In its basic and general form, a mortgage is simply a type of debt used to buy real estate.  A familiar use of a mortgage, a residential mortgage, allows individuals to pay for their home over time instead of in full.  Since residential mortgages tend to dominate the mortgage market, they will be the primary focus for this article. 

Mortgages can be approached in two general ways.  First, from the perspective of most homebuyers, a mortgage is an avenue to property ownership.  Secondly, from the perspective of the lender, a mortgage represents an investment full of different types of risks.  These risks help explain certain characteristics of the mortgage market which lends further insight into the way financial institutions operate.  Because financial institutions are a focus of popular and governmental scrutiny we can treat this interesting topic on a different occasion and keep the focus on discussing residential mortgages.

There are a number of key characteristics that can help a prospective homebuyer better understand his or her mortgage.

First, mortgages typically come from financial institutions like banks, savings institutions, and of course mortgage companies, to name a few. Financial institutions are important in the mortgage market because they serve as an intermediary, a “middle man,” between the loan money and the home buyer. For their part, financial institutions examine mortgage applications to assess the applicant’s credit, monthly income, down payment, and their general financial situation. Once approved, a mortgage contract is written that includes critical information for the buyer. For instance, the mortgage contract will specify the mortgage amount which is determined by subtracting the down payment from the price of the home. This contract also typically includes the interest rate charged to the homebuyer, the maturity (for how long the mortgage is held, whether for 15, 20, or 30 years), and collateral (usually the property being purchased). Other features of the contract include whether the mortgage is federally insured, the type of interest rate, and additional provisions native to these types of contracts.

Secondly, mortgages fall into two categories: conventional or federally insured mortgages. This insurance is an attempt to protect the financial institution from default risk on the part of the borrower. For instance, if a bank makes a mortgage loan and charges the homebuyer a certain interest rate for 30 years, the bank is betting that the homebuyer will pay on time and for 30 years. If any part of this equation changes, banks will lose money. Like the terms indicate, a federally insured mortgage is backed by the federal government and conventional loans can be privately insured so that the financial institution can protect itself from default.

Types of Residential Mortgages

There are several types of mortgages of which a few common ones are treated here:  fixed rate mortgages, adjustable-rate mortgages (ARM), graduated-payment mortgages (GPM), and growing equity mortgages.

With a fixed rate mortgage, the borrower pays the same interest rate throughout the life of the mortgage.  Since the interest rate does not change, the payment to the lender is the same.  Therefore, a fixed-rate mortgage protects the borrower from upward changes in interest rates.  But on the contrary, if interest rates decline, the borrower with a fixed rate mortgage cannot take advantage of lower rates and thus lower mortgage payments. 

Adjustable-rate mortgages (ARM) change with market conditions and unlike a fixed-rate mortgage, payments will change to reflect movements in the interest rate.  The interest rate adjustment is done at regular periods depending on what is specified in the mortgage contract.  For example, a common ARM will adjust every year and the amount of change is normally tied to the previous year’s rates on Treasury bills.  It is also common for mortgage contracts to specify whether the homebuyer can switch from an ARM to a fixed-rate mortgage.  It is important to note that the value of ARMs lies in that fixed rate mortgages charge historically higher interest rates than ARMs.  For this reason, homebuyers need to be aware of interest rate trends in order to take advantage of an ARM.  Unaware homebuyers financing under this option will find their mortgage payment may increase to beyond what they can afford and not fully understand why.

Unlike a fixed rate or adjustable rate mortgage, a graduated-payment mortgage (GPM) allows borrowers to start paying their mortgage in smaller payments.  During the next 5 to 10 years, the mortgage payments grow and eventually plateau.  This type of mortgage can be useful for borrowers who expect to make more money in the long term and therefore able to afford larger payments on their mortgage.  The result is that as the borrower’s income grows so does the mortgage payment.

Lastly, a growing-equity mortgage allows borrowers to pay off their loan in about 15 years or less.  The accelerated payments are a result of a payment structure similar to a GPM but instead of reaching a plateau, the payments continue to increase some 4% for the life of the loan.  Like a GPM, the loan payments with a growing-equity mortgage start low and grow as time passes.

Closing Remarks

The current economic downturn has taught many mortgage borrowers some expensive lessons from which future homebuyers can learn.  Understanding your mortgage is important for effective household financial management and long-term financial planning.  Like in any other matter in business, education is key to making solid and sustainable financial decisions.