Introduction to mortgages
What is a mortgage?
A mortgage is a secured loan for which real property, such as a home, is used as collateral. With the loan, a house can purchased or built. You can obtain a mortgage loan from a financial institution such as a bank or credit union. A mortgage loan is a long term loan. The amount which is borrowed, also called the principal, must be repaid to the financial institution typically between 15 and 30 years. During this loan term, you make monthly payments, which are called installments. In each installment, a part of the loan amount is repaid, as well as interest charged by the lender. The height of the payments mainly depends on the loan amount, the interest rate and the loan term. You can calculate monthly payments here
If the monthly installments are not paid or you break other terms in the mortgage agreement, the financial institution can foreclose, which means it will take the house and sell it. You might end up with a loss when the selling price is lower than the price the borrower paid. It is not required to keep the home for the mortgage loan term. You can sell the home earlier and use the money the new buyer paid to pay off the loan amount that is left on the mortgage.
The amount of money that can be borrowed from the lender depends on your income and other financial commitments. In general, a mortgage up to 2.5 times the annual salary is considered acceptable. Furthermore, banks look at the property value. They will normally only borrow 80% of the property value without additional costs. This ratio between the loan and the property value is called the loan-to-value (LTV) ratio. The leftover percentage must be covered by a down payment. The down payment is usually made at closing. Here is an example: if someone wants to buy a home of $200,000 and can only borrow 80% of the value (e.g the LTV ratio is 80%), he/she can borrow $160,000. The leftover percentage is 20% which has to be covered by a down payment of 20%, so the down payment is $40,000.
You can also borrow a higher percentage, so that the down payment becomes smaller. The monthly payments will be higher though, because more money is borrowed. Mortgage down payments typically vary between 3.5% and 20% of the purchase price. For down payments smaller than 20%, most lenders do require a Private Mortgage Insurance (PMI). This insurance protects the lender against loss if the borrower defaults. In general, the PMI has to be paid by you until you acquire 20% equity in your home. They typically cost between 0.5% and 1% per year of the loan amount. So for a $200,000 mortgage, the homeowner could be paying up to $2,000 a year, or $166.66 per month when an annual 1% rate is assumed. Note that a PMI can be tax deductible in the US since 2007, depending on the income of the homeowner.