What is a Mortgage and How Do They Work?
As a first-time homebuyer, you might be confused or even bewildered by the mortgage process and its many moving parts. Here's what you need to know about what a mortgage is and how it works for all parties – when you peek behind the curtain, you'll realize it's just another tool for purchasing a home.
Whether you are buying a house in Atlanta or a condo in Miami, it is a big decision. From start to finish, it can take a year or more to plan, save for a downpayment, find a lender, and then to find and make an offer on the house you want to buy. But before you get ahead of yourself, first things first, understanding what a mortgage actually is and how it works. In short, a mortgage is a loan from a lending institution to cover a home's purchase. The bank or lending institution holds the note for the house as collateral for the loan. The mortgage is also called a "lien against property," or sometimes referred to as a "claim on property."
You can start by using an online mortgage calculator, or visit with your bank or another mortgage lender so you'll know what you can afford in terms of a mortgage payment. This will also help you understand how much you may need to save for a downpayment.
A mortgage loan has 3 components:
- Principal: The principle is the difference between the home's final purchase price and the amount of your down payment. For example, if you provide $20,000 as a downpayment for the home you plan to buy for $200,000, your principal loan amount would be $180,000.
- Interest: The loan's interest is what you pay the bank or lender in exchange for providing and servicing the loan. This amount is based on the loan's interest rate, which will vary depending on the term (length of time) and type of loan.
- Downpayment: The downpayment is the amount you pay upfront, at the time of the purchase transaction, as your direct financial interest in the home.
As you make regular monthly mortgage payments, each payment includes the monthly interest on the outstanding loan balance and an amount that pays down the principal. When your principal amount is high at the beginning of your loan, most of your monthly payment goes to paying off interest. If you can, some people pay an additional amount toward the principal in efforts to pay less in interest over the life of the loan.
Additional costs first-time homebuyers often include in a mortgage payment.
As a homeowner, you are responsible for costs in addition to your mortgage payment, such as property taxes, homeowner's insurance, and possibly private mortgage insurance. Some people choose to tie these payments into their mortgage, rather than make separate payments. The bank then makes an all-inclusive payment to ensure the homeowner stays current on these obligations.
- Property taxes: Your county and municipal government assess property taxes on your home and land, which go to fund schools, roads, and other local government services.
- Homeowners Insurance: You can purchase homeowner's insurance through an insurance provider of your choice. This insurance covers most or all of the cost if you experience major property damage or a loss, such as roof damage from a storm or to repair or rebuild after a fire. Your lender will require you to have homeowners insurance.
- Private mortgage insurance (PMI): If your down payment is less than 20%, your lender may require you to have private mortgage insurance until you have acquired 20% equity in your home, usually meaning you’ll need to pay off 20% of the original home loan.. This insurance protects the lender in case you default on the loan.
There are many types of mortgage lenders and many types of mortgages.
Know that you have options. You can – and should – shop around for the best rates and payment plans. You may even be able to find programs that eliminate PMI requirements or allow you to purchase the home without a downpayment.
Mortgages fall into two basic categories: Fixed-rate or adjustable-rate.
- A fixed-rate mortgage maintains the same payment of principal at an interest rate set for the loan term. Lenders offer these mortgages for either a 30-year term or 15-year term. On a 30-year fixed-rate mortgage, you will pay more over the loan's lifetime because you will be paying interest for the life of the loan, but the monthly mortgage payment will remain the same as long as you have the loan. On a 15-year fixed-rate loan, your monthly payments will be higher, but more of each payment applies to the principal to pay off the home in 15 years. The total amount of interest you pay will be less.
- An adjustable-rate mortgage (ARM) has an interest rate that is subject to change over the loan term. An ARM usually carries a lower interest rate for the first few years but then adjusts after a set period, typically five years, to a new rate tied to market interest rates. A first-time homebuyer may benefit from a lower mortgage payment for the first few years, but faces the risk that the rate will increase when the adjustment date comes around.
Fixed-rate and adjustable mortgages are the basis for specific loan programs.
- For borrowers who qualify, a Federal Housing Administration loan or FHA loan allows for a low down payment, typically requiring only 3.5%. This can be a great option for many first time homebuyers or homebuyers that have little in terms of a downpayment. However, because you are not making a standard downpayment of 20%, your lender will require you to pay for PMI.
- A Veterans Affairs or VA loan is offered to anyone who served or is currently serving in the U.S. military. You must have served 90 consecutive days during wartime, 180 consecutive days during peacetime, or six years in the reserves to qualify. These loans typically require no down payment and do not carry PMI requirements, and come with a reasonable interest rate.
- Buyers in rural areas may qualify for a U.S. Department of Agriculture or USDA loan. These loans also do not require a downpayment. They have reasonable interest rates, and your income and location will determine if you qualify.
Make no mistake, a mortgage is a big commitment. When you understand how it works and what options are available to you, you are in a good position to start talking to lenders as you shop around to find the loan option that best suits your individual circumstances.