Loan Basics
What is a Mortgage or Trust Deed?
A common expression to describe a loan to purchase a home is a mortgage. However, a mortgage is more than that. Mortgages aren't used only to facilitate home purchases. They're utilized whenever people acquire any kind of real property, from vacant lots to commercial real estate such as shopping centers, office buildings, or warehouses. Mortgages encumber (burden) real property by making it security for the repayment of a debt. A first mortgage describes the very first loan that's secured by a particular piece of property. The second loan secured by the same property is called a second mortgage; the third loan is a third mortgage, and so on. You may also hear lenders refer to a first mortgage as the senior mortgage. Any subsequent loans are called junior mortgages.This type of financial claim on real property is called a lien. These type of liens have two integral parts: (1) a Promissory Note: This note is the evidence of your debt that specifies exactly how much money you borrowed as well as the terms and conditions under which you promise to repay it; and (2) a Security Instrument: Mortgages and Deeds of Trust (also called Trust Deed) are security instruments. A security instrument is a document evidencing that an asset of the borrower (i.e., the real property) shall act as the collateral for the loan. If you don't keep your promise, the security instrument gives your lender the right to take steps necessary to have your property sold in order to satisfy the debt. The legal process triggered by the security device is called foreclosure. From a lender's perspective, each successive loan on property is increasingly risky. That's because in the event of a foreclosure, mortgages are paid off in order of their numerical priority. In plain English, the second mortgage lender won't get one cent until the first mortgage lender has been paid in full. If the foreclosure sale doesn't generate enough money to payoff the first mortgage, tough luck for the second lender. Due to their higher risk, lenders charge higher interest rates for junior mortgages.
For simplicity's sake, we use mortgage, deed of trust, and the loan you get to buy a home as interchangeable terms.
How Much Can I Afford?
Determine Your Potential Home Ownership Expenses
Assuming you have a good credit history and an adequate cash down payment, the lender can quickly estimate the amount of mortgage debt you can obtain. Suppose a mortgage lender says that you qualify to borrow, for example, $250,000. What a lender is basically telling you is that, based on the assessment of your financial situation, $250,000 is the maximum amount that this lender thinks you can borrow on a mortgage before putting yourself at significantly increased risk of default. Do not assume that the lender is saying that you can afford to carry that much mortgage debt given your other financial goals. Your personal financial goals should help direct how much you borrow. For example, have you considered and planned for your retirement goals? Do you know how much you are spending per month now and how much room if any, you have for (additional) housing expenses including a large mortgage? How are you going to pay for college expenses for your kids? Etc. Ideally, you should collect spending data for a three- to six month period to determine how much you spend in a typical month for taxes, clothing, meals out, and so forth. If your expenditures fluctuate greatly throughout the year, you may need to examine a full 12 months of your spending patterns to obtain an accurate monthly average.
If you're in the market to buy your first home, you probably don't have a clear sense about the costs of homeownership. Even people who presently own a home and are considering trading up often don't have a good handle on their current or likely future homeownership expenses. Click on the links below to learn more about homeownership expenses.
Which Loan Should I Get?
How Much Financial Risk Can You Accept?
Many homebuyers, particularly first-timers, take an adjustabIe-rate mortgage (ARM) because doing so allows them to stretch and buy a more expensive home. If you're considering an ARM, you absolutely, positively must understand what rising interest rates and, therefore, a rising monthly mortgage payment would do to your personal finances. Only consider taking an ARM if you can answer "yes" to all of the following questions:
1. Is your monthly budget such that you can afford higher mortgage payments and still accomplish other important personal financial goals, such as saving for retirement, for your children's future educational costs, for vacations, and the like?
2. Do you have an emergency reserve, equal to at least three to six, months of living expenses, that you can tap into to make the potentially, higher monthly mortgage payments?
3. Can you afford the highest payment allowed on the adjustable-rate mortgage? The mortgage lender can tell you the highest possible monthly payment, which is the payment that you would owe if the interest rate on your ARM went to the lifetime interest-rate cap allowed on the loan. Never take an ARM without understanding and being comfortable with the highest payment allowed. If you are stretching to borrow near the maximum the lender allows or an amount that will test the limits of your budget, are your job and income stable? If you expect to have children in the future, consider now the fact that your household expenses will rise and your income may fall with the arrival of children.
4. Can you handle the psychological stress of changing interest rates and mortgage payments? If you are fiscally positioned to take on the financial risks inherent to an ARM, by all means consider one. Odds are you'll save money in interest charges with an ARM. Relative to a fixed-rate loan, your interest rate should start lower and should stay lower if the overall level of interest rates doesn't change. Even if interest rates do rise, as they inevitably and eventually will, they inevitably and eventually will come back down. So, if you can stick with your ARM through times of high and low interest rates, you should still come out ahead. AIthough ARMs do carry the risk of a fluctuating interest rate, almost all adjustable-rate loans limit, or cap, the rise in the interest rate allowed on your loan. Typical caps are 2 percent per year and 6 percent over the life of the loan.
Consider an adjustable-rate mortgage only if you're financially and emotionally secure enough to handle the maximum possible payments over an extended period of time. ARMs work best for borrowers who take out smaller loans than they are qualified for or who consistently save more than 10 percent of their monthly incomes. If you do choose an ARM, make sure that you have a significant cash cushion that is accessible in the event that rates go up.