Understand These Mortgage Basics to Make You a Savvy Homeowner and Real Estate Investor
There are many different types of mortgages out there. As savvy homeowner or real estate investor, you need to understand mortgage basics. The more you understand how mortgage works and the types of mortgage available, you’ll have more options in financing your purchase.
If you’ve been alive the last couple of years, you’ve probably heard a lot about Fannie Mae and Freddie Mac on the news in relation to the real estate bubble burst in 2008.
Who are Fannie Mae and Freddie Mac?
Fannie and Freddie are not real person. Just as Uncle Sam is not real.
Fannie Mae is nickname for Federal National Mortgage Association and Freddie Mac is nickname for Federal Home Loan Mortgage Corporation. They are both government agencies that purchase home loans from banks.
Watch this video from Wall Street Survivor, which will explain the mortgage basics in a nutshell.
Here…I’m going to discuss the most simple and common types of mortgages or home loans available to finance a home or investment property purchase. Just so you can get some ideas to start with. There are many more different types of mortgages and creative strategies to fund a home or investment property purchase.
There are generally 2 types of homes loans or mortgages: CONVENTIONAL and NON-CONVENTIONAL
Ok…here’s the true story.
After a bank closes on your mortgage, they’ll turn around and sell your mortgage note to Fannie Mae or Freddie Mac. That is the reason why banks have to follow the guidelines from Fannie and Freddie, such as minimum 20% down payment, debt to income ratio of less than 43%, etc.
That's "conventional mortgage" in a nutshell. Plain vanilla loan.
Low Down Payment Loans
FHA Loans - 3.5% down payment for owner-occupant
Fannie Mae HomePath Home Loan - 3% down payment for owner-occupant, 10% for investor
100% Financing or 0% Down Payment Loans
With any low- or no-down-payment home loans, you, the buyer, has to be aware of Private Mortgage Insurance.
Fixed vs ARM You’ve seen banks everywhere advertising their “fixed” and “ARM” home loans.
Exactly, what are they?
Fixed rate mortgages is when the rate of the mortgage is “fixed”. With a fixed rate mortgage, the interest rate you pay is the same every year as long as you have the mortgage.
The ARM or Adjustable Rate Mortgage, on the other hand, gives you flexibility in the interest rate. Usually you have the option for the mortgage rate to be fixed for a certain number of years initially, after that the rate will follow the market rate, which may be higher or lower than your initial fixed rate.
An adjustable rate mortgage is also known as a "variable-rate mortgage" or a "floating-rate mortgage".
Related article: What is Annual Percentage Rate (APR)
Prequalifications vs Preapprovals
With a prequalification, your assessment to purchase a mortgage or home loan is based solely on a verbal conversation. There’s no credit check, which can lead to a less accurate assessment of how much home you can afford.
On the other hand, when you get a documented preapproval, you’ll know exactly what you can afford and how much since a credit check is part of the process. You can then shop for a home with a realistic budget in mind.
Amortization vs Simple Interest
Understanding how amortization works for the bank and knowing the difference between amortization and simple can save you loads of money in interest payment. And you’ll also understand why you shouldn’t refinance your mortgage.
Amortization is the process of paying off your mortgage with regular payments over time. You pay the same amount every month for 15 or 30 years, depending on your loan terms. In the beginning of your loan, you’re paying mostly interest, and very little of your payment goes to the principal. As the time goes by, you pay less and less interest and more toward principal.
If you only plan to be in a home short term, it is important to remember that you will owe a majority of the principal when you go to sell since you pay more interest in the beginning.
This is the exact reason why you should NOT keep refinancing your home loans. Each time you refinance, you reset the clock to the beginning. The 30 year starts again. Then you end up paying mortgage interest forever, and never get to pay down your principal. People always think refinancing to a lower rate mortgage will save them money. It is not true.
If you want to pay off your mortgage fast, make additional or larger payments each month helps save money in the long term. Specify that you want the additional payments to go towards your principal balance. Be sure there is no prepayment penalties by paying off your mortgage sooner. The prepayment penalty can eat up all your interest savings.
Related article: Pay Off Your Mortgage in 7 Years
Another way to pay off you mortgage quickly is with a home equity line of credit or HELOC
Well…this is a good time to introduce the concept of simple interest. I love simple interest as a borrower.
Simple interest is how credit card companies figure out how much you owe. Bank uses this same concept to calculate your interest in your savings account, and HELOC.
Simple interest is calculated on a daily basis. If you pull one of your credit card statement out, and look at the back, you’ll see different rates that your credit card company charges you. One of the rate is a daily rate, which maybe 0.0004%. Your interest on your credit card balance or HELOC balance is calculated on a daily basis. The lower your daily balance the lower your rate, which gives you the incentives to pay down the balance as soon as possible.
With a HELOC, you save on loan interest, pay off your principal sooner and you have a line of credit that is available also as your emergency fund.
Related article: Home Equity Line of Credit