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A mortgage is a legal document that pledges a property to the lender as a security for payment of a debt.  Essentially, a mortgage is a long-term loan that you have to obtain from a lender (mortgage banker, mortgage broker, wholesale lender) in order to feasibly pay of the property.  The property is basically the collateral for the mortgage that you take out.  If you don’t make payments as agreed in the mortgage contract, the lender can take possession of your home through foreclosure.

Since mortgages are such big loans, consumers pay them off over long periods of time, usually around 15 to 30 years.  Mortgages also represent a hefty investment, so be diligent in your research and selection of a particular mortgage loan.  Be sure that it is well suited for your particular situation.  You can have different kinds of mortgage and depending on the type that you have, your monthly payments may also include a different section for private mortgage insurance or things like government-backed mortgage insurance premium.

Mortgage Payments 

When escrow is used, a monthly mortgage payment is called a PITI payment. That's because each one covers a portion of the following four costs:

- Principal - the loan balance

- Interest - interest owed on that balance

- Taxes (Real estate) - taxes assessed by different government agencies to pay for school construction, fire department service, etc.

- Insurance (Property) - insurance coverage against theft, fire, hurricanes and other disasters

Borrowers can choose to pay their real estate taxes and insurance in lump sums when they come due, rather than in monthly installments to their escrow accounts.  The breakdown of each payment (the amount that goes toward principal, interest, etc.) changes over time because mortgages are based on a repayment formula called amortization.  Amortization is a fancy term meaning the lender spreads the interest you owe on the mortgage over hundreds of payments so that the overall loan is as affordable as possible.

Fixed Rate Mortgages vs. Adjustable Rate Mortgages 

There are many types of mortgage loans. The two basic types of amortized loans are the fixed rate mortgage (FRM) and adjustable rate mortgage (ARM).  In a FRM, the interest rate, and hence monthly payment, remains fixed for the life (or term) of the loan.  In an ARM, the interest rate is fixed for a period of time, after which it will periodically (annually or monthly) adjust up or down to some market index.  Common indices in the US include the Prime Rate, the LIBOR, and the Treasury Index ("T-Bill"). Other indexes like COFI, COSI, and MTA, are also available but are less popular. 

FRM - Interest rates and payments from FRM’s remain constant so there won't be any surprises even if inflation surges out of control and mortgage rates head to 20 percent.  The stability in mortgage payments may make budgeting easier since payments are certain for your financial management.  Also, FRM’s are simple to understand, so they're particularly beneficial for first-time buyers who may not understand more technical details from ARM’s. 

Disadvantages of FRM’s are that you have to be there at the right time to capitalize on low (or falling) interest rates.  To take advantage of low or falling rates, FRM holders have to refinance.  That means a few thousand dollars in closing costs, another trip to the title company's office and several hours spent digging up tax forms, bank statements, etc. 

ARM – Typically features lower rates and payments early on in the loan term.  Because lenders can use the lower payment when qualifying borrowers, borrowers can purchase larger homes than they otherwise could buy.  ARM’s allow borrowers to take advantage of falling rates without refinancing.  Instead of having to pay a whole new set of closing costs and fees, ARM borrowers just sit back and watch their rates fall.  ARM’s can also help borrowers save and invest more money.  For instance, someone who has a payment that's $100 less with an ARM than with a FRM for a couple of years can save that money and earn more off it in a higher-yielding investment.  ARM’s offer a cheap way for borrowers who don't plan on living in one place for very long to buy a house.

Disadvantages of ARM’s are that interest rates and payments can rise significantly over the life of the loan.  It the economy is doing well, the interest rate of ARM’s can rise significantly in a relatively short period of time.  A borrower's initial low rate will adjust to a level higher than the going fixed-rate level in almost every case even if rates in the economy as a whole don't change.  That's because ARMs have initial fixed rates that are set artificially low.  The first interest rate adjustment usually takes a lot of borrowers by surprise!  Since some annual caps don't apply to the initial change someone with an annual cap of 2 percent and a lifetime cap of 6 percent could theoretically see the rate shoot from 6 percent to 12 percent just only one year after closing, if rates in the overall economy skyrocket. 

