Understanding the Mathematics of Personal Finance

Mortgages

The common use of the term mortgage today is that a mortgage is simply a loan you take when you buy a house. If I could leave it like that, this paragraph would be the entire chapter. After all, Chapter 3 discussed paying off loans, so what more is there to say?

Let’s start by clearing up the definitions a bit. A mortgage is a common way of securing a loan with real property that you own. For most of us, real property simply means our house and the lot it sits on or our condominium. Typically, we take a loan to help pay for the house we are buying, and we secure the loan with a mortgage on the house. The terminology varies somewhat from state to state in the United States, but the idea is the same everywhere; you are pledging a property that you own as a security on your loan. The property is worth more than the amount of money you want to borrow, so that your lender doesn’t have to worry about getting his or her money back.

Another common term is s econd mortgage. If you already have a loan for a part of the value of your house that is secured by a mortgage, and then you take a second loan that you secure with some of the remaining value of the house (some of your equity in your house), this is commonly known as a second mortgage.

Sometimes you’ll take a home equity loan. A home equity loan is a loan that’s secured with equity in your house, so it’s very similar to a second mortgage. What’s different is that a home equity loan often comes in the form of a checkbook that you can write checks on up to some predetermined limit. When you write a check on this account, you are actually borrowing some money, using a presigned contract for the terms of the loan. As you write checks and make payments, the balance of this loan goes up and down with the lender tracking everything and charging interest each month on the current balance.

Going back to mortgages, we don’t have to stop at a second mortgage; there can be a third mortgage and so on. Unless you have significant real estate holdings such as an office building that’s worth many millions of dollars, you might find that banks get a little nervous with something like the eighth mortgage holder, but concep­tually, you can keep going as long as there’s equity in your property. Lenders will

Understanding the Mathematics of Personal Finance: An Introduction to Financial Literacy, by

Lawrence N. Dworsky

Copyright © 2009 John Wiley & Sons, Inc.

usually appraise the property and put a limit on how much they will loan, for example, up to 80% of the value of the property. This is because real estate values can change, and also, there are costs involved in a lender seizing a property if the borrower defaults on the loan.

In late 2008, real estate values dropped so drastically that many borrowers found that they owed more than their houses were worth. What happens in this unfortunate situation is not within the scope of this book. There are only two facts about this situation that I’m sure of: Neither borrowers nor lenders ever want to find themselves in this mess, and if it does happen, everybody is certain that somebody else’s poor planning is at fault.

The bottom line is that what makes a mortgage a special kind of loan is that the lender has his or her money secured by your real property. For the typical borrower who is not planning to default on the loan, this is advantageous—a loan that gives the lender a superior, secured position over other existing secured creditors to the extent of repossessing the real estate is typically made available at lower interest rates than higher risk loans.