What is a mortgage?

Owning a home is probably the largest financial transaction most people will do in their entire lives. The unfamiliar terms & documents can prove to be a daunting undertaking for a prospective home owner.  In simple terms, a mortgage is a loan that is secured by a piece of real estate that the borrower owns or will own.  This article will make it easier to understand the terms the you’ll hear speaking with realtors, loan officers and accountants that get involved in your mortgage.

The word “secured” means that if a borrower doesn’t pay their mortgage payments, then the bank will have the right to take the real estate. This is what happens in a foreclosure.  Creating a loan requires two primary documents: a promissory note and a mortgage or deed of trust.  The promissory note usually a very short document, only 2-3 pages long and it is your unconditional promise to pay the bank back plus interest in equal monthly installments. A mortgage is a loan secured by the property itself, and the CFPB publishes a plain-English guide to what a mortgage is and how it works.

Because a mortgage is a loan secured by real estate, the bank or lender will typically only give you a percentage of the value of that real estate.  That percentage is call the Loan to value or LTV.  It’s the amount of the loan divided by the value of the real estate.  The lower the LTV the safer the bank feels that they won’t lose money if the borrower doesn’t pay their loan for some reason.  If the loan-to-value is less than 80% the lender feels very comfortable that it’s a safe loan because the borrower has “skin in the game”. 

Using government guaranteed loans we can give borrowers larger loans – up to 97% loan-to-value – because if something goes wrong, the government will step in and prevent investors from taking any kind of loss on the mortgage.

A Mortgage Is a Loan With Four Parts

Each month you’ll make a payment either to the bank or a servicer, someone hired by the bank to take monthly payments on their behalf.  The payment will generally consist of four parts:  Principal, Interest, Taxes and Insurance.  Some loans will also have mortgage insurance.

Principal

If you took out a loan for $150,000, that amount is called the principal.  Each month you’ll pay back a small amount of the principal along with the interest due.  As the years go by, your payment will typically stay constant (unless you have an adjustable rate mortgage or ARM). However, the percentage of your payment that goes to principal vs. interest will change monthly.  It may be easiest to explain this concept by example:  Let’s say that you borrow $1,000.  The first payment is $20 and might be a principal payment of $1 and an interest payment of $19.  In the second month your principal balance is now $999 because you paid $1 in the prior month.  Your payment in month two will still be $20, but, when they compute interest due it’s only 18.75 because of the reduced principal amount, and this month you’ll pay down $1.25 of principal.  This entire process is called amortization and works to pay down you loan principal of the loan over a long period of time – 15-30 years.

Interest

is the fee the bank changes for the use of their money.  Interest rates today are in the 3-4% range, which is an all-time low.  Rates usually run closer to 6%.  If someone has a poor credit score, meaning their credit scores are below a 640, the banks will generally charge a higher interest rate to compensate them for the additional risk they feel they may be taking in giving that person a loan.

Property Taxes

We pay a fee to our local government for providing services such as repairing the roads, providing schools for our children and emergency services like fire, first aid and police protection.  Property taxes cover these services and many more.  Each month you’ll pay approximately 1/12 of the total amount of the taxes due to the bank, who will hold the taxes until they’re due to be paid and then the bank will pay them.  While the timing of the payment varies from state to state and county to county, the government will usually collect the taxes twice a year.

Insurance

Banks don’t like to take unnecessary risks and things like fires and floods or windstorms or falling trees are all unusual events. But they do happen.  To prevent a catastrophic loss, the bank will require that you carry hazard insurance on the property.  They may also ask for flood insurance, earthquake insurance, environmental insurance and title insurance depending on the type of transaction that they’re being asked to do.  Like property taxes, the bank will pay the entire first years insurance premium and then escrow 1/12 of the insurance amount monthly.

Because a mortgage is a loan repaid through scheduled installments, the combination of expenses (Principal, Interest, Taxes and Insurance) is called PITI, and that makes up your entire monthly payment.

One additional form of insurance is Private Mortgage Insurance (PMI).  If the Loan-to-Value on your home is greater than 80%, the bank may request that you carry private mortgage insurance.  People that have lower credit scores, foreclosures or bankruptcies may not qualify for bank financing and we would have to place their loans with FHA.  There is usually an upfront fee (1.75% of the loan amount) that the either HUD or the mortgage insurance companies charge, called UFMIP or Up Front Mortgage Insurance Premium. In short, a mortgage is a loan secured by your home, which is exactly why lenders require these forms of insurance to protect that collateral.