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What Is a Mortgage?

Mortgage is a generic term used to describe several different combinations of legal documents that allow you to get financing to buy a home. The documents (note, bond, mortgage, deed of trust, open-end-mortgage, security deed, and riders) that you use depend on the state in which the property is located and the type of loan you are getting. (See Appendix K for a list of what system each state uses.)

A mortgage is a financial claim against your real estate. You give a mortgage to a lending institution, along with a bond or a note, which is a personal promise to repay In return, the lender gives you money – cash. You are the mortgagor The lender is the mortgagee.

A document called a deed of trust secures loans on properties located in deed of trust states. When you sign a deed of trust, you actually transfer ownership of the property to a trustee. Until such time that the loan is paid off, the trustee holds the deed to the property in trust. If a dispute arises between lender and borrower, the trustee must resolve the dispute according to state law. If the borrower stops making loan payments, the trustee must hold a foreclosure sale to pay off the lender. The deed of trust and state law clearly spells out the procedure for a foreclosure, and in most states, a court hearing is not required. In most mortgage states, however, the lender must go to court, argue the case before a judge, and obtain the judge's approval before holding a foreclosure sale. Lenders prefer to have loans secured by deeds of trust because foreclosing on a deed of trust is cheaper and quicker than on a mortgage. As a borrower, you can consider mortgages and deeds of trust as generally interchangeable terms in this book.

The Price of a Mortgage

Question: Which is a better deal: (1) a 30-year fixed-rate mortgage at 8 percent interest plus three points or (2) a 30-year fixed- rate mortgage at 8.25 percent interest plus only one point?

Answer: It depends.

Comparing prices of different mortgages is complicated. In addition to the quoted interest rate, lenders charge a variety of additional up-front fees:

• Discount points

• Origination fee

• Appraisal and credit report fee

• Inspection fee (for new homes)

• Underwriting/review fee

• Document preparation fee

Discount points, often referred to simply as points, are usually the largest fee that lenders charge. Each point equals 1 percent of your loan amount. If you borrow $200,000 but have to pay three points, you really get only $194,000. However, you have to repay $200,000, and you have to pay interest on $200,000.

Points change the interest rate that you pay. The real rate is the effective interest rate. For a 30-year loan at 8 percent plus the three points repaid over its full 30-year term, the effective interest rate is 8.32 percent.

The annual percentage rate (APR) is the effective interest rate for loans that are repaid over their full term. After you apply for a loan, truth-in-lending laws require lenders to tell you a loan's APR within three business days. While this is better than not knowing what rate you are paying, there are two problems with this procedure:

1. Finding out the APR after you apply does not help you with comparison shopping.

2. The APR calculation assumes that you will keep your loan for its full 30-year (or 15-year) term. However, most people sell or refinance their home within 6 to 12 years.

The effective interest rate depends on how long you keep your loan. If the $200,000 loan were repaid after six years rather than 30 years, its effective interest rate would be 8.66 percent, not the 8.32 percent APR.

You need a computer or financial function calculator to determine effective interest rates precisely, but the following formula is a fairly accurate way of estimating it for comparison shopping:

Effective interest rate = Quoted rate + (Number of points ÷ 6)

(If you know that you will be keeping your loan for more than 12 years, divide the points by 8 instead of 6. If you plan to stay for only four to six years, divide the points by 4. If you plan to stay for one to three years, divide the points by the number of years.)

Let's go back to the question posed at the beginning of this section: “Which is better, (1) a 30-year fixed-rate loan at 8 percent plus three points or (2) a 30-year fixed-rate loan at 8.25 percent plus one point?” Loan number 2 is better.

Loan 1: Effective rate = 8% + (3 points -r 6) = 8.50%

Loan 2: Effective rate = 8.25% + (1 point -r 6) = 8.42%

That small percentage difference does not seem like much, but for a $200,000 loan paid off after 12 years, you would save $2,000. If you paid off the loan after only six years, you would save $3,000. Shopping and knowing how to shop saves money!

Sometimes lenders charge a one point (or half-point) origination fee. This has the same effect as discount points. You should add an origination fee to the discount points before you calculate your effective rate.

For purposes of comparison shopping, you usually do not have to add the other miscellaneous fees (credit report and appraisal, inspection, etc.) into your rate calculations. Although they increase your effective interest rate somewhat, they are less significant than points, and most lenders charge about the same amount of miscellaneous fees as their nearby competitors.

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