Mortgage Basics You Should Know Before Borrowing
A mortgage is a written real estate document between a mortgagor and a mortgagee. The mortgagor is the borrower or home buyer. The mortgagee is the lender, the entity lending money to the buyer. The mortgage uses the real estate as collateral for the loan. If you go to Bank of America to get a mortgage, for example, you are the borrower and Bank of America is the lender.
If a borrower misses a few payments, the lender reserves the right to seize the loan's collateral in a process called foreclosure. Each state has its own laws that establish how long a lender must wait before taking the home away from the borrower.
Borrowing and Lending Basics
Generally, as long as the borrower makes payments on time, the mortgage balance is reduced and the borrower gains equity in the home, meaning they own an increasing portion of it. The lender also gains additional security for the loan as equity grows.
When home values fall, a lender's security is often diminished. If the security value falls below that of the mortgage balance, a borrower might need to sell as a short sale—one that pays the lender less than it is due after all costs of the sale are factored in—in order to eliminate the debt.
Many lenders sell their conventional loans in the secondary market, which consists of other lenders, companies that package mortgages into securities, and investors. In the event a mortgage or the right to service it is sold to another lender, the borrower will have to start making mortgage payments to the new lender. The original lender can sell a mortgage without the borrower's permission.
Buying vs. Renting
The simple act of financing a real estate purchase does not make buying a home with a mortgage riskier. Home buyers run into trouble when they overextend themselves. For example, if it takes two income earners to pay a mortgage and one person loses a job, your home could be at risk. However, you could say the same thing about renting a home: You might need two incomes to cover your rent, too, and may get kicked out by the property owner if you fall behind on your rent payments.
A mortgage frees up capital and gives you financial leverage—the ability to use borrowed money to purchase something you didn't have enough cash to buy. If your mortgage payment is close to the amount you would pay in rent, then you are probably coming out ahead.
That's because mortgage interest is deductible from your federal income taxes on loans up to $750,000. Plus, paying down a mortgage builds equity for you; renters never own a part of their property, no matter how much money they pay.
Mortgage vs. Deed of Trust
You may hear the term deed of trust or maybe trust deed being used interchangeably with the term mortgage, but they are different. A financing instrument used by a major banking institution for real estate is generally one of these two things:
- A mortgage
- A promissory note secured by a deed of trust
Whereas a mortgage contains a mortgagor and a mortgagee, a trust deed contains three parties: a trustor, a trustee, and a beneficiary. The trustor is the borrower/home buyer. The beneficiary is the lender, the entity providing the money. The trustee is a third party—either a person or company mutually agreed upon by the trustor and the trustee—with power of sale.
Many states that use a mortgage as a financing instrument follow laws that make foreclosures a much longer process than states that use a trust deed. Foreclosing upon a mortgage can often take a year or longer. A trust deed foreclosure that utilizes a trustee's power of sale can be finalized in fewer than four months after a notice of default—a public notice that the borrower is behind on payments, or in default—is recorded.
Establishing Credit With a Credit Card
You generally need established credit to get a mortgage to buy a home. This means you should have at least one credit card in your name.
While it isn't impossible to obtain a mortgage without established credit, it is difficult. You will probably pay a higher interest rate because no credit means no FICO score, a measure banks use to estimate how likely you are to default on your mortgage. So if you don't already have one, obtain a credit card. You can pay the balance in full every month and avoid finance charges while you build credit.