Another disadvantage of ARM’s is that they may be difficult to understand, particularly for first time buyers.  Lenders have much more flexibility when determining margins, caps, adjustment indexes and other things, so unsophisticated borrowers can easily get confused or trapped by shady mortgage companies.  On certain ARMs, called negative amortization loans, borrowers can end up owing more money than they did at closing. That's because the payments on these loans are set so low (to make the loans even more affordable) they only cover part of the interest due.  Any additional amount due gets rolled into the principal balance.  

Other Types of Mortgages 

Although the majority of buyers will go with the standard fixed-rate or adjustable-rate mortgages, there are other types of mortgages (the mortgage market is much more diverse than some borrowers think) that are available to finance your piece of real estate.

Jumbo mortgage - is considered a nonconforming loan because it exceeds the loan limit set by Fannie Mae and Freddie Mac, the two publicly chartered corporations that buy mortgage loans from lenders, thereby ensuring that mortgage money is available at all times in all locations around the country.  If you require more money in your loan, then a jumbo mortgage could be for you.  You’ll have the opportunity to purchase larger, more expensive properties.  But be warned, you’ll also be paying a higher interest rate in exchange for the lender’s higher risk.

Two-step mortgage - are mortgages that combine elements of fixed and adjustable-rate mortgages.  Typically a two-step mortgage will feature a fixed rate and payment for an initial period, followed by one adjustment, then a fixed rate and payment for the remainder of the loan term.  These mortgages will have names such as 2/28, 5/25 or 7/23.  A 7/23 mortgage, for example, has an initial fixed period of seven years, an adjustment, and then 23 more years of payments following the adjustment.  These mortgages allow borrowers with damaged-credit an opportunity to buy a home and to establish better credit.  However, if your credit does not improve, you could be stuck in a high-rate loan for much longer than two or three years.

Biweekly mortgage - is a fixed-rate mortgage in which payments are made every other week, instead of monthly.  Typically, it is a method used to shorten the life of a 30-year mortgage simply by dividing what would be your monthly payment into two.  That means you will be paying 26 "half-payments" a year (the equivalent of 13 monthly payments), with the 13th monthly payment applied entirely to the principal balance.  By making more payments, you’ll have a dramatic impact on the length of the loan.  For example, a 30-year loan can be paid off in about 23 years through this method.  The only tricky part of changing to a biweekly mortgage is in making sure your lender accepts your payments and correctly credits the extra portion to principal.  Besides cutting your mortgage short, biweekly payments could serve as a good budgeting tool for many people.  Although it is not recommended for people who may encounter financial problems since these payments are made so close together. 

Balloon mortgage – these mortgages give borrowers lower rates and payments for a specific period of time, which usually is anywhere from three years to 10 years.  After this point, the borrower has to pay off the principal balance in a lump sum.  Under certain conditions, the mortgages can be converted to fixed-rate or adjustable-rate loans. Many borrowers either sell their homes before they get to their due dates or end up refinancing their balances into new mortgages.  This is a great mortgage option for buyers who don’t plan on living in the property for long.  A disadvantage to this mortgage option is that the plans are prone to changes.  If it does change, the buyer will have to pay off, or refinance balance, with time, effort and more closing costs.

Assumable mortgage - are relatively rare mortgages. A homeowner with an assumable loan can "hand off" the loan to a buyer instead of paying it off using proceeds from the home sale.  If rates are low and you can get one, by all means do so.  If rates rise, buyers will want to assume your loan (and will be willing to pay more for your house!) because it'll be much cheaper than any loan they could get from a bank or other source.  An advantage of assumable mortgages is that it reduces monthly payments and saves money on closing costs.  A disadvantage of assumable mortgage is that sellers will charge more for their property, so buyers need more cash to cover the difference between asking price and loan balance.

Subprime mortgages – are reserved for individuals with less-than-satisfactory credit, based on their FICO scores.  These mortgage loans have higher interest rates and more onerous terms than conventional loans, but they can help bruised-credit borrowers the chance to reap the benefits of homeownership just like their more creditworthy cousins.  But these people must be prepared for inconsistent terms because interest rates, fees, and underwriting guidelines can vary drastically.