Buying a home is likely the largest purchase you will ever make in your life. But not that many people have a few $100K in the bank just waiting to buy a home outright, so most buyers have to take out a mortgage in order to become homeowners.
But just what is a mortgage, and how does it work?
The first question has a relatively simple answer. A mortgage is a specific type of loan that is tied to the purchase of real estate. With a mortgage, the borrower agrees that the lender has the right to take ownership of the property and sell it if the borrower does not make payments according to the terms of the mortgage agreement.
How a mortgage works, on the other hand, is rather more complicated. There are various types of mortgages available, which can make choosing the best one somewhat confusing to those unfamiliar with the topic. However, there are several factors to consider that can help you decide which type of mortgage is right for you. Here, we’ll answer four common questions many homebuyers ask when seeking their first home loan.
How Does a Mortgage Payment Work?
First, it’s important to understand the four main components of any monthly mortgage payment. These are summed up in the acronym PITI, which stands for:
The principal is the initial amount of the mortgage loan. As an example, suppose you want to buy a house that costs $300K. You are able to put down 20% of the cost of the home, or $60K. In this case, your loan’s principal amount would be for the remaining $240K.
Next is the interest. When you first take out a mortgage, the bulk of your monthly payments will usually go toward interest, or the amount you owe your lender for financing the loan. An interest rate of 3% or 5% may not sound like a lot, but it adds up over time. For example, on a $200K 30-year loan with an interest rate of 5%, you’ll pay almost as much in interest ($186,500) as you will in principle.
Property taxes are the next line item in any mortgage payment, and will vary based on where your property is located. And while you will eventually be able to pay off your loan’s principal and interest, you will still have to pay property taxes once your mortgage is paid in full.
The same goes for insurance — it is a lifetime cost — although it is usually considerably less than tax payments. According to Zillow, you can expect to pay approximately $35 per month for every $100K of your home’s value. In other words, your $300K house would cost you about $105 per month in insurance payments.
What Types of Mortgages Are Available?
How much you pay in principal, interest, and insurance will depend on the type of mortgage you take out. While the basic principle of all mortgages is the same, there are two primary factors that will determine how long you will make payments and the amount you pay each month.
Long- or Short-Term Loan
The first thing you’ll want to decide is the length of the loan term. A 30-year mortgage is perhaps the most popular loan term, as it allows for relatively low monthly payments. In fact, about 90% of Americans choose a 30-year mortgage. However, there are other loan terms available, the most commonly available terms being 10 years or 15 years.
It’s important to know what loan term is right for you — or how much monthly payment you can afford — as it will also impact the next major component of your loan agreement: the interest rate.
As a good rule of thumb, the longer the loan term, the higher the interest rate. For instance, according to Freddie Mac, in March 2019 the average interest rate for a 30-year mortgage was 4.28%, while 15-year mortgages averaged a 3.71% interest rate for the same time period.
Assuming your interest rate is below 5.5%, financial advisors will generally recommend a 30-year fixed rate loan. While they can have a slightly higher interest rate than a 15-year loan, you’re often better off paying the lower monthly payment on your loan and putting the difference into the market where investors have earned an average of 7% over the last few decades.
|30-year Mortgage||Lower monthly payments||Pay more interest over the life of the loan||Buyers with lower monthly incomes and/or lower down payments|
|10- to 15-Year Mortgage||Pay less interest over the life of the loan||Higher monthly payments||Buyers with higher monthly incomes and/or higher down payments|
Fixed or Adjustable Interest Rate
While a lower interest rate is always better (all else being equal), as it means you will pay less in interest over the term of the loan, it’s important to understand the type of interest rate that applies to your loan. There are three types of mortgage interest rates:
- Fixed rate mortgages (FRMs)
- Adjustable rate mortgages (ARMs)
- Interest-only loans
The interest rates in the examples mentioned above apply to fixed rate mortgages. With a fixed rate mortgage, the interest rate is set when you take out the loan. In other words, if your mortgage is for 30 years, you will pay the same interest rate for all three decades.
These types of mortgages offer stability, as you will know how much you will pay each month for the life of the loan. As a result, this is a great option for homebuyers who are planning to stay put for many years.
On the other hand, there are adjustable rate mortgages, also known as variable rate mortgages. Often ARMs offer a lower initial interest rate than FRMs, but as the name would suggest, that rate can change. With a 5/1 ARM, for example, the 5 denotes the number of years your initial interest rate will stay the same, while the 1 denotes how often your rate can be adjusted after the initial fixed interest rate period is over.
In other words, for every year after the 5th year of your loan, your interest rate can change based on the index, which is a measure of international interest rates most commonly tied to the rates of U.S. one-year-constant-maturity Treasury securities, the Cost of Funds Index (COFI), and the London Interbank Offer Rate (LIBOR). Most ARMs today are fixed for 5, 7, or 10 years and adjust annually thereafter.
Finally, there are interest-only mortgage loans, but these are much rarer than FRMs and ARMs. In fact, only about 1% of all mortgages in the U.S. are interest-only loans. The few homebuyers who choose this type of mortgage usually do so because monthly payments are significantly lower on an interest-only mortgage during the initial phase of the loan, which allows them to purchase a larger home than they might otherwise have been able to afford. However, monthly payments increase significantly during the final period of the loan term.
