While the “American Dream” is centered around home-ownership, owning a home can be a costly and time-consuming enterprise. While someone’s home is likely their most valuable asset, it is also likely to be their most serious monetary obligation. Few people bask in the luxury of having enough cash on hand to purchase a home outright. Indeed, current data indicates that 62% of Americans carry a mortgage. For this reason, mortgages are essential to both individual people and the economy. In this article, we will discuss what a mortgage is, the “components” of a mortgage (along with how to navigate the components of a mortgage and how to work these components to your benefit), the advantages that come along with having a mortgage, and the disadvantages, too. We will begin with exploring what a “mortgage” is.
Put simply, a mortgage is a loan. However, the term “mortgage” is the unique term used to describe a loan used to purchase a home. The mortgagor (the lender) provides the total amount to purchase the home in exchange for the mortgagee (the purchaser) giving the mortgagor a “security interest” in the home. The security interest is what gives the mortgagor the right to repossess the home should the buyer discontinue their payments—sending the home into foreclosure (foreclosures will be discussed at more length in an additional article). Accordingly, the mortgagor remains the true “owner” of the home, and title does not pass to the mortgagee until the loan—plus interest—has been paid to the mortgagor.
Components of a Mortgage
Regrettably, there is much more that goes into a mortgage than the money to purchase a home. Prior to considering whether to purchase a home and what your budget will be, you will want to have a solid understanding of what it will take to repay the mortgage. A mortgage, at heart, has three essential components: principal, interest, and taxes and insurance (with taxes and insurance encompassed in a single component). Here, we’ll discuss the three components of a mortgage at length here, starting with “principal.”
The payment made towards the “principal” is the amount that you will pay every month towards the total outstanding loan amount. With every payment you make towards the principal, the loan amount will decrease until it’s been paid. For example, suppose that you purchased a home for $200,000 and you mortgaged the home for $150,000 (your down payment was $50,000). Next, suppose that it has been determined that your monthly payment is $1,300 (not including interest, taxes, and insurance). Once you make the initial payment towards the principal, the total outstanding loan amount will be reduced to $148,700.
While the “principal” owed on the total outstanding loan amount is a simple concept, principal is a crucial element to the remaining components. To be discussed more extensively below, your interest rate directly correlates to the total amount owed on the loan. The more expensive the home is, the more the outstanding loan amount will be, the more your payment towards the principal will be, and consequently, the more interest you are likely to pay.
For most, the “interest” component is where mortgages become burdensome. “Interest” can best be explained as the personal cost to you—the mortgagee—in borrowing the money. Interest rates are determined by a multitude of factors (some of which are completely external, having little do with you, the mortgagee). At its core, interest is about the risk the mortgagor is taking in lending you the money. Every lender (or mortgagor, in this case), takes some level of risk in lending to you. To a lender, you are a number on a piece of paper—a credit score representing every money mistake you’ve made. You can combat the assumptions a lender will necessarily make about you by engaging in wise transactions pre and post mortgage.
How to Reduce Your Interest Rate
Provided the information above, you can see why interest is easily the most burdensome aspect of a mortgage—and consequently—the most burdensome aspect of home ownership. However, there are simple steps you can take to reduce your interest rate. Let’s review:
Shop The Best Interest Rate
First, take the time to shop for the best interest rate. Not all mortgagors are created equal. While you may be anxious to purchase a home, taking the time to locate the mortgagor with the best interest rate available will save you thousands. In this sense, purchasing a home is much like purchasing a car; there will always be another, better deal. Long term, a lower interest rate will minimize the potential that your home will be foreclosed on.
Make Extra Payments
If you have the spare cash to do so, making extra, more frequent payments will allow you to “pay down” the outstanding mortgage, resulting in less interest on your now-smaller outstanding debt. This is particularly good advice if you have a “variable” interest rate. A variable interest rate is one that will vary over time, depending on certain conditions (not discussed at length here). Making more frequent payments—particularly when your interest variable rate is low—is a smart money move. Conversely, seeking a “rate lock” interest rate could be equally smart. A rate lock interest rate is the direct opposite to a variable interest rate; your interest won’t change along with the ever-changing market conditions. However, the consequence is that your interest rate will never be lower than the rate that you’re “locked” into.
The interest rate type that you chose will likely depend on the cash you expect to have on hand. Those with less available cash on hand would probably be advised to choose a locked interest rate to avoid the consequences of a drastic change in market conditions. Conversely, someone who has surplus cash and disposable monthly income could manage a variable interest rate despite an unpredictable market. Even with a locked interest rate, making additional payments would have a positive impact. Not only will you pay down the mortgage at a speedier rate, but you’ll also pay less interest over time.
