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Mortgage Guide
Buying a house is one of the biggest decisions for most people, and your home is likely to be your most valuable single asset. Making sure that you get the right mortgage for your financial life is as important as choosing the right home. Our mortgage calculator can help you understand all the parts that comprise a mortgage, and also how much you will have to pay every month.
While every mortgage will be similar, each one will be created specifically for a borrower. There are many things to consider when buying a house, and if this will be your first mortgage, it is very important to take time for research before you buy. Locking in a big debt on bad terms can cost you a bundle, and it is difficult to get out of a bad mortgage once it is signed.
There are many aspects to how a mortgage is structured, and a failure to fully understand your responsibilities could lead you into an unpleasant situation that could have been avoided. Let’s look at how mortgages work, and some of the things that you can do to ensure that you get the most for your money!
How Does a Mortgage Work?
The basics of a mortgage are simple enough. A bank will loan you money to buy real estate, and then, you will make payments over a long period of time to pay off the loan. The loan is secured by the real estate, and you won’t be the owner of the home until the debt is fully paid off.
Many people think they own a home when they have a mortgage, but this isn’t true. Banks are able to issue mortgages at relatively low-interest rates because they are secured by real estate, unlike unsecured debts, such as credit cards.
Because a bank is the legal owner of a mortgaged property, anyone with a mortgage will have to both insure the real estate with a comprehensive insurance policy, and pay property taxes as a part of the mortgage payment.
Banks don’t want to have any issues with the assets that are securing their investment (your mortgage loan) and so they make sure that the asset is insured and free from tax debts. There are a few important parts of a mortgage loan, and you should understand all of them before you borrow any money for real estate.
The Guts of a Mortgage
A mortgage is comprised of a few different parts. You should understand what all the terms listed below mean, and how they will affect your financial life.
Loan Amount / Principle
The loan amount or principle refers to the gross amount of money that a bank lends to you via a mortgage. The principal may be almost the entire cost of a property, or it could be a partial amount. You will be responsible for paying the entire loan amount back to the bank or lender over the course of the loan term.
Down Payment
Nearly every mortgage lender will require that you make a down payment on your loan. The amount that borrowers have to pay up-front has fallen over the decades, and today, some mortgages can be obtained with a down payment of as little as a single-digit percentage (ex. 5% down).
Keep in mind that while a bank or mortgage lender may accept a down payment of less than 20%, the borrower may have to pay for Private Mortgage Insurance (PMI) until there is a minimum of 20% equity in the mortgage (also known as the loan-to-value ratio). PMI adds costs to the borrower’s monthly payments, and some borrowers find that making a higher down payment actually makes more sense in the long run.
Additionally, making a higher down payment on a mortgage will likely incentive lenders to lower the interest rate for a mortgage. The less money you have at the beginning of a mortgage, the more it is likely to cost over the term of the loan, which is worth considering before you decide to borrow to buy real estate.
Loan Term
The loan term is simple. Term refers to the amount of time that you are given to pay back the loan for your real estate. The most common terms for a mortgage in the US are 15 or 30 years, but the term can be written at just about any length the lender or bank chooses to allow.
In general, the shorter the term, the lower the interest rate. Again, if you have money to pay a larger down payment, and the income to pay on a shorter loan term, you will be able to push down the interest rate you pay and save money on your mortgage.
Interest Rate
The interest rate that you will have to pay on a mortgage is probably the most confusing part of real estate borrowing. There are two types of interest rate structures that are used, and most mortgages will use one or the other.
The first kind in a Fixed-Rate Mortgage (FRM). An FRM will have the same rate for the entire term of the loan, and the calculator above is only able to work with FRMs (more on that in a minute). The second type is an Adjustable-Rate Mortgage (ARM), and the rate that you will have to pay with an ARM will change after a given number of years.
Know your Rates
Either kind of interest rate will likely be quoted in annual terms. For example, an interest rate of 6% on a $100,000 mortgage will require that you pay $6,000 over the course of 12 months, although that number will drop with every payment (which is why that mortgage calculator is so useful).
In general, it is probably better for people who plan to own real estate as a home to choose an FRM. The reason is simple: you will know how much you have to pay for the term of the loan. Many times ARMs are advertised at lower rates, but they will probably reset higher after a year or two, and can then rise from there, depending on how the loan is written.
An ARM can be handy for real estate speculators who plan to flip a property quickly. If the ARM has a low rate for two years before the first adjustment, that could be more than enough time to do any improvements to the property and put it back on the market. By the time the loan would have been adjusted higher, it will be paid off, and any profits will be booked.
The reason why our mortgage calculator won’t work for an ARM is that they are far more complex, and there is no telling where your lender or bank will reset the mortgage when they have the chance. As we said above, if you are buying real estate as a home, it makes sense to save a bit more, make a bigger down payment, get a shorter term, and choose an FRM.
Some Other Costs That You Need to Know About
When you decide to buy a home or any kind of residential real estate, there are going to be some costs that aren’t related to the mortgage (at least to the actual debt) that you will have to pay. All of these costs add up and will affect the financial commitment you will make to own a home.
We can separate these costs into two categories: recurring costs, and non-recurring costs. Recurring costs will be paid more than once, usually on a monthly basis. Non-recurring costs will only be paid once, but still, add to the price a homeowner will have to pay.
