interest rates go down, the rate on your ARMs may not [source: Federal Reserve]. In other words, read the fine print.

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


Other Types of 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?


Understanding APR

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

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:

  • The more you borrow, the less impact all of those fees will have on the APR, since the APR is calculated based on the total loan amount.
  • The length of time you're actually in the home before you sell or refinance directly influences the effective interest rate you ultimately get. For example, if you move or refinance after three years instead of 30, after having paid two points at the loan closing, your effective interest rate for the loan is much higher than if you stay for the full loan term.


Qualifying for a Loan

Are you in the market for a new house? That probably puts you in the market for a mortgage, too -- along with dozens of terms, hours of paperwork and decades of payments. Learn how to make the most of your money.

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.


Mortgage Application

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:

  • Money for the closing costs
  • Completed sales contract signed by buyers and sellers
  • Social Security numbers of all applicants
  • Complete address for the past two years (including complete name and address of landlords for past 24 months)
  • Names, addresses and all income earned from all employers for past 24 months
  • W-2 forms for the two years prior to your loan application
  • Most recent pay stub showing year-to-date earnings
  • Names, addresses, account numbers, monthly payments and current balances for all loans and charge accounts
  • Names, addresses, account numbers and balances for all deposit accounts, such as checking accounts, savings accounts, stocks and bonds
  • The last three statements for deposit accounts, stocks and bonds
  • If you choose to include income from child support and/or alimony, bring copies of court records of cancelled checks showing receipt of payment.

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.

What Are Closing Costs?

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.

List of Closing Costs, Part I

Here are some of the major fees included closing costs:

  • Processing fee --This is what the lender charges to cover initial loan processing costs. It includes the application and credit report access fees. These charges are usually around $400 to $550. Something to watch for when comparing lenders: Sometimes the credit report fee will be listed separately from the processing fee.
  • Appraisal fee -- Because the lender wants to make sure the property is worth what you are paying for it, it requires an appraisal. An appraisal compares the value of the property to similar properties in the same neighborhood. These services are performed by independent appraisers and usually cost around $250 or more depending on the price of the property.
  • Origination fee -- In addition to the application or processing fee, the lender may also charge an origination fee. This covers the additional work the lender has to do when preparing your mortgage. The charge may be a flat fee or a percentage of the mortgage. If the fee is a percentage of the loan, then it is typically considered a "discount point" in disguise. This changes the tax implications and your costs, so be sure to ask the lender about this fee.
  • Discount points -- Buying discount points means that you're buying "down" the interest rate you'll be paying. One discount point equals 1 percent of the loan amount. These points are paid either when the loan is approved or at closing. Buying points can save a lot of money in interest payments over the life of the loan, so investigate it when you're shopping around. Some lenders will let you add the cost of the points to your mortgage, or you may have the option of paying for them up front. You can also deduct those points from your federal income tax. For more information about what is tax deductible, click here.
  • Document preparation fee -- This charge may be included in the application or attorney's fee. It pays for the preparation of the mound of documents that have to be prepared and is usually a flat rate, but can also be charged as a percentage of the loan amount -- usually less than 1 percent.

List of Closing Costs, Part II

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

  • Attorney fees -- Both you and your lender will incur attorney fees. This charge ensures that your lawyer draws up the necessary documents and sets everything up properly for the closing. Your own closing attorney will represent your interests and may be present at, or may facilitate, the closing itself. The closing attorney collects all fees, transfers the deed to the buyer, pays outstanding taxes and utility bills, pays himself and all other closing costs and gives all remaining money to the seller. The attorney fees may range from $500 to $1,000 or more, depending on the purchase price of the property and the complexity of the sale.
  • Home and pest inspections -- Your lender will probably require that the home be inspected to make sure it's both structurally sound and free of termites and other destructive insects. You may also have to have the water tested if the property uses a well rather than city tap water. In some areas, the water test means checking only the quantity of water available to the house, rather than the quality. If this is the case, you may want to have your own water quality test done.
  • Homeowner's and hazard insurance -- You'll have to have these policies in place (and the first year's premium prepaid) at the time of the closing in most states. This insurance protects your (and the lender's) investment if the house is destroyed.
  • Private mortgage insurance (PMI) -- If your down payment is less than 20 percent of the value of the house, you may be required to purchase mortgage insurance. This protects the lender in case you fail to make your mortgage payments. Premiums will usually be a part of your monthly mortgage payment and will be transferred into the same escrow account your taxes and homeowner's insurance fees are paid into. You have to pay these PMI premiums until you reach the 20 or 25 percent requirement -- or, they can go on for the life of the loan. (See the next section for more details on PMI.)
  • Surveys -- Many lenders will require that the land be independently surveyed. This is just to ensure that there haven't been any changes, like new structures or encroachments on the property, since the last survey. These usually run $250 to $500.

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

List of Closing Costs, Part III

Yes, there are more:

