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Understanding Mortgages - Guide To the Basics

Home ownership is the biggest creator of wealth in America and has been widely credited with the upward movement of the middle class. As such, mortgages are a vital element of personal finance.

On one hand, mortgages are incredibly simple. They are simply the loan that is used to purchase real estate.

On the other hand, mortgages can be incredibly complex. There are numerous variations. Some mortgage types include fixed mortgages, adjustable mortgages, or ARMs. There are also interest-only mortgages. With these home loans, the borrower only pays the interest each month and does not make any payments toward principal. Then there are negative amortization loans in which the borrower's payment amount is lower than the monthly interest. In this case, the balance of the loan actually increases instead of decreasing or staying the same.

Each of those types of mortgages come in varying lengths such as a traditional 30-year fixed mortgage, a 5-1 ARM in which the interest rate is fixed for 5 years and then becomes an adjustable mortgage after that.

Prime and Sub-Prime Mortgages

There has been a lot of talk in the news about sub-prime mortgages. While ominous sounding, sub-prime mortgages are neither inherently bad, nor doomed to being failed financial instruments.

A sub-prime mortgage is simply one in which either the terms of the loan were more lienent than they are with a prime mortgage, or the criteria used to determine the creditworthiness of the borrowers were relaxed. The most common example of the first, is a mortgage with a smaller than normal downpayment, or zero downpayment. The most common example of the second is a loan made to someone with a lower credit score than normally would be made.

Typically, in order for the lender to take on the additional risk of a sub-prime mortgage, the borrower will pay a higher interest rate than they would otherwise pay if they were to qualify for and recieve a prime mortgage.

Sub-Prime Mortgage Mess Trouble and the News

Especially when it comes to finance, the media seems to have a habit of both under-explaining what it is reporting, and overstating exactly what it is they are talking about. The case of sub-prime mortgages and the subsequent banking crisis of 2008 are no exception.

There is nothing wrong with sub-prime mortgages per se. In fact, a sub-prime mortgage may be the only way for younger borrowers to qualify for a mortgage at all. Additionally, sub-prime mortgages allow for home buyers to not have to come up with a full 20% down payment in order to purchase a property. In exchange, the bank recieves a higher interest rate.

Done properly, this is a win-win situation.

The borrower gets to buy a house they would otherwise be unable to qualify for a mortgage on, and the lender recieves extra income in the form of higher interest payments. If the lender is responsible and competent, the amount of extra income generated by the sub-prime mortgages will make up for the additional losses that such loans are expected to have.

Furthermore, many borrowers take on such loans and their higher costs expecting that they will be able to refinance their mortgage to a more favorable loan at a later date.

However, an irresponsible lender will allow the sub-prime part of their lending portfolio to grow too large. This sets up the bank for failure should there be any downward movement in the economy or real estate market. This is what happened in the run up to the culmination of the banking crisis in 2008.

Banks that overextended credit in order to generate higher revenues were hit with big losses when the real estate bubble popped. Without a solid prime mortgage portfolio to act as a cushion, these banks went under and were seized by regulators.

Ironically, the vast majority of borrowers, both sub-prime and prime, will eventually pay off their mortgages including all interest. Thus, banks that extended sub-prime credit responsibly will still make a long-term profit on their portfolio of sub-prime mortgages.