For instance, many interest-only mortgages have a 30-year term with a 10-year period where the homebuyer’s monthly payments only go toward the interest on the loan, rather than also paying down some of the principal. In other words, if you were to take out a $300,000 interest-only mortgage with a 4% interest rate, you would only pay $1,000 a month during the first 10 years of the loan. However, payments would jump to $1,900 per month for the remaining 20 years.
Fiduciary financial advisors typically recommend that you stay away from ARMs and interest-only loans unless you are a sophisticated buyer who plans to be in the property for less than 5 years. While the lower initial interest rate and monthly payment can be attractive, they often jump significantly when the rate resets or the balloon payments are due. Additionally, if you believe interest rates are likely to increase over time (and given that interest rates have stayed at historical lows since the 2008 recession, it’s plausible), ARMs may not be a good gamble.
|FRMs||Predictable monthly payments||Potentially higher interest rates||Buyers who plan to stay in their home long-term|
|ARMs||Potentially lower interest rates in the short term||Fluctuating monthly payments||Sophisticated buyers who plan to stay for 5 years or less|
|Interest-Only Loans||Lower monthly payments for early years of loan||Higher monthly payments for later years of the loan||Buyers who plan to stay for 5 years or less|
How Do I Get the Best Mortgage Terms?
Now that you know the pros and cons of the different types of loan terms, where do you get a mortgage with the optimal terms for your situation?
Before you even start looking for mortgages, you should first determine how much home you can afford. Once you’ve decided on a reasonable price range, there are four things lenders look at when deciding on your loan’s terms:
- Down payment
- Credit score
- Debt-to-income ratio
Most buyers are familiar with the concept of a down payment. This is, of course, the money you can pay upfront for the home. A higher down payment results in lower monthly payments, as well as a lower interest rate.
Your credit score is calculated based on a mathematical formula that takes into consideration things like your bill-paying history, your current unpaid debt, and how much of your available credit you’re using. Most scores range from 300 to 850, with a higher score signaling to potential lenders that you are more likely to pay back the loan.
As a result, banks usually charge borrowers with higher credit scores lower interest rates, which can save you significant money over the life of your mortgage. If you can improve your credit score before buying a home, you can save quite a lot of money in interest payments.
The final two items in the list are tied together. With a higher income, you are able to afford higher monthly payments, and therefore lenders are willing to approve larger loan amounts. That’s pretty simple.
However, your debt-to-income (DTI) ratio may be a bit less familiar. Your DTI is essentially your monthly debt payments divided by your gross monthly income. Put into numerical terms, if you owe $1,000 a month in debt payments, and earn $4,000 before taxes, your DTI would be 25%. Lenders will typically not lend to you if your total DTI (including your new mortgage) is over 45% because it’s a signal that you might be too stretched, and won’t be able to afford your monthly payment. Additionally, the lower you can get your DTI before applying for a mortgage loan, the better your terms will be.
Where Do I Get a Mortgage?
Once you’ve taken as many steps as possible to ensure you get the best loan terms available, you can start looking at mortgage providers. There are two main types of mortgage lenders — government-backed lenders and traditional lenders.
When it comes to government-sponsored mortgages, the most popular for first-time homeowners is a Federal Housing Administration (FHA) loan. FHA loans are intended to help Americans afford homes who otherwise might be priced out of the housing market.
Among the beneficiaries of FHA loans are first-time homebuyers, as well as those with low incomes or little savings. Generally, FHA loans have less stringent financial requirements — which is great if you have less than perfect credit — and require lower down payments. The downside is that FHA loans require upfront mortgage insurance, which can’t be canceled unless you make at least a 10% down payment.
Another type of government-backed mortgage is a VA loan, which is sponsored by the U.S. Department of Veterans Affairs. The advantage of a VA loan is that they often don’t require a down payment or mortgage insurance, but they do require a funding fee that can run from 1.25% to 2.4% of the loan amount. And as you might guess, this type of loan is available only to military service members and their families.
Finally, the United States Department of Agriculture (USDA) also provides a loan program for those who would like to buy homes in rural areas, and who meet certain income requirements. These loans don’t require a down payment or mortgage insurance, but borrowers have to pay an upfront fee — 1% of the home’s purchase price.
If you don’t qualify for any of the government-sponsored mortgage programs, you can take the more traditional route and finance your home purchase through a bank or credit union. These mortgages are not guaranteed or insured by the government, instead conforming to loan limits set by Fannie Mae and Freddie Mac.
For borrowers with higher credit scores and a stable income, traditional loans are often the best choice, as they result in the lowest monthly payment.
Pick a Mortgage That’s Right for You
The process of buying a home can be overwhelming — from financing to the home search to packing up and moving. However, 75% of non-homeowners and 90% of homeowners believe that home ownership is still a quintessential piece of the American dream.
While owning a home might be one of your personal goals as well, knowing how mortgages work — and how you can get the best one for you — is crucial to ensuring your new home is a source of joy rather than a monthly stressor.