What is a mortgage? Should I consider a refinance? Rates, points, fees, it all seems so complicated; how do I know what I should do?
After working in the finance world for several years I began to get similar questions from friends and family. Mortgage rates were at historic lows so everyone was buying or refinancing. At first I was hesitant to discuss; the mortgages I worked with daily were multi-million dollar entities with very different structures; not the same thing, right?
What I found though, consistently, is that even the very basics of what a mortgage is were often not clear. Some of the most intelligent people I know had been so intimidated by the math and massive paperwork that they’d just shut their eyes and signed, and they were starting to realize that they didn’t actually understand the details of the biggest financial transaction of their lives.
With time I’ve thus built up a basic primer about mortgages, based on the problems and misunderstandings I’ve encountered. I also built a tool/calculator for evaluating options.
In particular, and keeping with the theme about improving our intuitions about the world, the below explains how to think about mortgages so that they become easier to understand. When you have this basic view, figuring out the best choice for you will be much easier.
In this article I’m broken the discussion up in an easier-to-digest form. Instead of one big article the entire discussion is done FAQ-style. You can read them all or click only on the parts you want. I would encourage most readers to look at the first and second sections though; beyond that jump around in whatever approach is most useful to you.
Also, the bottom section includes a calculator where you can enter details of a mortgage or refinance and build up your intuition for how it works.
Mortgages – An Overview
The Basics: What is a mortgage?
A mortgage is a fancy name for a particular type of loan. The difference between it and any other loan is that a mortgage is attached to a piece of property (a house for most people) and if you don’t pay the mortgage off, the bank gets that property.
The Basics: How to think about mortgages; renting money!
A mortgage is basically you renting money. This is one of the most useful ways to think about it.
If you rent an apartment you pay rent every month to get to use the apartment. A mortgage, or any loan, is the same thing with money. You borrow money from the bank to pay for your house, and until you have paid that money back you have to pay rent on that money. This rent payment is more complicated though because the amount of the money you borrowed changes over time. (whereas when you rent an apartment the apartment stays pretty much the same over time)
How loan rent (i.e. interest) works
With a mortgage, the rent you pay is based on an interest rate. This means your rent on the money, is a percentage of the money you’ve borrowed. If you borrowed $100 at this rate you’d have:
- Principal (money you’ve borrowed) – $100
- Interest rate – 5.0%
- Interest (i.e. rent each period) – $5
This of course gets more complicated because you have to make payments over years and you need to pay both the interest and the original loan back. Banks do some math here to figure out what your monthly payment should be for everything to even out, but you don’t really need to know about it; the point is to think about interest rates as your rent payment on the money.
Note: The above assumes you have some knowledge about interest rates and such. The point here is just to communicate this concept of interest being the rent on your money, but if you’d like to dig into the details I’d recommend Khan Academy’s interest course or percent course to learn more.
Mortgage Choices – 15, 20, or 30 Year? Smaller or Larger?
When you get a loan you often have choices. You can borrow more or less, you can borrow for 15 years or 30. The thing to remember here is that the interest (i.e. rent) you pay works just like you’d expect; if you borrow more money or borrow it for longer it will cost you more. If you borrow less money or borrow it for a shorter time you won’t have to pay as much for the privilege.
Of note, the math works out such that when you borrow for a shorter period your payments are generally higher. This is because you’re paying more of your principal (the money you borrowed) back each month.
How much higher you can discover using a calculator (see bottom section of this page), but the trade-off here is between higher payments (which costs you less in interest/rent in the long run) and higher interest/rent (which can get you lower payments each period). Pay more faster and it will cost you less in the long run.
What are interest rates? – Mortgage weather forecasting
A fascinating fact about the finance world that I never really understood until I worked in it is how interest rates work. Interest rates are basically like the financial weather. Sometimes they’re high, sometimes they’re low, sometimes they jump around. In fact, in the finance world one regularly talks about the interest rate environment.
This is something you have no control over, but it makes a BIG difference. Interest rates are based on inflation and government bond rates and a whole bunch of other economic things, and all that you can do is go online and figure out what they are right now and try to get one on the low end. The rate you get on your mortgage is based on interest rates, with some extra costs added in. You can see a history of the 30-year mortgage rates at this link, which shows the almost 18% rates in 1982 and the 3.5% rates in 2016.
There is one important thing to remember though:
No one knows what future interest rates will be.
Lots of people have predictions or educated guesses and some of them can even be decent, but no one knows for sure even if they think they do. I spent a lot of time in the finance world hearing people say that interest rates “couldn’t go any lower” (they went lower) or that they “had to go up soon” (they didn’t) or that they “wouldn’t go up again” (they did). Point is, even the real pros don’t know about this. People can have educated guesses and can make them sound very fancy, but no one knows.
Mortgage Choices – Fixed Rate or Adjustable/Floating Rate
- Fixed rate loans cost a bit more, but they mean the bank takes all the risk of interest rates going up.
- Floating/ARM loans can be a bit cheaper but you take all the risk of interest rates going up.
One of the choices you might see with mortgages is Fixed Rate or Floating/Adjustable Rate mortgages (Adjustable Rate Mortgages are abbreviated as ARM, and sometimes called “Arm Loans”).
