Most people will need a mortgage to finance a home purchase. A mortgage works much like any other loan: You borrow money from a bank, credit union, or other lender and then pay it back over time. The main difference? A mortgage is the largest loan that most consumers will take on during their lifetimes.
Because of this, it is important for homebuyers to understand exactly what goes into a mortgage and what will be required of them to obtain one.
Those buyers who do their research will dramatically increase their odds of obtaining a mortgage that best fits their needs.
The Basics
Once you take out a mortgage, you’ll make monthly payments to pay it back. The duration of your loan varies depending on the type of loan you take out. Most homeowners choose between a 15-year and a 30-year mortgage.
When you send your payment to your lender each month, your dollars go toward paying off several components of your mortgage. There is the principal balance, of course. This is the amount of money you borrowed. If you borrowed $200,000 to purchase your home, that $200,000 represents your principal balance.
When you submit a mortgage payment, not all of it goes toward reducing your loan’s principal. A portion of your payment covers interest, which is how lenders earn money on the loan. For example, with a long-term fixed-rate mortgage on a $200,000 loan, borrowers can pay well over $250,000 in interest over the life of the loan if payments are made according to schedule.
This figure is so high because $200,000 is a substantial loan amount, and interest costs compound over time. The longer the loan term and the higher the interest rate, the more interest you will ultimately pay.
Part of your monthly payment, depending on the arrangement with your mortgage lender, may also go toward annual property taxes and homeowners' insurance premiums. Both of these costs vary widely by location and property type. In some parts of the country, homeowners may face annual property taxes of $10,000 or more. In other regions, those taxes may be closer to $2,000. Homeowners insurance premiums also vary, with annual costs commonly ranging from a few hundred dollars to well over $1,000 depending on coverage levels, location, and home value.
Types of Mortgages
Homebuyers can choose from several different types of mortgages, each with its own advantages and disadvantages.
The two most common options are the 30-year and 15-year fixed-rate mortgages. As their names suggest, the interest rate on these loans remains unchanged for the life of the loan. The key difference between the two is the repayment period. With a 30-year mortgage, borrowers make payments over three decades. With a 15-year mortgage, the loan is paid off in half the time.
Monthly payments on a 30-year fixed-rate mortgage are lower because the balance is spread over a longer period. However, 15-year fixed-rate mortgages typically carry lower interest rates, allowing homeowners to pay significantly less interest over the life of the loan.
Borrowers may also choose an adjustable-rate mortgage. As the name implies, the interest rate on these loans changes over time. Typically, the loan begins with a fixed interest rate for a set number of years, such as five or seven. After that period ends, the rate adjusts based on market conditions and other economic factors, meaning it can increase or decrease.
The main benefit of an adjustable-rate mortgage is that the initial interest rate is usually lower than that of a traditional fixed-rate loan. The risk is that the rate may rise after the introductory period ends, resulting in higher monthly payments.
Escrow Accounts
When you buy a home, you are responsible for paying property taxes and maintaining homeowners' insurance. If you have a mortgage, you may choose to pay these expenses yourself or include them in your monthly mortgage payment and have your lender manage them.
The second option involves an escrow account. For example, if your annual property taxes total $6,000, you could pay that amount in a lump sum or contribute $500 each month as part of your mortgage payment. Your lender deposits those funds into an escrow account and uses them to pay your tax bill when it comes due. This approach can help homeowners avoid the burden of setting aside a large sum of money each year to cover taxes and insurance.