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Saturday, September 8, 2012

Understanding Mortgage

Understanding mortgage and few other key terms and concepts around it will help us understand more on this critical aspect of money management in our lives. So, lets go..

In layman's definition, a mortgage is a loan to finance the purchase of one's home. This is clearly the biggest debt that you would ever get into in your life.
Literally, The word mortgage is a French Law term meaning "death contract", meaning that the pledge ends (dies) when either the obligation is fulfilled or the property is taken through foreclosure.

Your home is a collateral for such a loan. Collateral means anything that you pledge as security for re-payment of your home loan. For mortgage, your home is the collateral. Remember that the collateral is subject to seizure on default. It is logical and very obvious that the bank would not give you a loan which is more than the value of the collateral.

To repay the debt (loan), you make monthly installments or payments that typically include the following:

(1) Principle: The principal is simply the sum of money you borrowed from the bank or financial institution 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 by the bank.

(2) Interest: Usually expressed as a percentage called the interest rate, interest is what the lender charges you to use the money you borrowed.

Principle and interest comprise the bulk of your monthly payments in a process called as amortization. Amortization is a process which reduces your debt (principle) over a fixed period of time. Over this period, which can be generally anywhere between 10 to 30 years, the principle component of the loan (the original loan) would be slowly paid through Equated Monthly Installments (EMIs). With amortization, your monthly payments are largely interest during the early years and principal later.

(3) Taxes: The taxes are the 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 after your mortgage is paid off.

(4) Insurance : Though this is optional in some regions of the world, you might definitely want to consider one or both of the following insurances to safeguard your home:

a) Home insurance This covers your home and your personal property against losses from fire, theft, bad weather, natural calamities 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. 
b) Life Insurance - You should consider buying life insurance if you think that it would be financially challenging for someone in your family to continue to pay the EMIs for your home in case of your death. Typically, you should go for a term plan which gives you maximum returns with minimum investments.  

Foreclosure or Repossession 
The possibility that the lender has to foreclose, repossess or seize the property under certain circumstances is essential to a mortgage loan. Without this aspect, the loan is arguably no different from any other type of loan.

Types of Amortized loans 
Across the globe, there are two types of mortgage loans available:

1. Fixed rate mortgage (FRM)
The interest rate charged by the lender is fixed at the time of signing the mortgage contract and does not vary irrespective of prevailing market and economic conditions
2. Adjustable-rate mortgage (ARM) 
This is also known as a floating rate or variable rate mortgage. In some countries, such as the United States, fixed rate mortgages are the norm, but floating rate mortgages are relatively common in other countries like India.

Adjustable rates / Floating Rates transfer part of the interest rate risk from the lender to the borrower, and thus are widely used where fixed rate funding is difficult to obtain or prohibitively expensive. Since the risk is transferred to the borrower, the initial interest rate may be, for example, 0.5% to 2% lower than the average fixed rate.

Mortgage underwriting 
It is the process a lender uses to determine if the risk (especially the risk that the borrower will default) of offering a mortgage loan to a particular borrower is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit, capacity and collateral (In the UK they are known as the three canons of credit - capacity, collateral and character).
To help the underwriter assess the quality of the loan, banks and lenders create guidelines and even computer models that analyze the various aspects of the mortgage and provide recommendations regarding the risks involved. However, it is always up to the underwriter to make the final decision on whether to approve or decline a loan.

Getting involved with real estate, and hence with mortgage loans, is a critical aspect of financial freedom, even after you are financially free.  In fact, my book "From Rat Race to Financial Freedom" will explain you how you can leverage the mortgage loans to maximize your annual returns.

Happy mortgaging till then !!


Manoj Arora

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