PURCHASE MORTGAGE

Mortgage loan types

There are many types of mortgages used worldwide, but several factors broadly define the characteristics of the
mortgage. All of these may be subject to local regulation and legal requirements.

Interest:

interest may be fixed for the life of the loan or variable, and change at certain pre-defined periods; the
interest rate can also, of course, be higher or lower.

Term:

mortgage loans generally have a maximum term, that is, the number of years after which an amortizing
loan will be repaid. Some mortgage loans may have no amortization, or require full repayment of any
remaining balance at a certain date, or even negative amortization.

Payment amount and frequency:

the amount paid per period and the frequency of payments; in some cases, the
amount paid per period may change or the borrower may have the option to increase or decrease the amount
paid.

Prepayment:

some types of mortgages may limit or restrict prepayment of all or a portion of the loan, or require
payment of a penalty to the lender for prepayment.
The two basic types of amortized loans are the fixed rate mortgage (FRM) and adjustable rate mortgage (ARM) (also
known as a floating rate or variable rate mortgage). In many countries, floating rate mortgages are the norm and will
simply be referred to as mortgages; in the United States, fixed rate mortgages are typically considered "standard."
Combinations of fixed and floating rate are also common, whereby a mortgage loan will have a fixed rate for some
period, and vary after the end of that period.
Historical U.S. Prime Rates
In a fixed rate mortgage, the interest rate, and hence periodic payment, remains fixed for the life (or term) of the loan.
In the U.S., the term is usually up to 30 years (15 and 30 being the most common), although longer terms may be
offered in certain circumstances. For a fixed rate mortgage, payments for principal and interest should not change over
the life of the loan, although ancillary costs (such as property taxes and insurance) can and do change.
In an adjustable rate mortgage, the interest rate is generally fixed for a period of time, after which it will periodically
(for example, annually or monthly) adjust up or down to some market index. Common indices in the U.S. include the
Prime Rate, the London Interbank Offered Rate (LIBOR), and the Treasury Index ("T-Bill"); other indices are in use
but are less popular.
Adjustable rates transfer part of the interest rate risk from the lender to the borrower, and thus are widely used where
fixed rate funding is difficult to obtain or prohibitively expensive. Since the risk is transferred to the borrower, the
initial interest rate may be from 0.5% to 2% lower than the average 30-year fixed rate; the size of the price differential
will be related to debt market conditions, including the yield curve.
Additionally, lenders in many markets rely on credit reports and credit scores derived from them. The higher the score,
the more creditworthy the borrower is assumed to be. Favorable interest rates are offered to buyers with high scores.
Lower scores indicate higher risk for the lender, and higher rates will generally be charged to reflect the (expected)
higher default rates.
A partial amortization or balloon loan is one where the amount of monthly payments due are calculated (amortized)
over a certain term, but the outstanding principal balance is due at some point short of that term. This payment is
sometimes referred to as a "balloon payment" or bullet payment. The interest rate for a balloon loan can be either fixed
or floating. The most common way of describing a balloon loan uses the terminology X due in Y, where X is the
number of years over which the loan is amortized, and Y is the year in which the principal balance is due.
Loan to value and downpayments
Upon making a mortgage loan for purchase of a property, lenders usually require that the borrower make a
downpayment, that is, contribute a portion of the cost of the property. This downpayment may be expressed as a
portion of the value of the property (see below for a definition of this term). The loan to value ratio (or LTV) is the
size of the loan against the value of the property. Therefore, a mortgage loan where the purchaser has made a
downpayment of 20% has a loan to value ratio of 80%. For loans made against properties that the borrower already
owns, the loan to value ratio will be imputed against the estimated value of the property.
The loan to value ratio is considered an important indicator of the riskiness of a mortgage loan: the higher the LTV,
the higher the risk that the value of the property (in case of foreclosure) will be insufficient to cover the remaining
principal of the loan.
Value: appraised, estimated, and actual
Since the value of the property is an important factor in understanding the risk of the loan, determining the value is a
key factor in mortgage lending. The value may be determined in various ways, but the most common are:

1. Actual or transaction value: this is usually taken to be the purchase price of the property. If the property is
not being purchased at the time of borrowing, this information may not be available.

2. Appraised or surveyed value: in most jurisdictions, some form of appraisal of the value by a licensed
professional is common. There is often a requirement for the lender to obtain an official appraisal.

