Mortgage

Definition

A mortgage is a loan used to finance the purchase of real estate, where the property serves as collateral for the loan. It is a long-term financial agreement between a borrower and a lender, typically a bank or a mortgage company, that allows the borrower to acquire a property by making periodic payments over an extended period of time.

5 Must Know Facts For Your Next Test

1. The stated mortgage rate is the interest rate quoted by the lender, while the effective mortgage rate takes into account additional fees and costs associated with the loan.
2. The monthly mortgage payment is calculated using a financial calculator or spreadsheet, taking into account the loan amount, interest rate, and loan term.
3. The Equal Payment method, where the monthly payment remains the same throughout the life of the loan, is a common way to structure mortgage payments.
4. The Effective Annual Rate (EAR) of a mortgage is the true annual interest rate that considers the compounding effect of the stated interest rate and any associated fees.
5. Mortgage payments are typically made up of principal, interest, taxes, and insurance (PITI), with the interest portion being tax-deductible for many borrowers.

Review Questions

• Explain the difference between the stated mortgage rate and the effective mortgage rate, and how this difference can impact the overall cost of the loan.
  • The stated mortgage rate is the interest rate quoted by the lender, while the effective mortgage rate takes into account additional fees and costs associated with the loan, such as origination fees, points, and other closing costs. The effective mortgage rate is the true annual interest rate that the borrower will pay, and it can be higher than the stated rate due to these additional charges. Understanding the difference between the stated and effective rates is important because it can significantly impact the overall cost of the mortgage loan over the life of the loan.
• Describe the process of calculating the monthly mortgage payment using a financial calculator or Excel, and explain how the loan amount, interest rate, and loan term affect the payment amount.
  • To calculate the monthly mortgage payment, you can use a financial calculator or a spreadsheet like Excel. The formula used is: Monthly Payment = [Loan Amount × (c/n)] / [1 - (1 + c/n)^(-n)], where c is the annual interest rate, and n is the number of payments per year (typically 12 for monthly payments). The loan amount, interest rate, and loan term all have a direct impact on the monthly payment. A higher loan amount or interest rate will result in a higher monthly payment, while a longer loan term will lower the monthly payment but increase the total interest paid over the life of the loan.
• Discuss how the Equal Payment method, where the monthly payment remains the same throughout the loan, affects the distribution of the principal and interest components of the payment over time, and how this can impact the overall cost of the mortgage.
  • In the Equal Payment method, the monthly mortgage payment remains the same throughout the life of the loan, but the distribution between the principal and interest components changes over time. Early in the loan, a larger portion of the payment goes towards interest, while later in the loan, a larger portion goes towards the principal. This means that the borrower pays more in total interest over the life of the loan compared to a payment structure where the principal and interest components are more evenly distributed. However, the Equal Payment method provides the borrower with a predictable and consistent monthly payment, which can be beneficial for budgeting and financial planning purposes.

Related terms

Amortization: The process of paying off a loan, such as a mortgage, through regular, scheduled payments that cover both the principal and interest over the life of the loan.

Loan-to-Value (LTV) Ratio: The ratio of the mortgage loan amount to the value of the property, which is used to determine the risk associated with the loan and the required down payment.

Mortgage Interest Rate: The interest rate charged on a mortgage loan, which can be fixed or variable, and affects the monthly payments and the overall cost of the loan.