Home Loan

What It Means

A home is usually the single most expensive purchase that a person will ever make. Few people, however, have enough money to pay for a home in its entirety up-front. Instead, most choose to take out a home loan, which is also called a mortgage. This entails borrowing money from a financial institution (such as a bank) to buy the house and then spreading out the repayment of the loan over a long period of time. That period is often 30 years. The lender also charges the borrower a fee called interest, which is a certain percentage of the amount of the loan.

A borrower repays a home loan on a monthly basis. Usually the payment is the same amount each month for the life of the loan. The amount of the payment is determined by several factors: the amount of the loan, the term (time span) of the loan, and the annual percentage rate (APR; the percentage charged by the lender each year on the amount of the loan).

For example, imagine you need to borrow $160,000 to buy a house, and you want to pay back the loan over 30 years (which would be 360 monthly payments). For that service the bank would charge you a fee—for example, 8 percent each year on the amount of the loan. In order to pay off both the original loan amount plus the 8 percent annual fee, you would need to make 360 payments of $1,174.02. This process of gradually paying back a loan over a long period of time is called amortization.

When Did It Begin

It was not until the creation of the Federal Housing Administration (FHA) in 1934 that long-term loans became widely used as a means of purchasing homes in the United States. Prior to the creation of the FHA, most loans had short terms of one to three years and only covered 30 to 50 percent of the price of the property. This was in part because few individual investors or small local banks could afford to loan such large sums of money for very long; the risk of it not being paid back was too great. People usually refinanced (took out new loans for) their homes every few years, which put them at risk of not finding a new loan to replace the old and therefore losing ownership of the house.

The FHA offered a mortgage-insurance system backed by the Federal Reserve, the central bank of the United States. This system made home loans less risky for lenders because the loans were backed up with money held by the federal government; if a borrower defaulted on (failed to pay back) one of these insured mortgages, the lender would still be repaid. As a result, banks started to offer longer-term loans for a much larger portion of the purchase price. Soon 30-year loans for 80 percent of the purchase price became commonplace, allowing more people than ever before to afford to buy their own homes.

More Detailed Information

A home loan is usually obtained from a bank but can be received from any institution willing to loan the money. Lenders normally require an initial payment from the borrower, typically 20 percent of the purchase price of the house; this is called a down payment. If the house is selling for $200,000, for example, the borrower must make a down payment of $40,000 and can then take out a $160,000 loan to cover the rest. Lenders require a down payment as a way to ensure that they can recover the money they have loaned in case the borrower defaults on it (that is, fails to repay it). In the case of default, the lender has the right to repossess the property and sell it to pay off the loan. The process of a lender taking possession of a property as a result of a defaulted loan is called foreclosure.

Lenders evaluate potential borrowers to make sure they are reliable enough to pay back the loan. Among the factors they review are the borrower’s income and ability to make the down payment. The U.S. government provides various forms of assistance to people who would not normally qualify for home loans. For instance, the Federal Housing Administration insures loans for low-income citizens in order to encourage banks to lend to them. It also runs programs that offer grants (money that does not have to be repaid) to cover down payments. One such program is the American Dream Down Payment Initiative. The Department of Veterans Affairs provides similar assistance for people who have served in the U.S. military.

The calculation banks use to determine monthly loan payments is complicated and often not understood by borrowers. Banks charge an annual percentage rate (APR) on the loan amount, or principal, in order to be compensated for the service of lending money (as well as to pay for their own expenses, such as hiring employees and maintaining buildings). Although the interest rate is quoted as an annual rate, in actuality the interest on a home loan is usually charged monthly. For example, if the APR were 8 percent, the monthly interest rate would be 0.6667 percent (8 percent divided by 12 months). The interest also compounds monthly, meaning that each month the interest fee is added to the original loan amount, and this sum is used as the basis for the next month’s interest. The borrower ends up paying interest on the accumulated interest as well as on the original loan amount.

To understand how this works, imagine that you had to pay an 8 percent annual fee on $100. The first month you would pay an interest fee of roughly 0.6667 percent of $100, or a little more than 66 cents, raising the total amount due to just over $100.66. The second month you would pay 0.6667 percent on the new loan amount ($100.66), or 67 cents, bringing the total due to almost $101.34. After 12 months of applying a compounding monthly interest rate of 0.6667, the total amount owed would be $108.30, or 8 percent more than the original loan amount plus 30 cents, the amount of interest that accumulated through compounding.

Mortgage payments are even more complicated because two things happen each month: in the example of an 8 percent APR, a fee of 0.6667 percent is charged to the total amount of the loan, but the total amount of the loan is reduced because the borrower has made a payment. Because the payment by the borrower is more than the fee of the monthly interest rate, the total amount owed gradually goes down.