3. Estimated value: lenders or other parties may use their own internal estimates, particularly in jurisdictions
where no official appraisal procedure exists, but also in some other circumstances.

Equity or homeowner's equity

The concept of equity in a property refers to the value of the property minus the outstanding debt, subject to the
definition of the value of the property. Therefore, a borrower who owns a property whose estimated value is $400,000
but with outstanding mortgage loans of $300,000 is said to have homeowner's equity of $100,000.
Payment and debt ratios
In most countries, a number of more or less standard measures of creditworthiness may be used. Common measures
include payment to income (mortgage payments as a percentage of gross or net income); debt to income (all debt
payments, including mortgage payments, as a percentage of income); and various net worth measures. In many
countries, credit scores are used in lieu of or to supplement these measures. There will also be requirements for
documentation of the creditworthiness, such as income tax returns, pay stubs, etc; the specifics will vary from location
to location. Many countries have lower requirements for certain borrowers, or "no-doc" / "low-doc" lending standards
that may be acceptable in certain circumstances.
Standard or conforming mortgages
Many countries have a notion of standard or conforming mortgages that define a perceived acceptable level of risk,
which may be formal or informal, and may be reinforced by laws, government intervention, or market practice. For
example, a standard mortgage may be considered to be one with no more than 70-80% LTV and no more than one-
third of gross income going to mortgage debt.
A standard or conforming mortgage is a key concept as it often defines whether or not the mortgage can be easily sold
or securitized, or, if non-standard, may affect the price at which it may be sold. In the United States, a conforming
mortgage is one which meets the established rules and procedures of the two major government sponcered entities in
the housing finance market (including some legal requirements). In contrast, lenders who decide to make
nonconforming loans are exercising a higher risk tolerance and do so knowing that they face more challenge in
reselling the loan. Many countries have similar concepts or agencies that define what are "standard" mortgages.
Regulated lenders (such as banks) may be subject to limits or higher risk weightings for non-standard mortgages. For
example, banks in Canada face restrictions on lending more than 75% of the property value; beyond this level,
mortgage insurance is generally required (as of April 2007, there is a proposal to raise this limit to 80%).

Capital & interest

The most common way to repay a loan is to make regular payments of the capital (also called principal) and interest
over a set term. This is commonly referred to as (self) amortization in the U.S. and as a repayment mortgage in the
UK. A mortgage is a form of annuity (from the perspective of the lender), and the calculation of the periodic payments
is based on the time value of money formulas. Certain details may be specific to different locations: interest may be
calculated on the basis of a 360-day year, for example; interest may be compounded daily, yearly, or semi-annually;
prepayment penalties may apply; and other factors. There may be legal restrictions on certain matters, and consumer
protection laws may specify or prohibit certain practices.
Depending on the size of the loan and the prevailing practice in the country the term may be short (10 years) or long
(50 years plus). In the UK and U.S., 25 to 30 years is the usual maximum term (although shorter periods, such as 15-
year mortgage loans, are common). Mortgage payments, which are typically made monthly, contain a capital
(repayment of the principal) and an interest element. The amount of capital included in each payment varies
throughout the term of the mortgage. In the early years the repayments are largely interest and a small part capital.
Towards the end of the mortgage the payments are mostly capital and a smaller portion interest. In this way the
payment amount determined at outset is calculated to ensure the loan is repaid at a specified date in the future. This
gives borrowers assurance that by maintaining repayment the loan will be cleared at a specified date, if the interest rate
does not change.

Interest only

The main alternative to capital and interest mortgage is an interest only mortgage, where the capital is not repaid
throughout the term. This type of mortgage is common in the UK, especially when associated with a regular
investment plan. With this arrangement regular contributions are made to a separate investment plan designed to build
up a lump sum to repay the mortgage at maturity. This type of arrangement is called an investment-backed mortgage
or is often related to the type of plan used: endowment mortgage if an endowment policy is used, similarly a Personal
Equity Plan (PEP) mortgage, Individual Savings Account (ISA) mortgage or pension mortgage. Historically,
investment-backed mortgages offered various tax advantages over repayment mortgages, although this is no longer the
case in the UK. Investment-backed mortgages are seen as higher risk as they are dependent on the investment making
sufficient return to clear the debt.It is not uncommon for interest only mortgages to be arranged without a repayment
vehicle, with the borrower gambling that the property market will rise sufficiently for the loan to be repaid by trading