Regardless of how robust or diversified a well-built personal investment portfolio is made, the fundamental investment in personal finances is always in the home. When looking at how people invest in or plan for their futures, a primary savings strategy will always revolve around the integrity of the home, and ensuring that associate mortgage debt is properly serviced.
While planning for these kinds of concerns can be a fairly major headache for most savers, it is important to recognize how taking the time to be aware how mortgage debt works can save both time and money over the long term. When the different aspects of a mortgage, as well as the different features and costs of associated products are fully understood, a saver is better positioned to take on their debt, and to comfortably manage their commitment over the long term.
How Home Equity Works (who owns the home?)
The first thing to understand about the nature of a mortgage is how the ownership of the property is split up. Specifically, we need to understand what kind of claim the bank has on the property, and how that claim reduces over time. To do this, we start by discussing the concept of home equity, and the way that the value of a home is divided between the two parties involved.
Home equity is a value that represents how much a home is worth. It is determined through professional appraisal, and reflects approximately how much a house would sell for on the open market in its given state and in the current market conditions.
However, it’s important to recognize how changing market conditions can both increase and decrease the value of home equity as an investment. As such, many people strategically choose the times at which they have their equity value assessed.
When purchasing a home, a borrower will make a down payment, allowing them to own a certain percentage of the home and therefore control an aspect of that home’s equity. After the down payment is made, a bank will provide mortgage financing to the borrower and take on ownership of the remaining amount of equity.
As the principle of the mortgage is paid out after interest, the bank will proceed to reduce their stake in the home, allowing the consumer to take control of the full value of the home’s equity at their own pace over time. Once the mortgage is discharged in full, the bank will release their claim on the home (called the lien), and the borrower will now own the full equity value of the home.
How to Qualify
Qualifying for mortgage loans online is typically a two-step process. Firstly, an individual must have a credit score sufficient to qualify for the mortgage itself. U.S. banks use what is called a FICO score, and may require approximately 620-680 points to qualify for the debt. FICO scores will look at the borrower’s past history, checking how they handle their debt, and evaluate the likelihood of their repaying a new loan based on these past tendencies.
While there are many resources available on the Internet that discuss how to effectively manage credit scores, the most effective way to build and maintain a credit score is to simply make debt payments consistently within 30 days of their due date. The heavy weighting that these scores place on payment history alone is enough to qualify or disqualify an individual from a mortgage debt.
After qualifying for a mortgage, a borrower can begin discussing amounts that can be loaned by the bank, and what kinds of rates can be obtained. While credit score will still provide a strong representation of an individual’s quality as a borrower, it is at this time that intangible aspects of negotiation can begin to have an impact. For example, an individual’s total net asset value or high monthly income may mean that they are better able to manage a mortgage. Therefore, the bank will not require as much of a down payment upfront.
Alternatively, a borrower may choose to place a larger down payment on their home to show a greater commitment to the property, and therefore qualify for a lower interest rate. Last, if an individual has a strong relationship with their bank, they may be able to negotiate additional flexibility into their agreement because of the way in which the bank values the incomes they are receiving from additional products in the borrower’s master contract.
Types of Mortgage Rates
When looking at the interest rates associated with a mortgage, a borrower should understand that there are a number of different terms available to accommodate a variety of financial situations and goals. When looking at the rate itself, a borrower can negotiate a variable rate or fixed rate. A variable mortgage rate will be initially lower than the fixed rate, but will fluctuate with changes in greater prime rate. This means that, as greater interest rates change, the rates on the mortgage itself will change as well. Alternatively, a borrower can agree upon a fixed interest rate, which will remain predictable for a given period of time.
When evaluating a fixed or variable interest rate, a borrower should keep their personal financial situation in mind, and whether or not they are comfortable making an evaluation of greater economic conditions. If the borrower is unsophisticated in their knowledge of economics, it might be best to choose the slightly more expensive fixed rate, so as to keep a predictable payment schedule. A borrower with a shorter timeline in a slow-moving market might feel that a variable rate is best, because it allows them to pay off more of the principle, and limits their exposure to macroeconomic movements.
After determining the type of interest that will be associated with the loan, a borrower can begin to look at how the principle itself can be best paid off. The first way to pay off the principle on a mortgage is through an open agreement. An “Open Mortgage” is one that can be paid off in full at any time, and without penalty. While interest amounts will usually still be applied to the mortgage, it means that the individual can settle the obligation itself in a shorter period of time, and no longer need to worry about it as a part of their debt portfolio.
An individual may also choose to agree to a closed term, which locks in the agreement for a certain period of time. By choosing to take on a “Closed Mortgage,” the borrower is only allowed to repay certain amounts of principle every year, and cannot repay the full principle early without paying an additional penalty for breaking the contract. That being said, the borrower will likely receive an incrementally more favorable interest rate on a closed mortgage than they would on an open.
When choosing between an open and closed mortgage, the key determining question is whether or not the borrower intends on selling the home within the term of the mortgage. If the borrower is planning to move again within the term of the mortgage, a closed mortgage is not ideal because of the fees that will be incurred at the time of breaking the contract.
Alternatively, an open mortgage would be conducive to such a situation because it allows the borrower to pay out one agreement and take on another on a new home. An individual that is concerned that mortgage rates will decrease significantly in the medium term might find an open rate to be ideal, because it allows them to easily transfer their debt to another institution upon receiving an offer for a better rate.
The last thing to consider about a mortgage agreement is its sheer size, and how its value could impact the family of the borrower. Insurance provides financial protection against events of death, disability, or illness. In the event that a borrower with life insurance dies, the balance of the loan is paid by the insurance company. Compared to the alternative of transferring the obligation to the estate and family of the deceased, an investment in insurance provides a very valuable service to the borrower.
The purchase of disability insurance provides value to a borrower by covering the costs of the mortgage in the event that an individual becomes unable to work for an extended period of time due to an injury or illness. While it does not pay out the lump sum of the loan all at once, as life insurance does, it does indeed cover at least a portion of the payments.
This coverage is extremely valuable in the event of disability, as treatment expenses tend to dramatically increase for the borrower, while incomes decrease. Essentially, because of the way in which both death and disability can be extremely costly events, insurance against either can prove to be an extremely valuable investment for anyone interested in taking on a major debt.
Having looked at the general mortgage process, and the different aspects of the debt itself that can have an impact on a purchasing decision, we can immediately recognize how simply understanding the nuances of such a major investment can simplify our personal finances. While not overly complicated on its own, the sheer volume of knowledge associated with home debt can be what people find overwhelming.
However, by taking the time to research the basics of a mortgage, a home buyer can save themselves hours of time and thousands of dollars over the full term of the agreement, not to mention all of the grey hairs from the sheer amount of stress that debt has been known to cause. With that in mind, a borrower should ask themselves if a few hours of their time spent in research is worth the peace of mind associated with being in control of their finances.