Seek a Short-Term Loan
Paying a larger amount on the principal over a shorter time-period can be advantageous; it can save you more money long-term because you won’t be required to make payments as long. However, short-term mortgages will necessarily result in a higher interest rate. You will want to balance the need to have your mortgage eliminated at an earlier date with the need to maintain a reduced interest rate—enabling you to keep surplus cash on hand.
Make a Larger Down Payment
As already hinted to, making a larger down payment will reduce your mortgage balance. With the knowledge that the total mortgage amount, your principal payment, and the interest rate that you receive are interconnected—with each component dependent on the other—you probably already know that a large down payment will also decrease the interest you’ll be required to pay.
Purchase a Home Within Your Means
Because interest rates are so closely linked with the total amount owed on the mortgage, you would be well advised to purchase a home within your means. What does that mean? It means that if you make $50,000 a year, you probably don’t need to make the commitment to purchase—and pay on—a home worth $1,000,000. If you were to be approved for a loan on a million-dollar home on a 50K per-year salary—which is unlikely at best—you are guaranteed to have an unbelievable (and unmanageable) interest rate. While this example is on the extreme side, you get the idea. It is better to have a home—be it an inexpensive home—than no home at all. With interest rates so closely linked to the principal payment, it is wise to be reasonable and realistic about your budget and the price you’re able and willing to pay long-term.
Improve Your Credit
Your already-existing credit score will directly correlate to the credit score you’re able to obtain when purchasing a home. Accordingly, available interest rates bear a direct relationship to your current credit score. It is important that you attempt to increase your credit score prior to home-ownership. A higher interest rate due to poor credit can result in continued poor credit, or even diminished credit. However, there are things that you can do to improve your credit. For example, you can open a low-cost checking or savings account. To create the most advantage, consider making periodic deposits. You should avoid credit card use, but when a credit card is necessary, pay the balance every month and keep your credit balance low. Ensure that you pay every bill on time and eliminate unnecessary expenses. The simplest task that you can engage in to improve your credit is developing a budget and seeking advice that a credit counselor can provide; nonprofit credit counseling can give you advice at no cost—assisting you in eliminating excess expenses.
Taxes and Insurance
“Taxes” are property assessments collected through your local government, also known as “property taxes.” Mortgagors will typically collect some portion through your monthly mortgage payment, the portion owed on property taxes is then held in account—called an escrow account—until the tax becomes due. With respect to insurance, there are two types: Homeowner’s Insurance and Mortgage Insurance. Here, both types are aimed to protect the inherent monetary risk that the mortgagor took in lending to you. Homeowner’s insurance gives the mortgagor (and the mortgagee) protection if an unpredictable event occurs—
flooding, fire, burglary, etc. With respect to the threat flooding can impose, a mortgagor may also require flood insurance, separate to the regular homeowner’s insurance that is always required.
Mortgage insurance, on the other hand, may not be required. Whether the mortgagor will require you to have mortgage insurance is directly related to the risk the mortgagor took in lending to you, as we have previously discussed. Mortgage insurance can also be dependent on the down payment you made, as well as other circumstances; the larger the down payment, the less likely it is that you will be required to have mortgage insurance. Mortgage insurance provides mortgagors if you can’t repay the loan. This makes recouping the remaining balance less burdensome on the mortgagor.
The most obvious advantage to a mortgage is the ability to have additional cash on hand. As discussed above, aspiring homeowners rarely can pay the purchase price in cash. A mortgage is a way to ensure that you can continue to pay your bills and daily living expenses while working towards complete home ownership. In opting with a mortgage, the cash that would have been put down to decrease the total loan amount can now be put towards incidental expenses: the electric bill, the gas bill, improvements to the home, etc. Home ownership provides no advantage when you’re unable to maintain the required upkeep. Without cash surplus on hand, your chances of being unable to pay on your mortgage—resulting in your home being repossessed by your mortgagor—rises exponentially.
However, even if you could pay the total cash price with excess cash to spare, would it still be wise to pay the total cash price? Although a debatable point, not all debt is necessarily bad debt. While a mortgage is a serious obligation, making the wise decision to purchase a home within your means can ultimately serve as a direct path to better credit. Making your monthly house payment on time—and over a long period of time—will result in a positive impact on your credit history and credit score—making other lenders more likely to extend credit to you on other big purchases. Accordingly, leaving something left to pay on each month—even a small amount—could have a long-lasting, positive impact.
