What Is a Mortgage?
A mortgage, also called a home loan, is a type of financing secured by real estate. “Secured by” means that if the loan is not repaid as agreed (the borrower defaults), the lender can reclaim the property and sell it. This process is called “foreclosure.
How Mortgages Are Used
Most mortgages are taken out in order to purchase the property that secures them. However, mortgages can be used to obtain lump sums of cash or lines of credit, and to build or renovate property. Homeowners can also refinance their current mortgages – to get news loans with more favorable terms. Here are the most common mortgages.
- Purchase money loans – one or more loans that are secured by the property being purchased.
- Home equity loans (aka second mortgages) – mortgages that deliver lump sums of cash and are repaid over a specific term in monthly installments.
- Home Equity Lines of Credit (HELOCs) – revolving lines of credit that can be used and reused up to their credit limits.
- Rate and term refinances – replacing one mortgage with another one in the same amount.
- Cash-out refinance – replacing one mortgage with a larger one; the excess cash is released to the borrower.
- Construction / renovation – Mortgage or refinance used to build or renovate a home.
- Reverse mortgage – type of home equity financing for those 62 and older.
The one thing all mortgages have in common is that if they’re not repaid as agreed, the property backing them can be repossessed by the lender.
There are many kinds of mortgage financing. Here are the main categories of home loans.
Conventional vs Government-backed
Conventional mortgages are offered by private lenders, who assume the risks of default and foreclosure. Conventional mortgage underwriting guidelines are typically stricter than those of government-backed loans for this reason. Borrowers with excellent credit and substantial down payments will usually pay less for a conventional loan than for a government mortgage.
Government-backed loans – FHA, USDA Rural Housing and VA loans – are insured by government agencies, but mostly funded by private lenders. Borrowers (not taxpayers) purchase the insurance, and it covers lenders when borrowers default on their home loans. This insurance allows lenders to approve loans to applicants with smaller down payments, lower incomes, and / or less-than-wonderful credit.
Conforming vs Non-conforming (Jumbo)
Conventional loans are divided into two classes – conforming and non-conforming. Conforming loans get their names because they must conform to guidelines established by Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs) that buy and sell most non-government loans in the US. Conforming loans are easier to sell to investors, increasing the availability of mortgage credit and keeping prices down.
Non-conforming loans are not sold through Fannie Mae or Freddie Mac. Their lenders can create their own guidelines. For instance, conforming loans cannot exceed loan amounts set out by the GSEs, but non-conforming loans called “jumbos” can be as large as their lenders are willing to allow. Non-conforming loans usually cost more than conforming loans.
QM vs Non-QM
The last main category of mortgage programs is the “Qualified Mortgage,” or QM, versus the non-QM home loan. This term did not exist before the Great Recession. The Dodd–Frank Wall Street Reform and Consumer Protection Act created minimum guidelines for mortgages that lenders could adhere to and be protected from lawsuits, loan buybacks, and other losses. Home loans that comply with these conservative guidelines are called QMs.
- Debt-to-income (DTI) ratio cannot exceed 43 percent.
- Loans backed by Fannie Mae, Freddie Mac, FHA, USDA and VA are all QMs regardless of DTI.
- Maximum term is 30 years.
- For most loans, fees and points cannot exceed three percent.
- Negative amortization, interest-only payments, and balloon loans are prohibited.
Note that there is no minimum down payment or credit score for QM loans.
Non-QM loans are not necessarily high-risk or sub-prime. In most cases, these programs require higher down payments when they allow lower credit scores or higher debt-to-income ratios. Non-QM does not mean stated income, because all lenders are required to verify that the borrower has enough income to repay the loan. However, non-QM lenders might allow self-employed applicants to prove their income with bank statements instead of tax returns.
First and Second Mortgages
The term “first mortgage” simply means that its lender is first to be repaid if the property is foreclosed and sold. If a homeowner has a first mortgage and takes on an additional loan, the new lender is in “second position,” and that loan is called a “second mortgage.” The lender in second position would not be fully repaid from a foreclosure sale unless the sale nets enough to repay both loans.
