At its basic core, a mortgage is a loan. No one expects you to be able to come up with hundreds of thousands of dollars on your own to purchase a house. This is where mortgages come in because they enable you to borrow extra money that you need to buy your house. You then agree to pay back this money over a set number of years (terms) at a higher cost than what you started with (interest).
While this debt can be a huge burden, the value in purchasing a home with a mortgage is that the mortgage helps you buy an asset with the expectation that its value will increase over time, adding to your net worth, providing tax breaks, and puts a valuable roof over your head. Over time, you will build equity by paying off your mortgage. This equity will become your largest asset and will provide security for you and your family.
A mortgage also allows you to pay a fraction of the home’s value (or in some cases, nothing) upfront. This is known as a down payment. The lender then loans you the rest of the money and you pay it back over time plus interest.
To make sure you pay back the money you borrowed, you are required to put your house up as collateral or security. If you stop making payments, the lender can take the house back (foreclosure).
Because there are so many mortgage programs, it is important to research and make sure you are getting the right mortgage for you. If you go with a program that is not right for you or you cannot afford it, your risk of defaulting or ending up in foreclosure increase significantly. It is important to choose a lender that has your best interests in mind and does not push you into risky or expensive loan programs. In fact, the lender should educate you throughout the entire process so you know what to expect, how much you are paying, and why you are paying this.
When looking to get a mortgage, the company that loans you money is called a lender. Lenders come in many shapes and sizes and can have different names, such as mortgage broker, mortgage lender, banks, mortgage banker, credit unions, community banks, and so on.
What makes up a mortgage payment?
A mortgage payment consists of Principal, Interest, Taxes, and Insurance (PITI). A mortgage payment may also consist of mortgage insurance.
The principal is the original amount that you borrowed to pay the mortgage. A portion of your monthly payment is applied to the principal to reduce the outstanding balance owed. The principal amount depends on the purchase price of the house and the amount of the down payment.
Interest is otherwise known as the cost of borrowing money from a lender. When you take out a mortgage, you agree to an interest rate, which will impact how much your monthly payment is. The higher the interest rate the higher your monthly payment will be. The interest rate is expressed as a percentage and depends on your credit score, income, debt-to-income ratio, down payment, and other financial information that assess the risk in lending you money and your ability to repay your debt. Your monthly payment is first applied to the interest due, then the principal amount. Because interest is frontloaded on your repayment plan, you will pay more in interest each month in the first years of your mortgage, which means the principal balance is reduced more slowly at first. A lower interest rate allows you to pay the interest off faster and build equity faster by reducing more of the principal with each month’s payment, instead of paying more interest.
Taxes refer to property taxes are paid twice a year or every six months. These taxes are averaged on a monthly basis and added to your monthly payment. The amount each moth is paid into an escrow account that was created at the closing of your mortgage. Each 6 months or whenever the taxes are due, your property taxes are paid in full. The set-up of the escrow reduces the need for you to save the equivalent amount each month or pay the taxes in one lump sum each 6 months, eliminating the possibility that you will be unable to pay your property taxes.
The Insurance refers to any homeowners insurance and hazard insurance required for the property. These premiums are also due on an annual basis or semi-annual basis. The premiums are averaged out for each month and added to the monthly payment similar to the property taxes. To ease another burden on you from coming up with another lump sum, these monthly payments are also added to an escrow account and paid when the insurance premium is due, ensuring that your insurance premiums are paid on time and in full.
Mortgage Insurance refers to the monthly payment required to protect the lender against the possibility that you might default on your mortgage. The amount and duration of mortgage insurance depends on your down payment and which loan program you go with. Mortgage insurance can go away after a certain period of time or when the loan-to-value (LTV) reaches a certain percentage. For conventional loans, mortgage insurance is required for any loans where the down payment is less than 20%. If less than 20%, mortgage insurance goes away once the LTV reaches 78%. For FHA loans, mortgage insurance is required for the life of the loan unless your down payment is greater than 10%.
Fixed-Rate Mortgage (FRM) vs. Adjustable-Rate Mortgage (ARM)
The most popular mortgage option today is the fixed-rate mortgage. A fixed-rate mortgage provides more stability and security for a borrower because the interest rate does not change throughout the life of the loan; therefore the monthly payments stay the same.
An adjustable-rate mortgage provides you with lower interest rates during an initial period of time (usually 1-10 years). After this period, interest rates can increase or decrease depending on the market conditions. This causes your monthly payments to rise or fall as well, providing for less security and stability as there can be cases of payment shock when monthly payments increase to levels that are not manageable given your budget.
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