The Truth About Mortgage Loans

© 2009, Brandon Cornett

Summary: This article provides an honest, in-depth look at the mortgage industry. It was written with first-time home buyers in mind.

The financial industry as a whole can be a little deceptive at times, and the same goes for mortgage lenders. I'm not saying they're all bad. In fact, some "small-time" lenders actually care about the people behind the paperwork. But there are enough bad apples in the bunch to warrant an article like this one. Let's face it. We live in a time when the phrase predatory lending is practically a household term.

That's where this website comes into the picture. We work hard to provide honest and objective information to home buyers and consumers. This lesson will be no different. In this lesson, you'll learn the truth about the mortgage lending industry. You'll also learn how to protect yourself during the mortgage process, how to choose the right type of loan, and how to attain long-term financial stability.

So without further ado, here's the hard truth about mortgage loans.

1. Your mortgage lender is not your financial advisor.

The first thing you need to realize, before venturing into the mortgage process, is that your lender is not your financial advisor. What do I mean by this? I mean that mortgage lenders are not concerned with your long-term financial wellbeing, not the way a financial advisor would be. Nor should you look to the lender for advice -- you'll learn why as we go along.

Here's what it boils down to. Mortgage lenders make money by charging interest on the money they lend you. The more interest they charge, the more money they make. They sit on one side of the seesaw, and you sit on the other. That is the full extent of your relationship with your lender. They are looking out for their own interests at all times. They are not looking out for you. Which brings us to our next bit of mortgage truth ...

2. You are your only advocate in the mortgage process.

There is only one person looking out for you during the mortgage process, and that's you. The mortgage lender will do whatever it takes to protect their own interests during the relationship, but they're not too concerned about what's best for you. Remember, it's just business. They are basically selling you money, at interest. That's it. So you need to be your own advocate during the process.

For starters, you need to research the different types of mortgage loans to understand how they work. You need to buy within your means. You need to examine every document they put in front of you, and ask questions when you don't understand something.

I know what you're thinking at this point. Like many first-time buyers, you might think the mortgage lender has an interest in looking out for you. After all, if you suffer some kind of financial calamity, they won't get their money back. Right? Well, not exactly. These days, most of the big mortgage companies sell their loans into the secondary mortgage market (see below). As a result, they're not too concerned about what happens to you five years from now.

Mortgage truth takeaway: You are your only advocate during this process. Aside from your friends or family, nobody else will be looking out for you. So it doesn't really matter what people say to you. It only matters what is written on the paperwork.

3. Secondary mortgage market = double-edged sword.

Without going too far into Economics 101, let's talk briefly about the secondary mortgage market. Here's a basic definition for you. The secondary mortgage market is where existing home loans are bought and sold. Much of it takes place on Wall Street. Mortgage lenders make loans to consumers (like you), and then they package them into "mortgage-backed securities" and sell them off. Freddie Mac is a major player in this market. Freddie buys (and later sells) many of these bundled securities. Not all lenders engage in this practice, but most of the big ones do.

Fair enough. But what does this mean to you, as a home buyer? You can think of the secondary mortgage market as a double-edged sword. On the one side, it encourages lending and makes home loans available to more people. On the other side, it removes the "burden" of responsible lending from the mortgage industry.

Think about it this way. If the lender were to keep your loan on their books for the entire life of the loan, they would be more concerned with putting you into an affordable loan. But they can sell the loan and get it off their books for good, which means they no longer care about you staying afloat. It no longer affects them.

And that brings us to the next bit of truth about mortgage loans...

4. You can be approved for a mortgage that's too big.

"Why would a lender give me a mortgage that I might not be able to afford down the road? Don't they stand to lose money if I default on the loan?" Sometimes they do. Other times they don't. We just learned the reasons for this, in our discussion of the secondary mortgage market. Chances are, the lender won't even have the loan on their books if and when you default on the loan. For this very reason, it's possible to get approved for a mortgage loan that's too big for you.

Going forward, you need to remember these steps.

  1. Review your monthly debt versus your monthly income.
  2. Determine a realistic home-buying budget, based on step #1 above.
  3. Apply for a mortgage loan.
  4. If the monthly payments would exceed your pre-determined budget, don't get the loan.

You need to do all of these steps, and you need to do them in this particular order. I cannot stress this enough. Some borrowers skip the first two steps altogether. They say, "Well, the mortgage lender will tell me how much I can afford." But this is dead wrong. Why? Because -- say it with me this time -- it's possible to get approved for a mortgage you cannot afford. It happens all the time.