For this reason, second mortgages are riskier to lenders and their interest rates are higher.
Mortgage Rates and Payments
Mortgage interest rates can be fixed for their entire terms (fixed-rate mortgages, or FRMs), or they can change at regular intervals (adjustable rate mortgages, or ARMs). The mortgage payment is determined by the loan balance and the interest rate applied to that balance.
Mortgages are usually paid monthly until their balances are zeroed. Each month, the interest due is subtracted from the payment, and the remainder is applied to the mortgage balance. Over time, the balance gets smaller – each month, less payment is required for interest, and more is applied to reduce the loan balance. This process is called “amortization.”
Rates vs Fees
In general, the lower an interest rate, the higher its loan fees. Borrowers must weigh the tradeoffs and decide how much they are willing to pay for a lower interest rate. For example, as of this writing, one national lender offers 30-year fixed loans at these rates and prices:
- 125 percent, $1,220 per $100k financed
- 250 percent, $430 per $100k financed
- 375 percent, $0 lender fees
When deciding how much to pay for a loan, consider the difference in payments, and note how many months it will take for the savings created by a lower payment to offset the additional cost of the lower rate.
Mortgages for Debt Management
Mortgages can be used to drop the interest rate and payment on higher-interest debt. This can be done with a cash-out refinance or a fixed-rate home equity loan (the HELOC, being open-ended and carrying a variable rate, is less appropriate).
There are several things to remember for successful debt consolidation:
- Debt consolidation dos not reduce debt – you owe the same amount.
- Most debt consolidation plans fail because borrowers don’t address their overspending problems.
- Failed debt consolidation leaves you with more debt and less home equity.
- Consolidation with a mortgage or home equity loan can mean paying more, even at a lower interest rate, if you take 15 or 30 years to repay it.
- You can avoid problems by getting credit counseling from a reputable firm and closing out excess credit lines.
- Paying the consolidation loan off as fast as you can minimizes interest charges.
- Home equity interest may be tax deductible – check with an accountant.
Help with Mortgage Problems
There are many reasons a mortgage can become unaffordable – financial emergencies, budgeting errors, unsuitable loans, or overspending. The best solution for you depends on your resources and the reason you’re in trouble with your home loan. Here are the most widely-used solutions.
Refinancing can reduce your mortgage payment by lowering your interest rate and / or extending your repayment term. Those without sufficient equity for a traditional refinance may qualify for a Streamline Refinance (FHA and USDA), an Interest Rate Reduction Refinance Loan (VA), or HARP loan (Fannie Mae and Freddie Mac – note the program ends 12/31/16).
Your lender may be willing to alter the terms of your mortgage to help you avert foreclosure. Modifications are more likely to be offered if the lender will lose more by foreclosing than by modifying. The Home Affordable Modification Program (HAMP) is a government mortgage modification plan that will end on 12/31/16.
If you have mortgage insurance from a government mortgage or a private insurer, you may be eligible for help. If the cause of your mortgage trouble is temporary and has been resolved, the insurer may advance enough money to bring your loan current and prevent foreclosure.
Forbearance involves skipping one or more mortgage payments -- with your lender’s permission. Normally, you’d have to show that your money problems were temporary, have been resolved, and were beyond your control.
Short sales don’t net enough proceeds to repay the loan against the property. When the loan balance exceeds the value of the property, your lender may accept less than the balance owed as payment in full. You normally need to obtain permission for this before proceeding with the sale.
Deed-in-lieu of foreclosure
Rather than forcing your lender to foreclose, sell your property and evict you, you may be able to simply sign over the property and walk away. Some lenders will even compensate you for doing so.
Filing for bankruptcy protection won’t save your home from foreclosure directly. Mortgages are secured by property, and when you don’t pay the mortgage, you forfeit the property. However, filing for bankruptcy can delay a foreclosure. By discharging your unsecured debts in bankruptcy, you may be free up enough income to afford your mortgage – just reaffirm the loan and make your payments.
Mortgage debt is complicated and highly-specialized, and the amounts at stake are high. Make sure you understand the terms of a loan before committing to it.