Basics of Housing Finance

Americans purchase homes and finance them with either 100% cash or a combination of cash and a loan.  These financing options are not unique to homes.  Most people take out a loan when purchasing an automobile, and some people purchase stocks on margin.

In all cases, lenders charge an interest rate and seek assurance they will get paid back.

Suppose someone is looking to buy a home that costs $200,000.  Paying for it using 100% cash may be a tall order, so the buyer would seek to borrow money from a bank.  Historically, it is common for creditworthy borrowers to receive mortgages equal to 80% of the purchase price.

In effect, the buyer purchases the home with $40,000 of his/her money, and borrows $160,000 from a bank to close the transaction with the seller.  The seller receives $200,000 before paying a sales commission and retiring any outstanding mortgage debt.

The buyer agrees to pay back the $160,000 mortgage to the bank, according to a payment schedule outlined in a contract both parties legally enter into.  To protect the lender, after a sustained period where the borrower fails to make required loan payments, the lender can foreclose on the property and gain control of it.

Without the home serving as secured collateral, instead of a borrower obtaining a mortgage at 5 or 6 percent, the rate would be closer to the 12-15 percent range, even for folks with good credit.

These concepts will tie directly with a forthcoming post about “underwater mortgages,” where a homeowner’s outstanding mortgage debt exceeds the value of the home.