For most people, a mortgage is the largest debt incurred in a lifetime and as well their largest single asset. As a result, the impact of a mortgage on financial planning strategies needs to be considered carefully.

A mortgage is a secured advance of funds for the purchase of an asset such as a home. Mortgages originated as a way to circumvent onerous laws against borrowing. The debt is secured with title to the asset. Mortgages allow the borrower to spread the acquisition of a major asset, such as a home, over a period of 20 years or so.

For most people, a mortgage is the largest debt incurred in a lifetime. At the same time, a home purchased with a mortgage may be the largest single asset. As a result, the impact of a mortgage on financial planning strategies needs to be considered carefully. Different mortgage payment options to provide liquidity and flexibility should be considered, as they permit the mortgage to be more customized to an individual’s requirements. Mortgages were once relatively generic with few or limited options, but today there are many types of mortgages and options available.

Mortgage Term and Amortization

The mortgage term is the length of time for which a mortgage is extended to the borrower. Normally, the term for a homeowner’s mortgage ranges from about 6 months to 10 years, which permits the interest rate and associated payments to be fixed for up to 10 years. At the end of the mortgage’s term (the maturity date), the borrower must either repay the mortgage or renegotiate it. Many mortgage borrowers choose to lock in their mortgage term for 5 years, the most popular mortgage term.

The total cost of the mortgage and the time that it takes to repay it are impacted by the mortgage amortization period. A longer amortization period will provide lower monthly payments. However, with the mortgage amount outstanding for a longer period of time, the total interest paid, and therefore the total price paid for the home, is higher. Even with a long amortization period, prepayments speed the repayment of the mortgage and reduce the remaining amortization period. Finally, given the long amortization period, small changes in the mortgage interest rate are magnified result in substantial changes in the total cost of borrowing.

Mortgage rates reflect current interest rate conditions. The relationship between short term, medium term, and long term interest rates is encapsulated in the yield curve. Since a typical yield curve exhibits higher interest rates for longer terms to maturity, a mortgage with a 5 year term typically has a higher interest rate than a 1 year term. In addition, open mortgages have a higher interest rate than closed mortgages given the same term. The advantage of a fixed interest rate is that the homeowner knows what the mortgage payments will be for the term of the mortgage.

The amortization period of the mortgage is the number of years during which payments occur. All else being equal, the longer the amortization period, the lower the monthly payments and the higher the cost of the mortgage. Although 25 year amortization periods are common, many homeowners choose shorter amortization periods to lessen the interest expense. There are likely to be several mortgage term renewals during the amortization period.

There are several mortgage payment options available that impact the total cost of the mortgage and the time that it takes to repay it. The higher the amortization period, the lower the loan payments, all else equal. In addition, the more payments made per year, the faster the mortgage can be repaid, all else equal. Finally, the lower the interest rate, the lower the total cost of borrowing. Since most mortgages amortize payments over 20 years or more, small changes in any of these variables are magnified and can impact the total cost or term of a mortgage substantially.

Mortgage Features

A mortgage is a major commitment, and any features that are available and that improve its attractiveness to the borrower should be sought. Some of the features available to a borrower when obtaining or renewing a mortgage include assumability, portability, and a selection of prepayment privileges.

Assumability is the ability to have a new purchaser assume the mortgage if the borrower needs to sell the property in the future. This feature can make it easier to sell in a weak property market. Although the buyer may still need to be qualified by the bank or mortgage lender in order to assume the mortgage, it may be an attractive feature. This feature is particularly attractive as a real estate selling tool if the mortgage rate is less than current mortgage rates.

Portability is the ability to use an existing mortgage to finance a borrower’s new home if the original home is sold. This is an alternative to allowing a buyer to assume an attractive mortgage, by allowing the borrower to maintain the existing mortgage. If additional funds are required to purchase the new property, the new payments will be a blended amount of the existing mortgage with the new mortgage.

The ability to prepay a mortgage is one of the most important features to a mortgage buyer in the current interest rate environment. At one time, mortgages permitted prepayments on the anniversary of the mortgage only, and borrowers who could not take advantage of that window had no recourse. Mortgages are available as closed, partially closed, and open. Closed mortgages have no prepayment privileges, or only allow pre-payment with a stated penalty. Partially closed or partially open mortgages allow prepayments at specific dates to a maximum amount of the principal. These are the most commonly found mortgages today. Open mortgages permit prepayment at any time and in any amount by the borrower. In reality, many mortgages today that are called closed mortgages do, in fact, permit some prepayment, often up to 10% of the mortgage principal each year.

Another popular method for mortgage prepayment is with “accelerated” weekly or bi-weekly payments. By increasing the total annual payments slightly each year, and by paying the mortgage more frequently than monthly, borrowers can shave years off their mortgage amortization.

The interest savings as a result of prepayment privileges are a tremendous incentive to individuals, and mortgage prepayment should be considered an important part of the overall financial plan. Since most mortgage interest is non-deductible, it should be retired once no further high-interest debt remains ahead of it.

Sources of Mortgage Funds

Mortgage funds are available from a variety of lenders. Most commonly, mortgages are obtained from financial institutions such as banks, credit unions, caisses populaires, or trust companies. The mortgage market is relatively competitive, since financial institutions realize that borrowers often bring other fee-generating requirements with them, such as registered retirement savings plans and mutual fund portfolios.

Mortgage funds may also be obtained from private lenders through the use of a professional mortgage broker. A mortgage broker arranges lenders for mortgage borrowers, collecting fee income for doing so. Mortgage brokers are often used when the subject property does not meet the standards for a conventional mortgage, or when the borrower does not have adequate financial resources to meet the lender’s criteria.

Funding from family members is often used for first home purchases. A private mortgage can then be made available for an individual who might not otherwise qualify for a mortgage from a traditional source. In addition, many sellers who own their homes free of mortgage are often willing to take a mortgage from the buyer. Known as a vendor take back (VTB) mortgage, a private mortgage can be an attractive selling feature to buyers with weak or limited credit ratings. The financial advisor should ensure that a good real estate lawyer and agent be involved in arranging non-traditional sources of mortgage funds.

Another source of funds for new home buyers are mortgages arranged by builders of homes, condominiums and townhouse developments. Although buyers must still be approved by the sponsoring financial institution, developers may negotiate special terms to help buyers put together financing for purchasing their homes. Prospective buyers will want to check the terms of financing carefully to ensure that they are as attractive as they appear to be. Sometimes, the advertised “low monthly payments” or “lower than rent” payments are obtained with a substantial ($100,000 or more) down payment and a long amortization period of 30 years.