What is real estate security when applying for a mortgage? Your new home is the security or collateral for the loan you are taking out to buy the house. You should take the time to learn how the bank will use your new house to secure the loan.
- Mortgages use amortization instead of compounding, so you have fixed payments
- Your real estate secures low fixed interest and long terms
The benefits are that you get low fixed rates and long terms. The disadvantages are that you can lose your house because of its collateral, and you as much or more interest than the principal amount over the life of the loan.
Mortgages and Amortization
The word mortgage is an old French term that means death pledge, and if you’ve ever had problems with your bank you can certainly appreciate the irony of the term. However, bankers originally used the term to mean that if the borrower pays off the loan, then the debt is dead. On the other hand, if the borrower defaults then his/her rights to the property are also dead.
These loans are special for a few reasons. Land ownership is fundamentally different from other kinds of possessions that can be transported, manufactured, or destroyed. Therefore, the land is a unique asset because of its permanence. Further, the land is usually by far the biggest purchase most Americans will ever make. Finally, the length of the contract (usually 30 years, but can be shorter) is longer than other financial agreements.
Mortgages, therefore, are unique debt obligations that require a mechanism that allows the borrower to make reasonable and consistent monthly payments over a long time period. That mechanism is called amortization.
What is a Mortgage?
You may think that people bought houses for a long time with mortgages, but these types of loans are a 20th-century development. Before the 1930s people paid cash or used personal loans to buy real estate. Often, generations of families lived in the same home while children saved to buy a house or simply lived their whole lives in the houses, they grew up in. There certainly wasn’t the movement that we have today.
Around 1930 that all changed with the introduction of the mortgage. These offered a practical way to finance the purchase of a home. However, these early mortgages were still not very practical for most people because they required a 50% down payment. Also, the terms were five to seven years. Finally, these usually only covered the interest payments and required a balloon payment at the end to pay the actual price of the property.
The Federal Housing Authority (FHA) was created in 1934 and introduced the 30-year fixed-rate mortgage that we are familiar with today. It is self-amortizing because the fixed rate and term make it possible to determine a consistent monthly payment that pays off the interest and principal at the same time. So, people can take out a very large loan for a house and make a manageable monthly payment over a long period; but how does amortization work to make this possible?1
What is Amortization?
Amortization is the mechanism that makes a mortgage work. It sets a fixed time period and interest rate in order to provide a consistent, affordable monthly payment for the borrower. It has two components, simple interest and the annual percentage rate (APR). Simple interest does not compound over time. Banks are not allowed to carry over unpaid interest add it to the next month’s remaining principal. Therefore, the bank can never add to the original principal. They add on additional fees and costs associated with the loan, and this determines the APR, which you pay each month.
In order to achieve a fixed monthly payment amortization structures first apply interest and then principal charges. So, in the beginning, almost all your payment goes toward interest and very little to the principal. As it matures you pay more principal and less interest until late in the period when almost all your payment applies to principal.2
How does a mortgage work?
Mortgages are special kinds of loans where a creditor lends money to a real estate buyer in exchange for the title of the property. These loans have the condition that conveyance of the title becomes void when the buyer repays the debt. In other words, your bank has a claim to the title of your house until you pay off the loan.
They work because they are amortized, like we explained earlier, and not compounded like credit cards or other types of debt. The benefit is that you can make a large, secured loan with an affordable payment. The drawback is that even with a very low-interest loan you pay almost as much interest as you the principal. Also, if your rate is very high you end up paying more interest than principal.
Why Use Real Estate as Security When Applying for a Mortgage?
We can easily see why this is a good deal for a home buyer. The borrower gets a low-interest rate over the long term so he/she can make a large purchase. But why will banks make these deals? They do it because it’s very secure. You can’t destroy or move land. You can destroy the house, but banks require you to have insurance in order to close the transaction.
With unsecured loans, like credit cards, the bank can’t seize any underlying asset if you default. They must charge high-interest rates and compound the interest in order to make up for unrecoverable losses due to nonperforming loans.
That is not the case with a home loan. Your debt is secured by your property. If you can’t pay your balance, then the bank can foreclose and seize your house. This security means that you can pay much lower interest for an extended period with consistent payments. It also means that you can lose your home if you don’t keep up with your monthly payment.
Final thoughts on Real Estate Security When Applying for a Mortgage
Now that you know why banks use real estate as security there is a way to use the structure to your advantage. Remember that early payments almost all go toward interest and very little toward principal. If you pay more toward the principal, the bank must accept it and recalculate your term. They cannot deny it or charge a prepayment fee.
You can add any amount to your monthly payment and designate it toward the principal. Even as little as $20 or $50 each month can make a big difference in how much interest you pay over the life of the loan. Also, it will reduce the term as well. So, you can knock years off your term by paying a little more each month. However, only do this at the beginning of the loan, within the first five years, because this strategy loses its value further into the term.