If you’re trying to buy a home for the first time, or even the fifth, you’ll want to know how mortgages work. Your home will probably be the biggest investment in your life so understanding what you are getting into only makes sense. And in the long run it may save you a lot of money.
And it’s surprising. Many folks who have been paying off a mortgage for years don’t really understand the details of how it all works. But it’s never too late to learn.
Of course if you are paying cash for your new home you don’t need a mortgage. But unfortunately most of us don’t have that kind of capital around so we need to borrow the money for the home. In effect, we’ll be using someone else’s money and they will make us pay for that privilege by charging us an interest rate. In a sense we are renting their money and we have to pay a monthly rental amount until the loan is payed back.
Mortgages have lots of jargon and terminology tossed around. Here’s an explanation of a few of the basics.
The amount that’s being borrowed is called the principal. That will be the selling price of the home and what the seller will receive after the “closing”. The closing is the final transfer of the funds between buyer and seller, or more accurately the lender and seller. Of course, the lender is also intimately involved with this closing process too.
The interest rate is the amount the lender receives for renting you the money. The rate can be fixed or adjustable depending on the loan arrangement. The advantage of an adjustable rate is it can be low in the beginning, to keep the monthly payments down, but will go up over time as the mortgagee is better able to afford payments. It’s always good to understand the lifetime cost of fixed loans versus adjustable loans. Doing the math will help you understand that everything has a price. Whether you pay now or later the lender will get their money back… plus interest. How much you end up paying for your mortgage is really up to you.
The Loan Term
The term of your loan is the length of time the lender gives you to pay it back. It can be any amount of time but typically the term is fifteen or thirty years. Twenty year terms and forty year terms are also becoming more common as folks take advantage of low interest rates to accelerate the payoff of their mortgages or try to lower payments by stretching out their terms.
By the way, just twenty years ago interest rates were much higher than they are now… 9% then versus roughly 4% today. They peaked at 19% in the early 80′s. Interest rates are historically low at the moment. They haven’t been this low since the 1960′s.
An interesting concept that many homeowners don’t understand is amortization. It’s probably the most complicated aspect of any loan. Here’s how it works…
Monthly loan payments are computed by dividing the total cost of the loan into monthly payments based on the term of the loan. As these monthly loan payments are calculated, more of the interest is being paid in the beginning while more of the principal is paid at the end of the loan term. The monthly payment is still the same over the life of the loan but the lender gets more of theirs first, before the mortgagee gets their payment applied to the principal amount. It all comes out in the wash. But if for some reason the homeowner defaults on the loan the lender has the advantage in this situation. As usual the lender just about always wins.
But that monthly payment is even a little more complicated than that.
There’s something called PITI which stands for Principal, Interest, Taxes, and Insurance. Some loans include all of these in the monthly payment. So it’s not uncommon to see additional breakouts from within that payment amount. Of course, this is all dependent on how your loan contract was arranged with your lender.
The Real Cost Of Your Home
If you’ve ever bought a home or have been to a closing, seeing the final amount that you will end up paying on the contract is always a sobering moment. A home that costs $100,000 will actually cost almost $200,000 by the time you pay off a 30 year mortgage with an interest rate of 5%. You better hope that home values go up in your area. Fortunately they usually do.