All You Ever Wanted to Know About Home Mortgages But Were Afraid to Ask
Do you need to make a move for a better job or to be closer to family? Or is it just time for something new? Maybe you're looking to buy a house for the first time in your life.
If buying a new home is on the horizon, you have many options to consider. First of all, what is the price you're looking for? How do you know if you're getting a good deal? If this is your first home, you're likely going to have many questions about mortgages. You may have already purchased a home and you have a mortgage, but you don’t really understand what your payment conditions mean or what other types of loans are available to home-buyers.
In this article, I wanted to outline many of those details and options to give you a better idea of what you're getting into giving you a clearer picture moving forward. If you look at it this way, the more knowledgeable you are getting started with the process, the less likely you can be taken advantage of, or get into trouble at a later date because of something you didn't know. Let's jump right in!
What Is a Mortgage?
Let’s start with defining what a mortgage is. A mortgage is a system of lending money that allows a purchaser to put down a smaller amount of money than what a home costs upfront. Say I want to purchase a $130,000 home, but only have $10,000 to put down, or sometimes nothing at all.
A bank or private lender then allows you to borrow the remainder of the cost of the home, and make payments to them, with interest, over a pre-determined amount of time. That amount of time you borrow the money is known as the "term" of the loan and can be as long as 30 years. To make sure that you keep your end of the bargain and pay the money back, your home is put up as collateral. In other words, if you stop making payments on the loan, the bank or lender can take the home back from you in a foreclosure process.
The parts of your specific loan include the Principal, the Interest, the Taxes, and the Insurance. The total of those four parts is commonly called “PITI,” which is simply the first letter of each part of your mortgage (Principal, Interest, Taxes, Insurance). But what do each of those words mean and what do they consist of? Great questions!
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The Parts of a Mortgage
So the four parts of your mortgage were the Principal, the Interest, the Taxes and the Insurance. Let's walk through each part to help you understand them better.
The Principal is the amount that you actually borrowed to pay for your new house. That is the price of the house, minus the amount you paid out of your pocket. If you didn't put any money down, the principal is the entire price of the house. For example, if you purchased the home for $300,000, and put down $60,000 (the magic 20% which is commonly what a lender likes to see and makes you a less risky buyer to them), then your mortgage (your principal) is $240,000.
Speaking of less risky buyers, if you do have at least 20% of the purchase price to put down on your home, you usually get a better interest rate, and you will then have fewer hoops to jump through to qualify for the loan you want. The bank/lender considers you more qualified at that point because you’ve got some skin in the game.
If you choose to put down less than 20%, the bank/lender probably won’t qualify you for the lowest interest rate possible, and will likely require you to purchase Private Mortgage Insurance (PMI). PMI protects the bank/lender in the event that you don’t make your mortgage payments. It is NOT the same as Homeowner’s Insurance which protects YOU in the event of fire, flood, burglary, etc.
Sidenote: If you don’t have or don’t want to put down 20% upfront and are required to purchase PMI, at some point when you have paid an amount sufficient to the bank/lender (usually that magical 20%), you can cancel the PMI and your monthly payment will go down a bit.
Interest is what the bank is charging you to borrow the Principal, just like on your credit card. For example, if your mortgage balance starts out at $100,000 and your loan is written at 5% interest, the 30-year term requires a monthly payment of $536.83. Over the 30 year loan, the total of all of your payments adds up to just under $193,259. That’s a 93% premium in interest payments on top of the mortgage balance!
Many homeowners with a 30-year mortgage don’t realize how much they are paying in interest. This is the problem. The solution for many is to accelerate the payment, either by paying more principal each month or by entering into a shorter repayment contract. The best-known among these is the 15-year term. I highly suggest looking into this further and comparing the monthly payment versus the payment over the entire loan period to make sure you get the best deal.
Taxes are the amount of property taxes that the home you’re purchasing has been assessed for. This amount is a percentage of the value of your home, and it’s based on the area where the home is built to support the city, schools, and county and/or the state infrastructure of that area. That value can go up and down depending on home values in the area over the life of your loan.
Typically this is already part of your payment and will be pulled out and put into an Escrow account to save up for your payment at the end of the year, but this is something you get to choose during the buying process. You may even get the option to lower your monthly payment and save up for taxes yourself. Another great topic to look into.
Insurance is paid to the company of your choice to insure your home against theft, fire, or any other disaster in the form of Home Insurance. You can opt-out of paying that as part of the mortgage and pay it on your own to the insurance company yourself if you so choose. However, if the bank/lender considers you a high-risk borrower, they may require you to include it in your mortgage payment. Most people opt to pay that with the monthly mortgage note anyway just because it’s easier.
Though your payments on a 30 year fixed rate (fixed rate meaning they can’t change your payment amount each month) mortgage will stay the same over the life of the loan, in the beginning it is structured so that most of the amount is distributed toward the interest you are paying on the loan. Meaning that, in a traditional 30-year loan, it takes more than 20 years to pay off half of the principal amount, as you are paying mostly interest up front. The other half is paid over the last 10 years. In fact, a 30-year term amortizes so slowly that after five years (60 payments), you still owe about 92% of the original balance.