This method of calculation requires that borrowers pay more in interest each month at the beginning of the loan than at the end. This can be seen in the example of a $160,000 loan paid over a 30-year period with an APR of 8 percent. After the first month of the loan, the bank charges a monthly interest rate of 0.6667 percent (really two-thirds of a percent, which would be a 0 with an infinite number of 6s after the decimal point, but it is rounded up at the fourth decimal point) on the $160,000 loan amount, for a fee of $1,066.67. At the same time, the borrower sends the bank a mortgage payment of $1,174.02; of this amount, $1,066.67 goes toward paying off the interest charge, and the remainder, $107.35, is subtracted from the $160,000 loan, bring the total amount due down to $159,892.65. The next month the bank charges the same monthly interest rate of 0.6667 on this new amount, $159,892.65, resulting in an interest charge of $1,065.95, just slightly less than the month before. When the borrower sends in his $1,174.02 payment, $1,065.95 goes toward paying off the new interest charge and the rest, $108.07, is subtracted from the loan amount ($159,892.65 − $108.07), with the resulting total amount due being $159,784.58.

Over the course of 30 years, three things happen: the total amount due on the loan gradually goes down; the interest charge also slowly reduces (because it is a fixed percent, 0.6667, of a gradually reducing loan amount); and an increasing amount of the payment begins to go to the loan amount, not the interest (because the interest charge gradually goes down while the borrower’s payment, $1,174.02, remains the same). After 270 months, or three-fourths of the way through the loan, $532.72 of the monthly payment goes toward interest and $641.30 is subtracted from the loan amount. By the end of the loan, the borrower would have paid $160,000 in principal and $262,652.18 in interest.

Purchasing a home involves paying what are called “closing costs” to cover the various transactions that must occur. Fees are charged by the broker or agent who arranges the home loan, the people who inspect the property to make sure it is sound, the title insurance company (which researches the legal ownership of the property to make sure the seller is really the owner and insures that the transfer of ownership goes smoothly). Additionally, there are various local and state taxes and fees to be paid, and there may be a partial payment due at the time of the mortgage’s inception. These charges are usually paid by the buyer at the very end of the lending process (hence the term closing costs).

In order to protect themselves and the home buyer from financial loss, lenders require that the property be covered by a homeowner’s insurance policy that insures the property against loss from fire (and in certain cases flood or earthquake) damage. To guarantee that the borrower makes his or her insurance payments, mortgage lenders set up what is called an escrow account and require that the borrower deposit a monthly payment into it to cover the cost of the insurance. When the annual insurance bill comes due, the mortgage company uses the money in the escrow account to pay it on behalf of the borrower.

Additionally, most real estate is subject to property tax, which is used to fund public schools and other local government programs. Because a failure to pay these taxes can lead to the seizure and sale of the property, the lender wants to make sure that these taxes are paid and hence requires the buyer to pay another monthly amount into the escrow account.

Despite the large amount of interest paid, there are many benefits to having a home loan. They allow people to buy homes that they would otherwise be unable to afford. In addition, once someone has a fixed-rate mortgage, the monthly payment never goes up. Rents, however, almost always rise over time. A homeowner also builds up equity in the house over the years. Equity is the difference between the current value of the property and the loans against it. In the above example of the $200,000 house, the owner immediately has $40,000 in equity because of the down payment; as the owner gradually pays back the loan, his or her equity increases. Furthermore, it is likely that 10 years later the house itself will have increased in value. If the house is, for example, worth $260,000 by then, the owner will have gained an additional $60,000 in equity. An owner can turn the equity in a house into cash by selling the house and pocketing the profits, possibly with the intention of buying another house, taking a long vacation, or having extra money for retirement. Finally, interest is usually deducted from a person’s taxable income, meaning that person will owe less in taxes.

Recent Trends

For many decades the only type of mortgage an average person could get was a fixed-rate 15- or 30-year loan. In the late 1970s interest rates in the United States rose sharply. Because the interest rate for a home loan has a direct impact on the size of the mortgage payment (higher interest rates mean higher monthly payments), fewer people could afford to buy homes or qualify for mortgages. This situation was made more difficult by a high rate of inflation (the general rising of prices), which lowered the value of any money that people had saved up. In order to encourage borrowing, lenders responded by offering new types of mortgages with lower monthly payments or artificially low interest rates. Among these were adjustable-rate mortgages whose interest rate (and therefore whose monthly payments) changed over time and interest-only mortgages whose monthly payments included only the interest on the loan and no repayment of principal.

Over time these new types of home loans contributed to a surge in lending and a nationwide increase in housing prices beginning in the late 1990s. This trend helped stimulate economic growth by generating income for those who invested in existing properties and for those involved in building new ones. The banking industry got a boost from people taking out second or third mortgages on their homes in order to take advantage of historically low interest rates. Some economists speculated that these loans put the national economy at risk because a downturn in housing prices or an increase in interest rates would leave many people with loans they could suddenly no longer afford to repay, which could lead to a large increase in the number of foreclosures across the country.