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When many people hear the word mortgages, they envision a complex tangle of long-term debt. Indeed, the world of mortgages abounds in variations of creative financing — a formidable-sounding obstacle for the neophyte. For many people, the purchase of a home represents the biggest single investment they make in a lifetime. Because they can seldom afford to pay cash on the barrel, they end up committing themselves to 20 or 30 years of mortgage payments. Yet, few stop to consider that the mere difference of 1 percent interest on, say, a $70,000 mortgage, can add more than $20,000 to the effective cost of buying the home over the full term of a 30-year loan. Since mortgages probably play such a big part in your life, you should develop a good working knowledge of this investment.
Once you have purchased a house, it may be all you can do to keep up with the mortgage payments, much less conceive of the mortgage as an investment. But your house is an investment, and the mortgage is a liability that forces you to invest. What happens, though, when your company suddenly transfers you out of town, forcing you to sell the house? If you have owned the house for a few years, you may have invested more money in the property than a new buyer is prepared to pay. As a result, you might end up "lending" part of the down payment in the form of a two- or three-year second mortgage. In effect, you will have invested in mortgages whether you wanted to or not.
Under those circumstances, you "invest" in a mortgage to improve your chance of selling the property at a good price. However, at other times, you may wish to add mortgages to your investment portfolio, since they may represent excellent sources of steady reliable income. And, like stocks, mortgage investments are available to suit most budgets and attitudes toward risk.
A mortgage is a legal contract in which the borrower (mortgagor) pledges certain assets (usually the property) as security against a loan to be paid back to the lender (mortgagee) under pre-established terms and conditions.
Always keep in mind that a mortgage, first and foremost, involves a loan. Accordingly, with a few modifications, both lender and borrower have the same rights and obligations they would have in financing, say, the purchase of an automobile. The main differences are the amount of money borrowed and the repayment period. Aside from that, the same basic rules of lending and borrowing apply.
Assume that you have found a house you want and now must find suitable financing. The price of $120,000 is right. The only hitch is that the seller wants all cash and you have only $24,000. To whom do you turn for the remainder?
Conventional lenders can play a role
The starting point would be a savings and loan association, a mutual savings bank or a commercial bank. Collectively, these institutions — referred to as conventional lenders — provide more than 90 percent of all residential real estate financing.
You should realize that the funds invested in mortgages by conventional lenders effectively belong to their depositors or shareholders. For that reason, loan officers have an obligation to ensure the money they lend is eventually repaid. Therefore, they carefully scrutinize all loan applications and will rarely lend you the full value of the property, requiring instead that you provide at least some cash security. Usually, the maximum amount available under a conventional mortgage is 80 percent of the property value.
Every buyer and seller of real estate should at least consider dealing directly with the other individual on some or all of the financing. Indeed, if it were not for sellers helping buyers with the financing, many real estate deals of recent years would never have been made.
A financial institution doesn't have to be involved if the buyer and seller can work things out between them. Consider this fairly typical example of how the parties to a house sale arrange financing that will benefit them both:
The seller plans to move to a warmer climate to live out his retirement years, so he puts his house up for sale. The prospective buyer isn't satisfied with the terms offered by the local financial institutions, which charge high interest rates and want 20 percent of the property value as a down payment.
With the aid of a broker, a lawyer or any other qualified third party, this sale can easily be consummated. One form it might take is for the buyer to agree to pay the full price asked for the property in return for a lower-than-market interest rate with the seller holding the mortgage for a given period, say five years.
Now, the seller gets monthly payments that help cover his expenses in retirement. The retiree knows that if the buyer defaults on the loan, he can regain his old house through foreclosure. And, if there is no reason to take the property back, remember he will have received his full price in the first place, not a discounted price because of poor market conditions.
For the buyer, the deal with the seller might be to pay only 10 percent down or maybe even no down payment provided he pays the full asking price of the house. In the meantime, he could evaluate the market and take out a new mortgage loan at a better interest rate when the cycle of high and low rates dips to an acceptable level. In the meantime, he will have had full use of the property.
Another scenario might be for the buyer to get the best financial deal possible in terms of down payment and interest rates, and persuade the seller to hold a second mortgage for the remainder of the down payment needed to buy. For example, the lending institution might agree to lend 75 percent of the value of a $100,000 house. The buyer would either have to come up with $25,000 or get the seller to hold a second mortgage for all or part of that amount.
Again, the seller has protection in that if a foreclosure occurs, he would get some money out of the deal after the lending institution's senior claim was satisfied (assuming that his home was as valuable as he thought). In the meantime, he would be receiving monthly payments at a good interest rate until the second mortgage debt was satisfied. There are endless variations on these themes, with the mortgage as the key to each.
Basic mortgage mathematics
A mortgage can be repaid in several ways. However, all repayment schedules are variations on one of four basic themes. Here is a summary of the four general categories of loan schedules:
- Interest only is payable until the loan matures on a certain date. When that date rolls around, the full amount of the principal is due and payable. This is often called a "balloon" loan because the final payment is much larger than each of the previous payments. This type of repayment plan is often used in the financing of a second mortgage.
- Predetermined monthly principal installments, with interest calculated on the declining principal balance. Repayment terms such as these are seldom offered on loans for residential property, although they are common in commercial mortgage lending.
- Fixed equal monthly installments, in which the ratio between principal and interest varies with each payment. In the early years of the loan, most of the monthly payment is eaten up by finance charges; in later years, most of the money is applied directly towards the principal. The loan is fully amortized (paid off) at the end of the loan term and no balloon payment is required. A prime example of this kind of loan is the 30-year, fixed-rate mortgage.
- Adjustable monthly payments, in which the ratio between principal and interest varies with each payment. The payment may differ from one month to the next, or may change every six or 12 months. A prime example of this type of loan is the adjustable-rate mortgage, or ARM.
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