First Mortgages: Making Money And How It Works

A first mortgage is the primary or initial loan obtained for a property, which is used to buy a home. The home acts as collateral for the debt. First mortgage loans make it possible for homebuyers to purchase homes, and they take priority over any subsequent second mortgages that may be associated with the property. First mortgages can take many different forms, depending on the type of home loan taken out. Private lenders offer conventional mortgages, which are the most popular option. FHA loans, for instance, allow you to purchase a one- to four-unit home with just 3.5% down and a credit score as low as 580. The economics of first mortgages are complex, with many factors influencing the amount of money made by lenders, such as interest rates, closing dates, and the loan-to-value (LTV) ratio.

Origination fees

A first mortgage is the primary or initial loan obtained for a property, enabling homebuyers to purchase homes. The home acts as collateral for the debt. First mortgages take precedence over second mortgages for repayment if the borrower defaults.

Now, when it comes to how mortgage lenders make money, one of the key ways is through origination fees. Mortgage origination fees are charges levied by lenders to process your loan. These fees are part of the closing costs that you pay when you obtain a mortgage and are detailed in the closing documents. The person taking out the mortgage is responsible for paying these fees.

In addition to the origination fee, there may also be an administration fee associated with the mortgage origination process. This fee covers additional services such as organizing and tracking your documents. It's important to note that origination fees are usually only paid if your mortgage application is approved and you obtain the loan. If your application is not approved, you typically won't be charged an origination fee.

Yield spread premiums

A yield spread premium (YSP) is a form of compensation that a mortgage broker, acting as an intermediary, receives from the originating lender for selling an interest rate to a borrower that is above the lender's par rate for which the borrower qualifies. The YSP can sometimes be applied to cover costs associated with the loan, so the borrower isn't burdened with additional fees.

Mortgage brokers can be paid in two ways: through an origination fee that is due at closing, or through a yield spread premium, which means the borrower will pay a higher interest rate than they would otherwise. The borrower may also pay a combination of these two fees, but they must ensure that the total seems reasonable so they do not inadvertently pay the broker twice.

The YSP is the difference between the "zero-point rate" or par rate, which is the base rate the borrower qualifies for, and the interest rate they end up paying. The YSP is often used to offer no-cost loans, which can be beneficial for borrowers as it reduces the mortgage's upfront costs. However, if a borrower does not pay closing costs or commissions, they will end up paying those fees over the life of the loan in the form of slightly higher monthly payments.

In 1999, legislation was passed to protect homebuyers against exorbitant yield spread premium fees, requiring that the yield spread premium be reasonably related to the actual services performed by the mortgage broker for the homebuyer. The YSP also had to be disclosed by law on the HUD-1 Form when the loan was closed. In 2010, the Dodd-Frank Act banned the practice of YSPs altogether to protect consumers after the 2008-2009 financial crisis.

Discount points

The longer the life span of a loan, the more you pay in interest. Therefore, discount points are ideally suited for a fixed-rate, long-term mortgage (20 to 30 years) that is not going to be refinanced anytime soon. Discount points are tax-deductible, and the number of points you buy is up to you. Typically, when lenders are displaying the mortgage options for which you qualify, they will show you several different rates, including the ones you can get if you purchase discount points.

The decision of whether to pay for points depends on whether you will keep the mortgage past the break-even point and how long you plan to live in the home. In some cases, it may make more sense to put additional money toward your down payment instead of paying for discount points, especially if it brings your down payment up to the 20% threshold that eliminates the need for mortgage insurance.

Closing costs

A closing disclosure is a crucial document that outlines the final terms and costs of the mortgage loan, including closing costs. It is accessible to the buyer three business days before settlement and should be carefully reviewed, compared to the loan estimate, and returned in a timely manner. The loan estimate is provided by the lender within three days of receiving the mortgage application and outlines the estimated closing costs and other loan details. While these figures may fluctuate by the closing day, there should not be any significant surprises.

There are various strategies to manage closing costs. Depending on the loan, buyers can add closing costs to their mortgage loan, but this option accrues interest over the years. Alternatively, buyers can ask the seller to cover part or all of the closing costs, which is more common in a buyer's market. Another option is to utilise down payment assistance programs offered by state and local government agencies, which provide grants to eligible borrowers. Additionally, buyers can use gift funds from relatives or significant others towards closing costs, ensuring the money is sent directly to their escrow account.

The first mortgage payment is typically due within 60 days of the closing date, specifically on the first day of the second month following the closing. This payment includes the interest for the previous month and an allocation for the principal. While the first payment is generally not due immediately, budgeting for it along with other post-closing expenses is essential for a smooth transition into homeownership. It is beneficial to estimate the first mortgage payment in advance to effectively manage finances after closing.

Mortgage-backed securities

MBS are asset-backed securities formed by pooling together mortgages. The investor who buys an MBS is essentially lending money to homebuyers. In return, they receive periodic payments, including interest and principal repayments from the underlying mortgages. MBS can offer regular income through interest and principal payments, portfolio diversification, and potentially higher yields than other fixed-income securities.

There are two basic types of MBS: pass-through mortgage-backed security and collateralized mortgage obligation (CMO). The pass-through mortgage-backed security is the simplest MBS, structured as a trust, so that principal and interest payments are passed through to the investors. It comes with a specific maturity date, but the average life may be less than the stated maturity age.

Collateralized mortgage obligations comprise multiple pools of securities, also known as tranches. Each tranche comes with different maturities and priorities in receiving the principal and interest. The tranches are also given separate credit ratings.

Agency MBS are issued by government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac, and Ginnie Mae, and are considered to be of the highest credit, given government backing. Non-agency MBS are issued by private entities and carry higher risk and potentially higher yields since they are not government-guaranteed.

Frequently asked questions