What is a Mortgage?
Question: What is a Mortgage?
A reader writes: "We are newly married and thinking about a mortgage for buying a home. Obviously, we are too young to pay cash, and we have a small savings account, by conservative measures. But my mom says it's enough to buy a house if we can get a mortgage. I've always felt that we should pay cash for a home and not try to leverage our finances. After all, we don't have any credit cards because we don't believe in debt. We believe if we can't pay cash for it, then we don't need it. But a home is little bit different. Can you please explain to us why we need a mortgage and what is a mortgage?"
Answer: Congratulations on your recent marriage. I love to see young couples starting out in life by talking about finances. It's more romantic than any love song; it's sweet music to my ears. But let me say that you are never too young to pay cash, although you might find you can borrow money more cheaply than the immediate yield on the cash. You are never too young to get a mortgage and buy a home, either. Real estate for the long term is a wonderful investment and we all need a roof over our heads.
Definition of a Mortgage
A mortgage is a written document that contains a mortgagor and a mortgagee. The mortgagor is the borrower, typically, YOU, the home buyer. The mortgagee is the lender, the entity lending money to the buyer. The mortgage uses real estate as collateral for the loan. If you go to Bank of America to get a mortgage, you are the borrower and Bank of America is the lender.
If a borrower, for example, misses a few payments, the lender reserves the right to seize the loan's collateral: the home. This is how a foreclosure generally happens. Each state has its own laws that define the time period for a foreclosure, and how long a lender must wait before taking the home away from the borrower.
As long as the borrower makes payments on time, generally the mortgage balance is reduced and the borrower gains equity. 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 in order to eliminate the debt. Many lenders sell their conventional loans in the secondary market, and then borrowers will make payments to a different lender.
They can do this without a borrower's permission.
Why is a Mortgage a Good Thing?
The simple act of financing a real estate purchase does not make buying a home with a mortgage more risky. Home buyers run into trouble when they over extend. For example, if it takes 2 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 vs. buying a home. If you can't pay rent, you can't pay a mortgage, either.
A mortgage frees up capital and gives you leverage. Leverage gives you control over an asset without paying cash for it. If your mortgage payment is close to the amount you would pay in rent, then you are probably coming out ahead. The reason you have an advantage is because you are paying interest on the mortgage, and that mortgage interest is tax deductible. Plus, unlike rent, paying down a mortgage builds equity for you.
Two Basic Types of a Mortgage
You may hear the term deed of trust or maybe trust deed used interchangeably with the term mortgage, but they are different. A financing instrument used by a major banking institution is generally one of two:
- a mortgage
- a promissory note secured by a deed of trust
Whereas a mortgage contains a mortgagor and a mortgagee, a trust deed contains 3 parties. Those parties are 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 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 4 months after a Notice of Default is recorded.
If you are worried about losing possession or being forced to move out of your home in the event of foreclosure, you might prefer a state that uses mortgages instead of a trust deed. However, if you are worried about foreclosure, then you might not be a good candidate to buy a home.
In closing, let me say that 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. I realize you prefer to pay cash, which is why you do not have any credit cards, but having no credit cards, believe it or not, makes you a poor credit risk in the eyes of a lender.
While it is not 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. So, do yourself a favor and obtain a credit card. You can pay the balance in full every month and avoid a finance charge while you build credit.
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.