Understanding Your Mortgage Contract

Mortgage laws, products and guidelines change constantly, so even experienced homeowners can find themselves as flummoxed as first-timers by the paperwork involved.  Many borrowers simply scrawl their names and pray they aren't making a mistake when they buy or refinance their homes.

We can all do better than that.

You Don't Have to Read Everything

Nobody should feel embarrassed about not reading every word of his or her mortgage agreement -- almost no one does that. A few years ago, CreditCards.com reviewed 1,200 credit card agreements and found that 80 percent of Americans couldn't fully understand those documents because they lacked the necessary education.

In addition, most standard forms are 90 percent boilerplate, meaning everyone who signs them is agreeing to exactly the same thing. You should feel pretty safe signing a customary form that's been vetted by at least one government entity. For example, every FHA mortgage comes with a disclosure informing you that old lead paint is bad for you. You can feel pretty safe signing that one -- it doesn't obligate you to anything.

But You Should Read the Important Stuff

It’s easier to get through mortgage paperwork if you’re not “on the spot” at a title office, seeing the documents for the first time. Ask for them a few days before your scheduled closing and go through them. Contact your loan officer if you have any questions about your documents. Do not sign until you understand and agree with the important features of your loan.

1. Compare Mortgage Rates and Other Basics

You've already compared mortgage rates to find the best quote. Now is the time to compare the rate on your Good Faith Estimate (GFE) and Truth-in-Lending (TIL) disclosures with the one on your closing documents. The lender is required by law to honor the terms disclosed on the last GFE provided to you (this is usually the one you get when you lock your loan).

Similarly, make sure the contract contains the numbers you expect:

  1. The "principal amount" -- the sum you're borrowing.
  2. The term -- the number of years you'll be making payments -- usually 15 or 30.
  3. Amortization – the way the loan balance will be repaid (or "killed off," which is what amortization means). A fully-amortizing loan is paid off a month at a time, until its balance reaches zero at the end of the loan term. Some loans are not fully repaid during their terms; they have large balloon payments at the end. Others, like interest-only loans, do not amortize at all because the monthly payments do not reduce the loan's balance,
  4. Rate adjustment -- is the loan a fixed-rate mortgage (FRM) or adjustable-rate mortgage (ARM)?

2. Know Your ARM Terms

Many people choose 30-year FRMs because they like the security a fixed rate brings. However, ARM mortgage rates tend to be significantly lower, and the initial period for which the rate is fixed can be long: three to ten years. So people who relocate frequently can be much better off with ARMs.

If you choose an ARM, check your closing documents for three things:

  1. The introductory period: that initial time in which the rate is fixed.
  2. The index: the published rate (LIBOR, for example, or 10-year Treasury) that your loan will be based on once the introductory period expires.
  3. The margin -- that's the amount that the lender adds to the index when it calculates your rate. Pretend that your loan is adjusting today – add your margin to the index and see what your potential rate looks like.

3. What Happens if You Prepay Your Mortgage?

Mortgages can have prepayment penalties – “soft” penalties are not charged if you sell your home, only if you refinance or repay more than allowed in a given year. “Hard” penalties are charged any time you pre-pay more than allowed, even if you sell the home. Penalties can be a percentage of the balance or several months' interest payments.

4. What Happens if Things Go Wrong?

Check your lender's definition of "default," and verify the penalties it could impose on you if you miss or are late with your mortgage payment. Also note the due date for your monthly payments, and any applicable grace period. Don't forget to make sure late-payment charges aren't exorbitant.

Relax

Don't let all this worry you. Over the last century or so, millions of borrowers in the US have signed mortgage contracts, and relatively few have had serious problems with them. Indeed, by checking yours before signing, you dramatically reduce your chances of being among those few. And that should help you sleep at night.

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