5. Good faith estimates are not always faithful.

When you apply for a mortgage loan, the lender is required by law to give you a good faith estimate. This is a list of fees and other costs associated with your loan, collectively referred to as closing costs. The lender must provide this estimate within three business days of your application. That way, you'll know if you can afford the loan. All of this is required by the Real Estate Settlement Procedures Act, or RESPA.

But "estimate" is the key word here. In some cases, mortgage lenders will downplay the closing costs of the loan. And then later, when the home buyers receive a finalized statement of the costs due at closing, they are surprised to see that it's a higher amount than previously stated. Why would they do this? To get more business, of course. They do this to seal the deal and put you into a mortgage.

Is it unethical? Yes. Does it violate the rules set forth under RESPA? Certainly. But it still happens quite a bit. How often does it happen? It happens often enough to warrant changes to lending laws. In fact, in January of 2010, the federal government will begin enforcing some new requirements for good faith estimates. Starting in 2010, mortgage lenders are required to use a new form that is supposed to give a more accurate estimate of closing costs.

Here's what HUD secretary Steve Preston said about it: "Buying a home in America should be the fulfillment of a dream. Instead, millions of families go to the settlement table each year without clearly understanding what they are paying for ... HUD's new Good Faith Estimate will offer consumers more certainty about the loan they're agreeing to."

This will help borrowers understand the full cost of the loan and comparison-shop more effectively. I think this is some much needed reform, but I don't expect it to fix the problem completely. So even after these new rules take effect, your actual closing costs could still be higher than the amount disclosed at application time.

What can you do about this? Two things. First, you can expect your closing costs to be higher than the amount quoted in the good faith estimate. If it's the same amount, great! If it's a higher amount, you'll be prepared for it. Secondly, you can start putting extra money aside for your closing costs -- the more, the better. You're going to need some extra cash for moving expenses anyway, so you should start saving early.

6. In certain scenarios, ARM loans can be dangerous.

Over the last few years, adjustable-rate mortgage loans (ARMs) have gotten a lot of homeowners into trouble. It's not that these loans are inherently evil or anything. It's just that many people don't understand how they work -- or else they're in denial about how they work. These days, most ARM loans are actually hybrid loans. They start with a fixed interest rate, and then at some point (usually three to five years later), the interest rate begins to adjust periodically. The rate will often adjust upward, and sometimes significantly.

We saw a lot of this between 2007 and 2009. Lenders were giving out ARM loans like crazy in the early to mid 2000s, and a lot of them started resetting at the same time. Millions of homeowners suddenly saw their monthly payments increase in size, often doubling. You know the rest of this story. It fueled a housing and foreclosure crisis, which eventually led to a full-scale economic recession.

So what did all of these homeowners do wrong? Two things. They took on more of a mortgage loan than they could realistically afford, and they held onto the loan past the adjustment point. You see, an ARM loan is basically a way to push some of the interest back a few years, to make the loan more affordable in the early years. Mortgage lenders often use this (and other) strategies to lure in borrowers. The borrowers fail to read the fine print, and in some cases they are simply lied to. In the end, the borrower is taking on a loan that's going to bite them in butt one day down the road.

Another key point. If you cannot afford to buy a house, you just cannot afford it. Nothing the lender does will change this fact. The idea of "home ownership for everyone" is part of the problem. Lenders are always finding new and creative ways to put people into loans they simply cannot afford. That's what the subprime lending industry was -- a way to give mortgage loans to people who were unable to carry a mortgage.

Like I said earlier, the ARM loan is not to blame. It's the manner in which they are used that leads to such problems. I used an adjustable-rate mortgage to buy my first home, because I knew I'd only be in the home for about three years, at most. So I had a smaller mortgage payment during those three years, and I sold the home before the first adjustment period. That's how you can use an ARM loan wisely.

But if you plan to stay in the home for many years, do yourself a favor and get a fixed-rate mortgage loan. Avoid the ARM altogether. Why? Because with a fixed mortgage, you can be sure that the rate will stay the same ... no matter how long you hold onto the loan. That's my advice, anyway.

7. Knowledge is your best asset.

This lesson has given you much of the information you need to be a smart mortgage shopper. But it hasn't given you everything, so you'll need to continue your research on this website and beyond. Here is some recommended reading to get you started:


About the Author Brandon Cornett is a consumer advocate and creator of the Home Buying Institute. He has been educating consumers on housing-related topics since 2004.