So what’s the difference? Well remember what the previous section said about interest rates being like the weather? A fixed rate mortgage basically says “I’m going to borrow money in the current weather and lock in my interest rate (rent) for forever.” That means if you borrow for 30 years at 4.5%, you’ll pay 4.5% the entire time, even if the weather gets worse. If interest rates go up the bank doesn’t make as much money but that’s their problem, not yours. The banks often charge a bit more for fixed rate loans because of this, but not a lot more. If interest rates go down you can refinance (see the Refinancing section) but if you don’t refinance you know what your payments will be for the entire loan; they’ll never go up.
A floating or adjustable rate means that your interest rate (rent) changes with the weather. This might seem cheaper than a fixed rate mortgage, but you don’t really know. If you get an ARM loan and interest rates stay down for the entire loan you might save a lot of money! But if you get an ARM loan and interest rates go up, your monthly payment could increase a LOT! For this reason, a fixed-rate mortgage is often preferred for most people.
Refinancing – what if interest rates go down?
What about if interest rates go down? Well, if you have a floating or ARM loan it doesn’t really matter, your payments will go down automatically.
If you have a fixed rate loan though, it’s possible that rates could go down so much that you’d want to refinance. This means you take out a new mortgage at current rates and use it to pay off the old one.
Any time you take out a mortgage though there are fees. The bank has to do paperwork and someone has to file it all so lawyers get involved. For a refinance of a house it’s typical that fees are a few thousand dollars so it’s generally only worth refinancing when the current rates are at least a bit lower than your rate.
There are also a few ways to refinance:
- Refinance to the lowest possible new rate and pay the fees yourself
- Refinance to a rate higher than the lowest current rate available and pay no fees
- Refinance to the lowest possible new rate and add the fees to your principal
If you current rates are lower than your rate, you’d like to convert from an ARM to a Fixed mortgage, or you’d like to refinance for any other reason ask your mortgage agent about these options.
Note: In Europe it is common that you can’t pay a loan off early without paying a penalty. In these cases refinancing often makes much less sense. Thanks to several US agencies however, the 30-year prepayable mortgage is the default, meaning you can pay early without issues generally. This is how refinancing happens since a refinance is really just taking out a new mortgage and using it to pay off the old one.
Terms and phrases – what does all this stuff mean?
Here’s a list of common terms and phrases you might encounter related to a mortgage, and a translation of what they actually mean:
- Principal – The money you borrow in a mortgage.
- Interest rate – The rate used to calculate the interest (rent) you pay to borrow this money, as a percentage of the money borrowed.
- Interest – The actual rent you pay for the money you borrow, as determined by the interest rate.
- Term – How long you borrow the money for (e.g. a 30-year term means you borrow for 30 years).
- Amortization – This is basically the fancy math that calculates what your payment needs to be during the loan. In the US amortization period is generally the same as term; in other words you finish paying off the loan at the same time that you have to pay it off. In business situations or in Europe you sometimes amortize for 30 years while having only a 10 year term, which means you have to refinance every 10 years for the remaining balance (this is called a balloon loan). If you’re in the US, getting a typical loan, and term and amortization are the same, then all you need to know here is that this is the math that works out what your payment ends up being.
- Down Payment – When you get a mortgage the bank generally won’t pay the entire amount for the house. Normally you pay a piece and get a mortgage to cover the rest. The piece you pay is called the down payment. This ensures that you have money invested in the process, which makes the bank believe you’ll actually care about paying the mortgage instead of letting them foreclose.
- Refinance – The process of taking out a new mortgage to pay off and old one, generally to get better rates or change mortgage types. See above section for further details.
- Points – These are options for you to pay extra money now in order to get a lower interest rate (i.e. pay less rent) on the money you borrow. You “buy points” which then reduces your rate (rent).
- Fixed Rate – See above section on mortgage choices.
- Floating Rate – See above section on mortgage choices.
- ARM/Adjustable Rate – See above section on mortgage choices.
- Foreclose – What the bank does to take ownership of the property (e.g. house) if you don’t pay off the loan.
Paying Extra or Prepaying – Why would I want to do that?
In the US you are often given the option to make extra payments towards your loan. This basically means that if your monthly (or bi-weekly) payment is $1,000, you could pay that and then pay more as well.
Why would you do this? When you pay more, you’re paying back some of the principal directly. Each month the interest (rent) on the money you’ve borrowed is based on the principal, and if you pay some extra money now then next month you’ll be borrowing less and so you’ll owe less! The more you prepay the sooner you pay off your loan and the less the loan will have cost you in the end. This means that your total “rent” will have been lower over the whole life of the loan.
Math!? Help! – Calculating, making decisions – Excel Download
There are many good options out there for calculating the details of a mortgage or refinancing. A refinance calculator can be found at LendingTree for example or a basic mortgage calculator can be found at the creatively named mortgagecalculator.org.
As I was helping friends and family however I at one point developed my own tool in Excel which they could used to consider options for both a new loan or a refinance. I’d once considered professionalizing and selling this tool, but in the end have decided simply to make it available for free. If you’d like to use it yourself it is available for download here:
Instructions are included in the file and I personally wrote all code and formulas in it so you can safely enable all code and macros. If you want to see what the “rent” will be for a particular loan, enter your information and look at the Total Paid (Fees & Interest) row, which calculates how much it cost you, in total, to borrow this money.
Have feedback? Questions? I sometimes still help people discuss and understand their personal situations more thoroughly. My contact form has the capacity to attach a file for just this purpose, so if you use the above Excel calculator and have issues or bug reports or if you have questions, comments, or feedback, drop me a line. I’m always happy to learn how I might improve the clarity or completeness of the above information.