The capital amount borrowed, on which interest payments are calculated, is the original loan principal. In an amortizing loan, part of the principal is repaid periodically along with interest, so that the principal balance decreases over the life of the loan. At any point during the life of a mortgage loan, the remaining unpaid principal is called the loan balance, or remaining balance.
The difference between the purchase price of a property and the amount financed by a loan is the amount of cash the buyer must produce at the time of purchase. This amount is the down payment. The cash amount pledged and escrowed at the time of the offer is applied toward the down payment at closing.
Lenders usually lend only a portion of a property’s value as a protection against loss. The relationship of the loan amount to the property value, expressed as a percentage, is called the loan-to-value ratio, or LTV. If the lender’s loan to value ratio is 80%, the lender will lend only $80,000 per $100,000 of a home’s appraised value.
Interest is a charge for the use of the lender’s money. Interest may be paid in advance at the beginning of the payment period, or in arrears at the end of the payment period, according to the terms of the note. Mortgage interest is most commonly paid in arrears. The interest rate is a percentage applied to the principal to determine the amount of interest due. The rate may be fixed for the term of the loan, or it may be variable, according to the terms of the note. A loan with a fixed interest rate is called a fixed-rate loan; a loan with a variable interest rate is commonly called an adjustable rate loan.
Because the interest rate on a mortgage loan does not reflect the full cost of the loan to the borrower, federal law requires a lender on a residential property to compute and disclose an Annual Percentage Rate (APR) that includes other finance charges in addition to the basic interest rate in the calculation.
Loan servicing involves the collecting and keeping records of loan payments and providing documentation of the loan to the borrower. The originating lender may provide the servicing and charge a percentage of the loan amount for the service, or it may pass the responsibility to another lender or financial services entity.
Mortgage lenders usually require borrowers to pay for property tax and hazard insurance in monthly instalments of 1/12 of the annual amount. These periodic payments are held in a reserve fund called the escrow account and paid out to the appropriate party as due . The Real Estate Settlement Procedures Act (RESPA) limits the amount of funds that the lender can require and hold for this purpose.
The borrower’s monthly payment to the lender for principal and interest is called the P&I payment (principal and interest). The amount which also includes the escrow payment is called PITI (principal, interest, taxes, insurance).
From the point of view of a lender or investor, the amount loaned in a mortgage loan is the lender’s capital investment, and the interest paid by the borrower is the return earned by the invested capital. It is often the case that a lender needs to earn a greater return than the interest rate alone provides. For example, a lender may require additional yield on a low-interest VA loan which has an interest rate maximum. In such a case, the lender charges up-front discount points to make up the difference between the interest rate on the loan and the required return. This effectively raises the yield of the loan to the lender.
A discount point is one percent of the loan amount. Thus, one point on a $100,000 loan equals $1,000. The lender charges this as pre-paid interest at closing by funding only the face amount of the loan minus the discount points. The borrower, however, must repay the full loan amount, along with interest calculated on the full amount.
The value of one discount point to a lender is usually estimated to be equivalent to raising the interest rate on the loan by 1/8%. Thus, a lender has to charge eight points to raise the yield by 1%. If a lender needs to earn 7% on a loan offered at 6.5%, the number of points necessary would be figured as follows:
7.0% – 6.5% = .5%
.5% x 8 (points per 1%) = 4 points
On a loan of $100,000, the 4 points would cost the borrower:
100,000 x .04 = $4,000.
The borrower would effectively receive from the lender $96,000, and owe principal and interest based on $100,000. For tax reasons, it is usually advisable for the borrower to receive the full loan amount from the lender and pay the points in a check which is separate from that used for other closing costs. As pre-paid interest, points paid in this way may be deductible on the borrower’s income tax return for the year of the purchase. The borrower should seek the advice of a tax consultant concerning this matter.
Lenders often charge borrowers a loan origination fee to cover costs of processing the loan application and obtaining supporting information such as credit reports. The fee is most often in the range of 1-2% of the loan amount.
A take-out commitment offers to make a loan that will “take out” another lender’s loan, i.e., pay it off and replace it. The take-out loan is most often used to retire a construction loan. The take-out lender agrees to pay off the short-term construction loan by issuing a long-term permanent loan.
The loan term is the period of time over which the loan must be repaid. A “30-year loan” is a loan whose balance must be fully paid off at the end of thirty years. A “five-year balloon loan” is a loan whose balance must be paid off at the end of five years, although its payments may be calculated on a term of another length, such as fifteen or thirty years. Such a loan is also sometimes described as a 30-year loan with a five-year “call.”
The loan term, loan amount, and interest rate combine to determine the periodic payment amount. When these three quantities are known, it is possible to identify the periodic payment from a mortgage table or with a financial calculator. Mortgage payments are usually made on a monthly basis. On an amortizing loan, a portion of the payment goes to repay the loan balance in advance, and a portion goes to payment of interest in arrears.
For example, Mary and Jerry King borrow $400,000 to finance the purchase of a home. The loan has a term of thirty years at an interest rate of 5% and is amortizing. The monthly payment for this loan will be $2,147. For the first payment at the end of the month, the Kings owe interest on $400,000 for the monthly period. At 5%, this amounts to $1,666.67. Since their payment is $2,147 and the interest charge is $1,666.67, the difference, which is $480.33, is applied to an advance payment of principal. The following month, the Kings will pay interest on the new, smaller loan balance of $399,519.67 ($400,000.00 – 480.33).
If a borrower pays more than the scheduled payment amount, the excess is credited to repayment of the principal, which is reduced by the amount of the excess payment. The required minimum payment amount remains constant for the life of the loan, but the loan term can be reduced by this means, thereby also reducing the total amount of interest paid over the life of the loan.
Assignment of mortgages
The holder of rights and interests in a property can usually transfer them to another by contract. This right of assignment generally holds true of mortgages. The assignee takes on primary liability and the assignor remains secondarily liable for any contractual duties unless a novation agreement relieves the assignor of responsibility.
In the case of a mortgaged property, The mortgage instrument and the promissory note are transferred by means of an assignment of mortgage, but it is the assignment of the promissory note that actually conveys to the assignee the rights to the mortgaged property. The original mortgagor now must make loan payments to the assignee.
Estoppel. The assignor of the mortgage provides to the party who purchases the assigned mortgage a certificate of estoppel that states the loan balance, the rate of interest, and the most recent date of payment to ensure that no contrary claims about these factors can be made later.