Intro to Mortgage

About mortgages, interest rates, points and mistakes

It might be due to my history with mortgages [1], or maybe because of common confusion about how to wisely optimize when purchasing real estate – I find that many people contact me with questions about financing. 


Most of the time I find it odd, since before choosing financing you need to understand how to choose a house (many times I identify critical mistakes that were made in the process, which I could have avoided if we had talked earlier – but that’s for another post…) – but anyway I think there is a place to address this issue of funding in the US.


I’ll try to make this as less boring as possible, but come on – this is a post about a mortgage. So make a cup of coffee, swallow 2 Ritalin and set a timer for another five minutes that will wake you up from the cramping.


Alright? Let’s hit it!


Mortgage routes

I will not dive deeply into how a mortgage works, because there is indeed a video [2] of mine on YouTube that dives deeply into how a mortgage works (which also applies to the USA), and I am still a programmer at heart and as such hate redundancy and code duplication.


However, it is important for me to point out that in the US there is really no “mortgage mix” and in practice we choose one specific route. Most often, this route will be a fixed interest rate (FIXED), sometimes it will be an adjustable rate (ARM), and rarely it will be something else.


These routes are very similar to the routes in the Bibi Land (i.e Israel), so feel free to take a look at the relevant chapter in my lecture [3] which explains in more detail about both. To summarize them in half a sentence: a fixed interest rate assumes that we know *exactly* what the interest rate is throughout the life of the loan, compared to a variable interest rate in which there will be a period with a known interest rate in advance, and then periods in which the interest rate will be updated according to the anchor we decided on with the bank.


If it is not obvious, I will state it explicitly – the reason to choose the variable route is that the initial interest rate will be lower, the risk is that the interest rate will rise in the future. There is no more “good” or “correct” route here, it’s a matter of needs and strategy.


30 years vs. 15 years

Because of the way the mortgage is structured, and the way in which compound interest works, there is apparently a built-in financial advantage to taking a mortgage for a shorter period of time: the reduction of the principal will also be faster, and the terms will also be better.


However, because most lenders do not require an additional payment for early repayment, as long as borrowers do not require someone to force them to pay more (“forced savings”), I see no reason to choose this route. Instead of choosing a mortgage spread over 15 years, you can sign a mortgage for 30 years and pay more every month in order to reduce the principal. The advantage is that you get flexibility (you don’t have to pay the higher payment if it is less suitable in a certain period of time), the disadvantage is that it still came out a little more expensive.


Points

The “points” method is actually a front-load on the interest rate: we pay more money at the closing point, and in return receive a lower interest rate that over time will cause the total cost of the mortgage to decrease.


What does that mean anyway? Even if we lowered the interest rate by a whole percentage, on day 0 we will be at a loss (because we paid more money today, and the interest benefit has not yet started to work). Next month we will be a little less at a loss, and God forbid until we reach the balance point – and from this point we will be at a profit that will only increase over time.


One of the tricks that lenders like to perform is to lower the interest rate by using points, since many borrowers do not fully understand the long document and the many numbers they are given and only look at the bottom line (the interest rate). Many realtors forget, don’t know or don’t want to deal with the loan matters, and thus a situation may arise where a customer chooses a borrower based on the lowest interest rate even though in practice he simply paid a lot of money for it in points.


Another method that lenders use is to load the loan with all kinds of small payments: lender fee, underwriter fee, loan origination fee, pants on fire fee, processing fee..

Then a more attractive interest rate is given, and the confused borrower compares incorrectly and chooses the least profitable loan.


The best way to compare loans is to understand this thing properly, the second best way is to trust someone who can explain it to you in depth (aspirationally: your realtor. Less aspirationally: your lender, since he has an interest), the last way is Compare the interest *along with* the cost of the loan, or compare the APR (an index that should weigh the above).
The points can save you tens of thousands of dollars, or cost you thousands of dollars – so I recommend dwelling on this point (ha) and not choosing the default on automatic.


[1]The full lecture – 150 paychecks

[2] Chapter 3 – Monthly repayment 

[3] Chapter 4 – tracks and mixes

The lecture is in Hebrew, You can find other content in English on our YouTube channel

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