Recurring Costs
When you buy a home, there are a number of costs that will need to be paid on a monthly basis, and many of them will be added to your mortgage bill. It is important to consider how local property taxes will affect your fiancees, and how much they will contribute to your annual expenditures. Here are some of the most common recurring costs for homeowners.
Home Insurance
Anyone who has a mortgage will be required to hold home insurance by the lender or bank. Because the real estate that is mortgaged is how the bank or lender would recoup any losses from a failure to pay, they need to make sure that any damage to the home would be covered by quality insurance.
The lender will stipulate the kinds of insurance that are required to buy, and they may extend to things like liability, as a lawsuit may use the home you live in as a means of gaining payment for a judgment against you.
Remember the total amount of the home will be insured, not just the loan amount. Even if you make a substantial down payment on your home, you will still probably have to insure it at its full value, which may be as much as 5% per annum. In some cases, it is far less and is under 1%. Make sure you understand the costs that insurance will add to your new real estate before you buy it.
Property Taxes
Almost all real estate is taxed, but the amount you pay will vary based on where you live, and how much your property costs. In many areas, property taxes fund local government programs, so if you live in a city with loads of social services, make sure you understand how much that will cost you every money when you pay your mortgage.
Private Mortgage Insurance (PMI)
If you don’t have a loan-to-value ratio of 78%, there is a good chance that you will have to buy PMI. Basically, PMI will cover any losses that your lender will face as a result of your inability to service a mortgage. The cost of PMI will vary based on a number of factors and should decrease as you pay down your mortgage. As soon as you reach the 80-78% threshold, you should be able to drop the PMI and save some money every month.
HOA Fees
Before you buy a residential property, it is a good idea to see if there are any Home Owners Association (HOA) fees that you will have to pay every month. An HOA will do things like maintain common spaces, or deal with other shared responsibilities in an area, and the costs for the HOA can vary based on what it is responsible for doing.
Non-Recurring (One Time) Costs
There are a few things that you will have to pay for when you buy a property on a one-time basis. Closing costs are probably the ones that can’t be avoided, but there are a few other things that are worth thinking about as well.
Closing Costs
Closing costs only have to be paid once, but they aren’t generally cheap. Closing costs cover the attorney fees if necessary, appraisal fees, inspection fees, home warranty, title service cost, a recording fee, the survey fee, and property transfer tax.
You may also have to cover a brokerage commission, mortgage application fee, points, pre-paid home insurance, pro-rata property taxes, pro-rata homeowner association dues if there are any, pro-rata interest, and other costs. You might be able to have the seller help with some of these costs, but they add up fast.
Upgrades
Once you move into your new home, it becomes much harder to do any upgrades that the property may need. You also may want to renovate a bathroom or kitchen before you move in, as it is much easier for everyone if the work is done on an unoccupied home.
Making upgrades to your new home is totally optional, but it is worth thinking about. The time and trouble to renovate will be much higher if you are living in the home, and you may be able to roll the renovation expenses into the mortgage or use a higher down payment to secure an equity loan in addition to your mortgage to cover the costs.
Other Things to Consider Before you Borrow
If this is the first time you are buying real estate, you might be thinking more about getting a loan than paying it off. It is very important to understand if you are able to make early payments, or pay off your mortgage before the term of the loan has passed. Many people save up money to pay down their mortgage, only to find that there are fees and penalties for doing so.
There are many ways that lenders penalize early repayment, and you need to understand the repayment terms before you take on a big debt. While most lenders do penalize early repayment, one way to sidestep these clauses is a new mortgage.
Remember, the terms of a mortgage tend to tilt in your favor as the down payment amount rises, and the term falls in duration. If you are saving up money as you make your mortgage payments, think about getting a whole new loan, and ‘buying’ your house from yourself. You probably won’t get nailed with penalties, and the terms of your new mortgage will probably be much better.
Does Early Repayment Make Sense?
Early repayment of a mortgage might sound like a good idea, but it is important to look at your entire financial life before putting your assets into your home. Because home loans are secured by real estate, the interest rates on mortgages tend to be some of the lowest available to consumers.
Unless you have zero debt besides your mortgage, it probably makes more sense to pay down high costs debts first, and then focus on your mortgage. There are also tax benefits for homeowners who are paying off a mortgage, and you need to make sure you aren’t giving away your tax breaks to build equity in an illiquid asset.
The situation is a little different for people that have an ARM, and want to switch over to an FRM. It is probably a good idea to use an FRM if you plan to live in your home for many years, as the FRM will give you a good idea of your monthly expenses for the foreseeable future.
Shop Around for the Best Mortgage
Buying a home is one of the most important milestones for anyone. There are numerous ways that a mortgage can be structured, and it is vital that you understand the terms that are written into your mortgage.
Today, there are a multitude of lenders in the marketplace, and you should spend time shopping for the best mortgage for your needs. If you spend a little time working with our mortgage calculator, it is easy to see how a small change in interest rate will shift the amount of money that you will pay over the term of your mortgage.
Make sure to shop around, and do your best to become educated on how mortgages work. If you understand the nature of lending, you can save a lot of money, and use your home as an asset that will help you create a stable financial life!
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