- January 26, 2018
- Posted by: fortunatetrader
- Category: Finance 101
What is a mortgage? – Part 1
Some of you might be familiar with the concept and know what a mortgage is but could you specifically describe how it works and enumerate all the different type of usages?
Probably not and it is totally understandable. It takes a PHD and a 50 000 pages of reading to know every program and type of financing available from institutional financing companies in North America alone.
A mortgage is a debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments. — Investopedia
In other words, someone gives you money in exchange that you back that amount with an asset, commonly a real estate, for a fee, for a period of time.
That “someone” can be an individual or a business.
The “borrower” can be an individual or a business.
The borrower agrees to repay the total of the loan plus a fee, known as interest, otherwise the lender can recall their repayment immediately and if the borrower can’t pay it in total the lender will seize the asset.
I don’t have any stats on the subject but I assume that most first time buyers will need to contract a residential mortgage for the purchase of a new house.
The most common way of committing to a residential mortgage is by pledging the stated house to a financial institution; like a bank.
People know the real sense behind it but more than often use the wording inappropriately. How often have you heard someone say: “I just bought a new house”? Technically, the BANK did.
The home owner gets the privilege to live in the house in exchange for the repayment of the total loan plus a fee. When the loan is repaid and all liens are settled, now the home buyer can say they own the house.
The advantage of this process is that you can live in your dream house and you don’t have to provide the entire amount of the real estate up front.
Here are the major concepts used and some of the unknown benefits.
Mortgages come in many forms. The most common requested by home buyers, is the fixed-rate mortgage also called traditional mortgage.
Some people like it because it charges a set rate of interest that does not change throughout the life of the loan. The total payment remains the same, which makes budgeting easy for homeowners, although the amount of principal and interest paid each time varies from payment to payment.
If an economic decision is made to increase the market interest rates, the borrower’s payment does not change. The opposite is also true, if the market interest rates decrease, the payment stays the same but some borrowers will take the opportunity to refinance and lock their mortgage to a lower interest rate.
Now that we know about the most commonly taken mortgage, the fixed-rate mortgage, you might be wondering if there are other options for you. Some people will prefer to benefit from the market fluctuation. By using fluctuation here, I’m talking mainly about the variation of the institution prime rate.
Mostly two options are available: the adjustable-rate mortgage (ARM) and the variable-rate mortgage (VRM).
With an adjustable-rate mortgage the interest rate is determined at the initial term but can change accordingly to the fluctuations in the prime rate.
In general, the actual interest rate for a mortgage is “prime” minus a discount. Example: 4.00% – 0.80% = 3.20%
If interest rates decrease later, the borrower may be able to pay lower monthly payments. Interest rates could also increase, making it unaffordable. In either case, the monthly payments are incoherent from the initial term but the original amortization schedule of the mortgage remains the same (number of months/years to repay the mortgage).
Variable-rate mortgages operate on the principle that the interest rate will vary over time with the market but the monthly payment amount will always remain the same.
The great thing about it is that when interest rates are lower, more of the payment will go towards paying the principal balance. However, when rates are higher, more of the payment is devoted to the interest.
Your amortization period may adjust and be shorter if rates have fallen or be longer if rates have risen since the beginning of the term.
With both of the adjustable-rate mortgage and the variable-rate mortgage, if you feel that the market interest rate will increase and you can’t tolerate any rising fluctuations, you can switch for a fixed-rate mortgage. Most of the time both rates are lower than the fixed-rate mortgage at start so people preconize the “more affordable” start and convert later.