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Mortgage: The Basics of What You Need to Know

Being forewarned is being forearmed.

No truer words apply to the mortgage business, an exotic business even before the recent rash of toxic news put many would-be homebuyers on edge. The best way to tackle this daunting process is to learn as much as you can before wading in.

This article will teach about mortgages, how they work, the different types, and define the archaic terms often bandied about.
A mortgage is a loan document in which you pledge your home as the collateral. Simply put, if somebody loans you money, this person will most likely ask that you put something up as collateral of equal or greater value. In the case of home loans or mortgages, the title is what is held as collateral. Basically the lender holds the title or in some states holds a lien to the title until the entire loan is paid off. The lender gives you the loan and in exchange you pay off the loan.

The lender who gives you a loan gets their money from many sources. For example a person with money in a savings account with a bank or other finance company might be paid 1% in interest; the lender takes this money, loans it to you and charges 5% interest on the mortgage.

Mortgages are relatively new. They really came about as a result of the Great Depression. Prior to the Great Depression of the 1930's, people generally paid cash for their homes. If a person did not have all the cash needed for a new home, he would have been taken a balloon mortgage for approximately five years, where interest was being paid for the five years and the entire amount was due after this time. When the stock market crashed in 1929, people were unable to pay off their homes as their entire savings were lost and their homes were taken from them.

After World War II ended, the federal government began lending veterans the money to buy homes, believing they would be good risks. The plan allowed veterans to borrow money and pay it back with interest over 30 years. This program was such a huge success that commercial lenders followed suit. This was the beginning of the modern day mortgage.

When you start comparing mortgage costs, you will see the mortgage quoted as both the rate, and the annual percentage rate (APR). You should really focus on the latter. The rate is simply the rate at which you will pay back the mortgage; the APR is the rate plus any other one-time charges that are included in your mortgage – it's a truer way to compare rates among different mortgage lenders.

The "term" of the home mortgage is basically the life of the mortgage or the time you will be making payments to pay the money back to the lender. The lender will often allow you to pay off the loan early or prepay the loan; ask about this when applying for a loan.

You will need to check this out with your lender to find out whether there are any penalties in prepaying the loan. Prepaying a loan can save you money. For example, if you make one extra payment on your loan each year, a conventional 30-year mortgage can be paid off in as little as 23 years.

This may be a choice for people who have yearly bonuses and can afford to do so. As the years go by and you begin to make more money, some of this could also be used to prepay the loan. However, you might be better investing the prepayment amount in another vehicle, like stocks, if you feel you can get a higher return for your money. Look at all your options.

Fixed-Rate Mortgage
As the name suggests, the interest rate on this mortgage type is set for the term of the mortgage. The term can be over 10, 15, 20 and the most popular, 30-year term. When interest rates are low this can be an excellent choice of a loan. The monthly mortgage payment of principal and interest remains the same over the term of the loan.

Adjustable Rate Mortgage
It's called an adjustable rate mortgage, or ARM, because the interest rate fluctuates over the term of the mortgage. The interest rates are pegged to a specific index, or Treasury bills. The initial interest rate tends to be quite low and is set for a specific amount of time.

Once the time expires, the interest rate may reset to current interest rates. There is usually a yearly cap of 2% on these types of loans and a lifetime cap of around 5%. Depending on the economic climate, interest rates may also go down which could save you thousands of dollars over the term of the loan.

This is the loan that's getting a lot of bad press lately. Many people took this type of loan to squeeze into a house that was beyond their means, and when the rate adjusted upward, they were unable to pay the new amount, and many are now facing foreclosure on their homes. Be very careful with the terms and conditions of this mortgage.

Advantages of an ARM?
You may more easily qualify for this loan because the lender uses the gross monthly income and monthly loan payment amount to determine how much you qualify for. The monthly amount will be less with a lower interest rate so you may qualify for more.

If you only plan to stay in the home for a couple of years this may be an excellent choice as the majority of benefits for the initial low interest rate will be gained initially. If current interest rates are very high, this may be the only loan choice available to you. But if you aren't a risk-taker, this may not be the best option  

Balloon Mortgage
These can be any length of time. Some require monthly payments or principal and interest and some require payment of interest only. When the loan comes due at the end of the term, the balance must be repaid in full.

Balloon mortgages can be paid in one of two ways. The first is when the mortgage is amortized over 15 or 30 years and the principal and interest is paid off monthly until the term ends and the remainder of the loan is paid off. The second way of paying off a balloon mortgage is to pay only the interest on the loan monthly until the term of the loan is up and then to pay off the principal entirely.

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