  • Prepaid interest -- Although your first payment won't be due for six to eight weeks, the interest starts accruing the day you close the sale. The lender calculates the interest due for that fraction of a month before your first official mortgage payment. It's a good strategy to plan your closing for the end of the month to reduce the amount of prepaid interest you'll owe.
  • Deed recording fees -- These fees, usually around $50, pay the county clerk to record the deed and mortgage and change the billing information for property taxes.
  • Title search fees -- A title search ensures that the person saying he or she owns the property is the legitimate owner. A title company closely examines public records such as deeds, records of death, court judgments, liens, contests over wills and other documents that could affect ownership rights. This is an important step in closing your loan because it assures that there are no outside claims against the property. The fees charged for title searches, usually between $300 and $600, are based on a percentage of the property cost.
  • Title insurance -- If the title company misses something during the title search, you'll be glad you have title insurance. Title insurance protects you from having to pay the mortgage on a property you no longer legally own. Lenders require title insurance to protect their investment, but you may also want to get your own policy. Title insurance has only a onetime fee that covers your property for the entire length of time you or your heirs own it (usually 0.2 to 0.5 percent of the loan amount for lender's title insurance, and 0.3 to 0.6 percent for owner's title insurance). It's also one of the least expensive types of insurance. If the previous owner of the property owned it for only a few years, you may be able to get title insurance at a "re-issue" rate, which is usually lower than the regular rate.
  • Closing Taxes -- Depending on the state you live in, you will have to pay anywhere from three to eight (or more) months' taxes at the closing, or place the money in an escrow account for later payments throughout the year. These include prorated school taxes, municipal taxes and any other required taxes. In some cases, you may be able to split these taxes with the seller based on when they are due. For example, you would only pay taxes for the months following the closing date up until the date the taxes had to be paid. The seller would have to pay for the months up until the closing date.

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

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.

Fannie Mae and Freddie Mac

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.

What Is Foreclosure?

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, borrowers can see if they qualify for one of four key programs:

  • Home Affordable Refinancing -- This program makes it possible for homeowners whose properties are rapidly losing value to refinance their mortgage at a lower rate. This program is for borrowers who have remained current on mortgage payments until now.
  • Home Affordable Modification -- If your monthly mortgage payments surpass 31 percent of your monthly gross income and you've experienced significant hardship (loss of job, medical bills), the government can help negotiate an affordable new rate and payment plan with your lender.
  • Second Lien Modification Program -- Many Americans not only have first mortgages they can't afford, but second mortgages as well. Under this program, the government offers incentives to lenders to allow qualifying borrowers to have their second liens forgiven or interest rates lowered to 1 percent.
  • Home Affordable Foreclosure Alternatives -- If a borrower doesn't qualify for refinancing or loan modification, there is still a way to avoid the credit stain of foreclosure. The government will work with lenders to encourage a short sale (the home is sold for a loss, but at least the mortgage lender gets the proceeds) or something called a deed in lieu of foreclosure, in which the borrower voluntarily transfers the deed to the lender, but doesn't owe the remainder of the mortgage payments. In both cases, the government will supply the borrower with up to $3,000 to cover relocation expenses [source:].

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.

Ways to Save Money

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

  • Negotiate -- The credit market is tight, but you can still negotiate for better rates or fee waivers (particularly document preparation fees or the lender's attorney fees). Everything other than the "real" costs of the loan -- appraisal, title fees, processing fee, private mortgage insurance, credit report fees and inspection fees -- is up for negotiation, especially if you have a good credit score.
  • Choose the right type of mortgage -- This can get tricky. It's true that a 30-year fixed-rate mortgage will result in the largest total mortgage payment over the life of the loan. But there's a reason that the 30-year fixed was the preferred mortgage for decades and decades: it is stable and secure. Before you sign up for an adjustable rate mortgage or hybrid fixed/adjustable plan like a 5/1 ARM, run the numbers carefully. Can you really afford the monthly payments when the rate resets in a year or five years. Factor in the possibility that you won't be making more money then than you are now. If the mortgage crisis has taught us anything, it's that a lower interest rate doesn't equal a better mortgage.
  • Make extra payments -- Extra payments go directly toward the loan's principal. This means that the actual principal of the loan is knocked down by that extra amount you pay, rather than having the bulk of your mortgage payments paying interest. In fact, you can reduce your mortgage by almost 10 years simply by making one additional mortgage payment each year. Try out this calculator to see how much money extra payments can save.
  • Biweekly payments - Just as making an extra payment will shorten the life of your loan, so will shifting your payment schedule to biweekly as opposed to monthly. What this schedule does is build in an extra payment each year without it "feeling" like an extra payment. Your mortgage payment can simply follow your paycheck schedule -- if you get paid every two weeks, that is. With biweekly payments, a 30-year fixed mortgage will be paid off in about 23-and-a-half years.
  • Avoid PMI - Try to put in at least the minimum 20 percent down payment so you can avoid paying private mortgage insurance. If you're already paying PMI, make sure you watch your equity and drop the PMI once you hit 20 percent.
  • Make sure paying points will save you money -- In some cases, paying points can save you money, but not always. Quicken has a points calculator that shows you how points will impact your interest rate and monthly payment. Make sure that what you pay will be recouped within the time you plan to spend in the home.

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

How Mortgages Work FAQ

What is a mortgage?
A mortgage is a loan in which your house is the collateral. The lender loans you a large amount of money to pay for the purchase of a home (minus your down payment), that you must pay back, with interest, over a set period of time.
How do you calculate monthly mortgage payments?
The larger your down payment, the lower your monthly mortgage payment will be. The easiest way to calculate this is use an online tool, such as Bankrate's Mortgage Calculator. If you are already working with a mortgage broker, they can also let you know how different unique factors will influence your monthly payment.
How is interest calculated on a mortgage?
Interest is a percentage of the amount of money borrowed that is generally calculated monthly. The lender takes the outstanding loan amount at the end of each month and multiplies it by your agreed upon interest rate, then divides that amount by 12 to get your monthly payment.
How do you know how much mortgage you'll qualify for?
The easiest way to determine this is to contact a broker and get pre-approved for a mortgage. They'll use indicators such as your debt-to-income-ratio, credit score, and down payment to determine exactly what size of mortgage you qualify for. There are several online estimators, though, that you can use beforehand, including one from
What is a good interest rate for a mortgage?
Interest rates change over time, but are currently at historic lows. The rate you get will depend on several variables, including your credit score, but 30-year fixed rate mortgages are available with interest rates around 3 percent and are expected to stay there through 2021, according to