Definition
A Direct-Reduction Mortgage is a mortgage structure mandating the repayment of both interest and principal with each scheduled payment. The payment plan is designed in a way that the level payment amount remains constant throughout the life of the loan. This approach ensures that the mortgage will be fully amortized by the end of its term. This type of mortgage reduces the principal amount owed with each payment, in contrast to interest-only loans.
Examples
- Fixed-Rate Mortgage: A typical fixed-rate mortgage could be considered a form of direct-reduction mortgage where each monthly payment includes a portion of both the interest due and principal to be repaid.
- Home-Equity Loan: Many home-equity loans are structured as direct-reduction loans, requiring regular payments that contribute to both interest and principal reduction.
Frequently Asked Questions (FAQs)
What is the main advantage of a direct-reduction mortgage?
The main advantage is the certainty of knowing that, by making regular payments, the loan will be completely paid off by the end of the term, helping borrowers manage their long-term financial planning better.
How does a direct-reduction mortgage differ from an interest-only loan?
In a direct-reduction mortgage, each payment decreases the principal balance, whereas an interest-only loan initially only requires payments for the interest, with the principal being paid later, often resulting in a balloon payment at the end.
Can direct-reduction mortgages have variable interest rates?
Yes, they can be established with either fixed or variable interest rates, although fixed rates are more common, offering stability in monthly payments.
What happens if I miss a payment on a direct-reduction mortgage?
Missing a payment can lead to penalties, additional interest, and potentially affect your credit score. Consistently missed payments can lead to foreclosure.
How is the monthly payment calculated in a direct-reduction mortgage?
The monthly payment is computed based on the loan amount, interest rate, and the term of the loan. This calculation ensures that the payment covers current interest and reduces the outstanding principal.
Related Terms
Level-Payment Mortgage
A mortgage in which the borrower makes the same payment each period—consisting of varying proportions of interest and principal—over the life of the loan.
Amortization
The process of gradually writing off the initial cost of an asset over a period. In the context of loans, it refers to spreading payments over multiple periods.
Principal
The amount of money borrowed or the remaining amount of a loan, excluding interest.
Interest
The charge for borrowing money, typically expressed as an annual percentage rate.
Online Resources
- Investopedia: Amortization
- Mortgage Calculator from Bankrate
- Consumer Financial Protection Bureau on Mortgages
Suggested Books for Further Studies
- “The Mortgage Encyclopedia” by Jack Guttentag: A comprehensive resource covering every facet of mortgage finance.
- “Home Buying Kit For Dummies” by Eric Tyson and Ray Brown: A practical guide for prospective home buyers covering mortgages.
- “Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques” by Frank J. Fabozzi: Advanced understanding of mortgage-backed securities and their financial structures.
Fundamentals of Direct-Reduction Mortgage: Real Estate Financing Basics Quiz
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