All You Ever Wanted to Know About Home Mortgages But Were Afraid to Ask
At some point in your life, you’ll probably make the decision to purchase a home and you’ll be faced with a decision about how to actually pay for it. 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. Here are a few details and options to consider when purchasing a home today.
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. A bank or private lender then allows you to borrow the remainder of the cost and pay them back with interest over a pre-determined amount of time. That amount of time 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, Interest, Taxes, and Insurance. The total of those four parts is commonly called “PITI,” which is simply the first letter of each part of your mortgage, and that term is usually how your Good Faith Estimate is given to you – as PITI. (ha ha)
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The Parts of a Mortgage
The Principal is the amount that you actually borrowed to pay for your new house. That is the purchase price, less the amount you put down out of your pocket.
If you purchased a home for $300,000, 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 and will require you to purchase Private Mortgage Insurance aka 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 basically the cost to you to borrow the Principal, just like on your credit card. We seem to be experiencing historically low interest rates. That means the cost to borrow the money is lower than what it has been in decades and in most of our lifetimes. This is s serious plus for buyers in the market for a new house!
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.
Insurance is paid to the company of your choice to insure your home against theft, fire, or any other disaster. You can opt out of paying that as part of the mortgage and pay it on your own to the insurance company yourself, unless the bank/lender considers you a high-risk borrower. If they do, they’ll want it built in to the monthly 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) 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. Over time, that shifts and more of the payment you are making will begin going towards the Principal. That means you’ll be building ‘equity,’ or ownership, of your house. That’s the goal!
So let’s talk types of mortgages or ways you can pay for your new home.
Traditional Types of Mortgages
The first option you might consider is cash (cha-ching)! If you’ve got a pile of dough saved, a wealthy relative who wants to give you a pile of dough, 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!
If, like the majority 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.
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. 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 (ARM’s) 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 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 can increase significantly. This is not the safest choice for a new homebuyer.
Those are the most traditional types of mortgages but there are a few other options to consider.
Non-Traditional Mortgage Options
Ever hear 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. 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.
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 and if the home is non-traditional. 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 the Seller’s pockets interest-wise. In exchange, the Seller takes a big risk that you are going to pay him, but should you fail to do that 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 to do a Carryback.
Another non-traditional option for purchasing a home would be Rent to Own, whereby you pre-arrange a portion of the rent you pay 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, you forfeit that additional ‘payment’ 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.
There are 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.
Hopefully some of this have been at least a little bit familiar, but I hope this helped answer at least one of your questions about mortgages. It can be a simple process, but it often causes a lot of anxiety. With these facts, I hope you can ease your fears and move on to the fun part, making your new ‘nest’!