When most people hear the word ‘mortgage’ they immediately think ‘house,’ and they know a mortgage is a loan used to by a house and…well, after that things get a little vague. Few people understand the anatomy of a mortgage: the process, the components, and how it all fits together. On this week’s show, we looked at the details of a mortgage, got down to brass tacks, and hopefully helped illuminate a concept that everyone knows but too few understand.
A mortgage is a loan secured by real property. When you take out a mortgage to buy a home, you are not financing the home—you are financing the property beneath it. The actual house on the property is considered an improvement to the land, which increases its value. The loan becomes a lien on the property, with a lien being a person’s or an entity’s claim on a property until said debt is paid. The land cannot be transferred to a new owner until the lien is and released.
This lien could potentially be on the property for 30 years. The United States is one of the few countries on earth where such a thing as a 30-year mortgage exists. This is made possible by the existence of Fannie Mae and Freddie Mac. Without these government-sponsored entities (GSEs), it would be impossible for lenders to offer long-term fixed loans.
The upside of stretching a loan over 30 years is that the monthly payment is reasonable. More people can afford to finance an entire house than they could without such generous loan terms. The downside is that, due to the inevitabilities of compound interest, the cost of financing the mortgage is substantial. Paying off a 30-year mortgage could cost double the principal amount just in interest, depending how high interest rates are at the time of taking out the loan. That is, a $200,000 mortgage at 5.5% (which is below the historical average as far as interest rates go) would end up costing about $408,000 in total.
This is why it’s imperative to either buy or refinance now, while rates are still extremely low. That same mortgage at 4% would save $50,000 versus at 5.5% over the life of the loan, which would put you $50,000 ahead for retirement. Similarly, you should consider a shorter loan term—say, 20 or 15 years—to save even more on interest. Further, such low rates are having a profound effect on the real estate market. Low rates allow more people to afford more expensive houses, allowing them to drive up the price. Denver especially has been witnessing robust price growth for several years. In just a year or two, not only will houses cost a lot more themselves but the cost of financing them will be substantially higher as well.
This has only scratched the surface of what you should know about mortgages, and in the coming weeks I will be covering other aspects in-depth to help my listeners gain a better understanding of the mortgage and lending industries. A home will be one of, if not the, biggest financial decision most people will make in their lifetimes, and it’s essential they understand them thoroughly before committing themselves to a 30-year liability.
3-28-15 Anatomy Of A Mortgage Part I: Fitbit Your Finances