While a mortgage is a huge undertaking that should not be taken lightly, a mortgage does have advantages. For example, “home equity.” Home equity is the percentage of the home that you own versus what is owed on the mortgage. To demonstrate, suppose that you purchased a home with $200,000 and you mortgaged the home for $150,000. You would have $50,00 of “equity” in the home. With every payment you make on your home, you gain equity—getting you one step closer to complete ownership. Accordingly, if you make the decision to sell your home, the “equity” is extra cash for your pocket.
However, even without making a monthly house payment, you are still ostensibly gaining equity through mere ownership. Using the example above, suppose that you purchased a home worth $200,000 with a $150,000 mortgage five years ago. Also suppose that, since you purchased the home five years ago, property values in your area have increased by 25%. Your home’s value has now increased to $250,000, leaving you with $100,000 in equity (not counting the monthly payments you’ve made over the past five years). For this reason, owning a home can be more advantageous than renting, for example. You can’t gain equity in something that you don’t own (absent a rent to own agreement or something similar). Ultimately, ownership equals equity, making home ownership—and incidentally, a mortgage—an advantage.
Tax Advantages Available on Mortgage Interest
Financing your home and having a mortgage can have tax advantages. In particular, the ability to “write off” your mortgage interest. While this won’t decrease your monthly mortgage payment, it can lower your annual income tax. However, this advantage has been limited since the Tax Cut and Jobs Act’s passage in 2017. Since then, the standard deduction has decreased, reducing the advantage in itemizing your deductions. Indeed, it is estimated that 4% of taxpayers were predicted to write-off their mortgage interest; down from 21% prior to the Tax Cut and Jobs Act.
Can Help Build Credit
While you likely need already-existing, good credit to purchase a home, making your required monthly payment on time can help build your already good credit. However, where a mortgage can help build credit, it can also work to destroy your credit.
Inherent Risk in Foreclosure
Because a mortgage is a secured transaction (with the home being the “security”), the mortgagor is entitled to repossession in the event that you become unable to make your monthly payments. While there are opportunities to avoid foreclosure even where the repossession process has begun, the anxiety a potential foreclosure threat can—and will cause—is worth the time and trouble associated with avoiding the threat altogether in the early home purchase stage (i.e., securing the right credit score, maximizing your credit score, etc.).
Long-Term Debt and Paying Back More Than You Borrowed
A mortgage is a long-term monetary commitment to pay back thousands. Because all mortgagors charge interest, you will inevitably be required to pay back more than what you have borrowed. Again, how much more you will be required to pay back will directly correlate with your down payment and the interest rate you can obtain. Accordingly, it is a good idea to look at the “big picture” and know the total amount owed once the mortgage has been cleared. Additional costs in purchasing a home must also be considered: the valuation costs, potential remortgaging costs, and conveyancing costs. You can be assured that you cannot recoup these additional—and likely unanticipated—expenses.
Depreciation and a Potential Decrease in Property Value
While home equity is a natural, positive consequence to mortgagees, as explained above, there are natural negative consequences that tag along with it. The advantage home equity provides can be directly counteracted with a potential decrease in the property values in your area. We’ve discussed property values when considering interest rates and the unpredictable market changes that can cause a once-manageable payment to spiral into unmanageable debt that can ultimately result in property repossession. It can be worrisome—and quite inequitable—that the value in home-ownership can sway based on circumstances unrelated to you, the mortgagee. This is an unavoidable consequence that requires us to necessarily rely on an unpredictable housing market. In better news, a decline in the housing market—and accordingly—a decrease in property values—has never been permanent, although it has been long-lasting.
Regarding deterioration and wear-and-tear on your home due to age is also a consequence. However, unlike the housing market—which you have no control over—you can at least somewhat control the way your home deteriorates—or at least retain the power to do something about it. The older the home, the more deterioration you can expect if you are unwilling to use the time and assets required to manage it. When purchasing a home, you should weigh a relatively older home’s decreased value with the repairs that will eventually be required (that a newer home wouldn’t).
To conclude, when considering home-ownership, a mortgage will more than likely be required. While it can be daunting considering the consequences merely having a mortgage can result in, there are measures that can be taken—as discussed above—that can put you at ease. While this is not an exhaustive list, here are some highlights on the considerations that should be made to purchase a home—and a mortgage: do some in advanced planning; buying a home is not a “hurry-up” deal, be real about your budget, review current interest rates, and develop a basic understanding on mortgages and what will be required to manage your monthly payments.