We all wish that money grew on trees but since we live in the real world, we know it doesn’t. So, when contemplating one of the biggest purchases you will ever make, a home, dealing with a lending institution to provide the money necessary to make that purchase is a must. The problem is that many of us have little or no knowledge about the terminology that gets thrown around in the world of mortgage financing and you may feel a little lost.
Here are a few terms that will help you navigate this wonderful new world when dealing with mortgage brokers, bankers and realtors:
• MORTGAGE TERM Lenders will only loan you money for a specific period of time called the mortgage term. The term can range from six months to five years (although some lenders may offer longer terms). When the term is completed, the remaining principal amount is payable in full, unless you renew the mortgage (or arrange new financing) for another term.
• AMORTIZATION Few of us can pay off the entire principal of a large mortgage in a six month term, or even a three-year term. Imagine your monthly payment if you did! So, to make it easier, lenders calculate or “amortize” the mortgage payment over a much longer time, often as long as 25 to 30 years. They are not loaning you the money for a single 25 year period, they’re just calculating the payment schedule as if it will take you that long to pay back the principal, plus interest. During the amortization period you will probably renew the mortgage for several terms. The longer the amortization period, the more money you pay in interest. Conversely, the shorter the period, the more you’ll save in interest costs.
• INTEREST RATES As you probably already know from credit cards or car loans, interest is the cost of borrowing money. Over years or months, the interest rate that lenders charge can rise or fall by several percentage points. Although interest rates fluctuate with the economy, the rate charged on your mortgage, and therefore your monthly payments, will be fixed for each term of the mortgage except in the case of variable rate mortgages. This is important to you because the rate of interest to which you commit at the beginning of the term can have a huge effect on the amount you pay monthly for your mortgage. This is especially true in the early years of a mortgage, when almost all of your payments is used to pay the interest, and very little is applied to the principal.
• PAYMENTS Most mortgage payments consist of two parts: 1. Principal and 2. Interest. This is known as a ‘blended’ mortgage payment. Each payment reduces the balance owed on the mortgage by the portion of the payment that is credited to the principal.
• PREPAYMENT PRIVILEGES The total amount of interest you pay over the life of a mortgage may surprise you. For example, a $50,000 mortgage, amortized over 25 years at a 7% interest rate, will cost you $55,061 in interest alone over the mortgage amortization period. That’s more than what you initially borrowed. Decreasing the total amount of interest paid, would make you happier, right? To do that, simply make extra payments toward reducing the loan’s principal whenever you can. The lower your principal, the less overall interest you’ll pay. But remember that for many mortgages, principal prepayments will not reduce your monthly payment amount during the current term. Fully open mortgages (those with no prepayment restrictions) let you make extra payments towards the principal anytime you want. Fully closed mortgages don’t allow prepayment privileges. Partially open mortgages (or partially closed) allow you to make very specific prepayments at certain intervals. For example, they may let you make one additional payment of no more than 10% of the principal each year.
Because I know that all of this information could be overwhelming, especially if you are a first time homebuyer, I will leave it here for now. Keep coming back to my blog and look for Part II of Mortgage Terms explained.
I welcome and look forward to your questions and comments. If you or anyone you know is thinking about buying or selling, please call me. I will be happy to provide a FREE market evaluation of your existing property or a list of homes that fit your budget and style.