In simplest terms, a mortgage is a loan used to finance the purchase of a home. The loan is secured by the property you purchase and represents a legally binding contract. For most people, a mortgage represents the largest debt they will ever assume, as well as the longest contract they will ever enter into. Most mortgages last between 15 and 30 years.
As mentioned, mortgages are composed of several components—the collateral used to secure them, the principal and interest payments, taxes, and insurance.
In addition, there are two primary types of mortgage products—"fixed rate" mortgage loans and "adjustable rate mortgage" (ARM) loans. A fixed rate mortgage features payments that remain the same throughout the life of the loan. An ARM begins with a lower initial interest rate and payment, but it will adjust with the market after a fixed period of time. We invite you to learn more about fixed vs. adjustable rate mortgages, including the advantages and disadvantages of each.
Key Components of a Mortgage
Collateral: The house you purchase serves as collateral for the mortgage loan. If you fail to repay the loan, the bank can take the house in lieu of repayment.
Principal and Interest: Principal is the amount of money you borrow to finance the purchase of your home. The interest is the additional amount you agree to pay, usually expressed as a percentage, in order to secure the principal amount.
Taxes: The taxes you pay on your property are generally proportional to the value of your home.
Insurance: In order to close the deal on your home, you will have to acquire homeowner's insurance. Depending on the type of mortgage, the terms of the mortgage, and your down-payment, you may also be required to purchase Private Mortgage Insurance (PMI). PMI is typically required if your down-payment is less than 20% of the purchase price.
Discount Points are fees that you pay to your lender, at close, in exchange for a lower interest rate over the life of your mortgage. As a result of this one-time payment, also known as a prepaid interest payment, you will have a lower monthly mortgage payment.
The cost of each Discount Point is equal to 1 percent of the principal loan amount. Therefore, if your principal loan amount is $200,000, 1 Discount Point would equal $2,000.
Whether paying Discount Points makes sense in your case depends, in part, on how long you plan to stay in your home. To help you decide whether you should include Discount Points as part of your loan process, use these steps when calculating your mortgage:
- Calculate the amount of your monthly payment at the interest rate you would be charged if you do not pay Discount Points.
- Calculate the amount of your monthly payment at the lower rate if you were to pay Discount Points.
- Deduct the lower payment from the higher payment to find the amount you would save each month.
- Divide the amount charged for Discount Points at closing by the amount you would save each month. The result is the number of months you would have to stay in your home in order to reach the break-even point on paying Discount Points.