Understanding the basics of this debt instrument
Likely the largest debt you'll ever take on, a mortgage is a loan to finance the
purchase of your home.
Your home is collateral for the loan, which is also a legal contract you sign to
promise that you'll pay the debt, with interest and other costs, typically over
15 to 30 years.
If you don't pay the debt, the lender has the right to take back the property and
sell it to cover the debt. To repay the debt, you make monthly installments
or payments that typically include the principal, interest, taxes and insurance,
together known as PITI.
Principal: The principal is simply the sum of money you borrowed
to buy your home. Before the principal is financed you can give the lender
a sum of cash called a down payment to reduce the amount of money that will be financed.
Interest: Usually expressed as a percentage called the interest
rate, interest is what the lender charges you to use the money you borrowed.
As well as the given rate, the lender could also charge you points, and additional
loan costs. Each point is one percent of the financed amount and is financed
along with the principal.
Principal and interest comprise the bulk of your monthly payments in a process called
amortization, which reduces your debt over a fixed period of time. With amortization,
your monthly payments are largely interest during the early years and principal
later. In addition to your principal and interest, your mortgage payment could include
money that's deposited in an escrow or trust account to pay certain taxes and insurance.
Generally, if your down payment is less than 20 percent, your lender considers your
loan riskier than those with larger down payments. To offset that risk, the
lender sets up the escrow account to collect those additional expenses, which are
rolled into your monthly mortgage payment.
Taxes: The taxes are property taxes your community levies based
on a percentage of the value of your home. The tax is generally used to help
finance the cost of running your community, say to build schools, roads, infrastructure
and other needs. You must pay property taxes even if you don't need an escrow
account and even after your mortgage is paid off.
Insurance: Lenders won't let you close the deal on your home purchase
if you don't have home insurance, which covers your home and your personal property
against losses from fire, theft, bad weather and other causes. Even if you
pay cash for your home, you should buy home insurance unless you can afford to repair
or rebuild your home if it's damaged or destroyed.
If your home is in a federally designated high flood risk zone within a flood plain
and you are signing for a federally insured loan, federal law mandates that you
must buy flood insurance. If you are not in a high flood risk zone, you still
may buy the coverage.
If you put less than 20 percent down on your home purchase, most lenders will also
charge you private mortgage insurance (PMI) premiums. The coverage doesn't
protect you, it protects the lender from you defaulting on the mortgage. Without
the coverage, many buyers could not otherwise afford to buy a home. Effective
for loans written on or after July 29, 1999, lenders must automatically cancel PMI
when your mortgage balance shrinks to 78 percent of the home's original purchase
price.