Fortunately, over time, that shifts and more of the payment you are making will begin going towards the principal. At that point, you’ll be building "equity," or ownership, of your house, and that’s the goal! But consider that the average first-time buyer only keeps their home less than five years when you sign that paperwork. Do your research!
So let’s talk about types of mortgages or ways you can pay for your new home.
Traditional Types of Mortgages
The first option you might consider is cash, as that sure would save you a boatload over time! If you’ve got a pile of dough saved, a wealthy relative who wants to give you a pile of money, or you won the Powerball, you don’t have to take out a mortgage at all. You can fast forward the purchase, relax, and start packing. You don’t even have to qualify for a loan. Congratulations!
However, if like the rest of us, you have to take out a mortgage for all or part of the purchase, here are the most common types of loans today:
A 30 Year Fixed Mortgage is by far the most common type of home loan. Over 75% of all purchases are financed with this type of loan. This means that the interest rate you get when you take out the loan remains the same for the next 30 years. These loans are best when the interest rates are low, or if the rates are rising as you have no way to predict how high they might go. They are also the first choice for people who want a predictable payment and plan to live in the home for an extended time, like 5 to 7 years. Your monthly payment will likely be lower with this plan, but you will pay more interest over time.
A 15 Year Fixed Mortgage is the same as a 30 Year Fixed Mortgage but you’ll pay off the loan in half the time, and pay 1/3 of the interest. These loans usually have lower interest rates but the monthly payment is higher (obviously) than for a 30 year loan. The obvious advantage for these loans would be that you pay the loan off sooner and you build equity in the home faster. The disadvantage could be the higher monthly payment if your budget is pretty tight.
Adjustable Rate Mortgages (ARMs) are loans that are adjusted at predetermined intervals to reflect the current mortgage rates at that time. You can opt for one of the most popular: a 3 Year ARM, a 5 Year ARM, or a 7 Year ARM. The advantages to an ARM are that the initial interest rates are usually lower than for a 30 year fixed rate, and if you don’t plan to live in the home longer than the adjustable time period that can mean a much lower monthly payment while you live there.
The obvious risk/disadvantage could be if you find yourself not in a position to move at the end of the ARM period and interest rates are considerably higher than when you purchased. Your payment could also increase significantly without warning one month, or for a time, making it impossible to make your payments. This is not the safest choice for a new home-buyer.
Keep in mind that these are only the most traditional types of mortgages, but there are a few other options to consider. You always have options!
Non-Traditional Mortgage Options
If all of this mortgage talk is too much and you need some other options, thankfully there are more available to you.
Have you ever heard of “Owner Carry” or “Seller Carryback”? This type of arrangement means that the seller of the home will finance all or part of the purchase of the property themselves. There are advantages for both parties in this type of financing. The Buyer pays fewer closing costs, is qualified easier, and has the potential for better terms and a lower down payment on the house. This also opens up more options for flexibility in the payment.
The Seller/Owner advantages are that a hard to sell property is easier to sell with this type of financing, especially in a weak market, especially if the home is non-traditional. But it also sets up the Seller to receive payments over time instead of one large lump sum while at the same time putting money in their pockets interest-wise.
In exchange, the Seller takes a big risk that you are going to pay him like you promise. However, should you fail to live up to your word and make regular payments, the contract has clauses in place that he can take the property back, much like a bank would do in a foreclosure process.
One point to note: The Seller must own the home free and clear from the bank themselves in order to do a Carryback.
Rent to Own
Another non-traditional option for purchasing a home would be Rent to Own. In this arrangement, you decide on a portion of the rent that you are paying to your landlord, to be designated toward a down payment for purchasing the home at the end of the specified term. If you decide not to purchase the home after all, you essentially forfeit that saved up money at the end of your lease. The rent for properties in that arrangement would typically be higher to compensate for the additional down payment money.
Interest Only and Balloon Mortgages
There are also Interest Only Mortgages, where you pay the interest on the loan for the first 10 years of the loan and none of the Principal, and also Balloon Mortgages, where you make low monthly payments for a specified amount of time (usually 5 to 7 years) and then the balance of the loan is due in one big lump sum. These types of loans are harder to obtain, riskier for you, and you should consult a qualified financial advisor before considering either of them.
When first considering a home mortgage, it can seem a bit complicated, and almost certainly overwhelming. It is for everyone, so you're definitely not alone. But it doesn't have to be complicated. With a little bit of research, maybe some online perusing, and asking lots of questions, you'll soon feel like an expert on the topic yourself.
Hopefully, this information has cleared up the process for you a little bit, and answered some of your questions about mortgages. It can be a relatively easy process if you know what you are doing, but it often causes people a lot of anxiety. With these facts, I hope you can ease your fears and move on to the fun part, choosing and moving into your new home!
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
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© 2013 Victoria Van Ness