Owning a house has been a fundamental part of the American dream for decades, but the housing market crash that kicked off the recent recession was a warning about how comfortable people had become with debt and risky mortgage loans. The housing market is still struggling to recover back to its pre-crisis levels, but it is on the upswing, and many people are starting to look into becoming homeowners. However, before you scrape together a down payment on your dream home, you should know more about mortgage loans.
1. What Is A Mortgage?
Even if you're still a renter, you can probably answer that question: a mortgage is a loan that is used to pay for a piece of property, which is repaid slowly over time, along with interest and any necessary fees. The property itself is typically used as collateral in the loan agreement, and can be repossessed by the lender if the borrower (owner) doesn't pay.
That's a good summary of how most mortgage loans work, but it's only a fraction of the real story. When they were first introduced in the 1930s, mortgages were always for 30-year periods, and the payments were only for the interest on the loan; at the end of the term, homeowners needed to provide a final “balloon payment” in the full amount of the loan's principal. This payment structure proved unrealistic, and foreclosures were very common, so the Federal Housing Administration (FHA) introduced the concept of amortization: the ability to pay an incremental amount of the loan's principal each month along with the interest payment, reducing the loan gradually over time.
Because of amortization, today's mortgage loan is open to many different payment options, usually reflecting how the interest is calculated and how quickly you will pay back the loan. While the original mortgage in the 1930s was a fixed-rate, 30-year term, there are now far more options. These options allow you to choose whether you'd like to pay back the loan quickly and with less interest, or pay slowly and regularly (even though your total contributions at the end of the mortgage will be far larger than the value of the principal). There are two basic types of mortgages: fixed-rate and adjustable-rate. A fixed-rate loan offers a stable interest rate that will never change, so you always pay the same amount every month. An adjustable-rate mortgage (or ARM), on the other hand, allows interest rates to fluctuate according to market conditions, and allows people to pay lower initial rates.
2. Fixed Rate versus Adjustable Rate
While there are other types of mortgages, most fall into these two categories, based on how the interest is charged. There are advantages and disadvantages to both types of loans. With a fixed-rate mortgage, you pay the exact same amount of money every month for a predetermined amount of time - usually 30, 20, or 15-year terms. The longer-term agreements allow you to pay the least amount each month, but you pay the most interest on the principal; the shorter terms allow for a quick payoff, and the interest rates can be lower, but you pay more per month. Fixed-rate mortgages are appealing because they offer long-term stability, which is good if you're planning to stay in your home for a very long time.
Adjustable-rate mortgages, in contrast, have an interest rate that will change - usually on a yearly basis - to reflect the current market conditions. It means that you will sometimes pay more one month than the next; however, the initial interest rate for most ARMs is significantly lower than the fixed rate. These mortgages make the most sense for people who are planning to sell their home within the next few years; they can start gaining equity on the property much faster, but are at the mercy of the market and risk being caught in a house with high interest rates during a market slump.
3. Comparing Mortgages
Very few people want to do complicated mathematics after they leave high school, but when it comes to your mortgage, it can be critical to take the time to sit down and calculate your best option.
Interest rates are one of the most confusing aspects of a loan. There are many different variations in how it's calculated. This includes whether the interest compounds, and how long the term is, as well as the principal loan itself. To make it easier, online mortgage calculators are available to help you better determine the costs associated with different mortgage terms and interest rates.
Annual percentage rates, or APRs, allow you to make comparisons and determine the actual cost of a loan; it's the average annual finance charge divided by the overall amount borrowed. This is an important tool because it takes into account all of the loan fees, closing fees, and other charges that may be applied to your mortgage. While your broker will give you the APR on your mortgage if you ask, it's important to know how your interest rate is calculated, when (if ever) it will change, and the entire amount paid when the mortgage is done.
So, for instance, take a $100,000 loan at seven percent interest, with monthly payments for 30 years (360 payments total). The payment would be $665.30 each month. Now, if the loan carries fees totaling $2,150, the actual loan amount is $97,850; the APR is the rate at which a monthly payment of $665.30 would pay for the actual loan amount minus the fee. In this case, the APR is 7.2 percent, not a flat seven percent.
This is especially important for people seeking adjustable-rate mortgages, as their interest rates will flux on a regular basis. There will also be caps on how high your interest rate can go over the course of the entire loan; if you don't know about them, you risk signing up for an ARM that can charge you through the roof and beyond.
4. Understand When a Deal Is Really a Deal
Buying a mortgage, like buying a car, is an intimidating process for someone who's unprepared; every broker wants you as their next client, and they will enthusiastically (or aggressively) offer you discounts, freebies, and other things that will appear to sweeten the deal. One of the most common ways to offer a discount is to include mortgage points in the offer. The points are prepaid interest, equal to one percent of your mortgage amount, which you pay upfront in exchange for a lower rate during the rest of your loan period. If you're planning to stay in your home for the long haul, points can help you; but if you're not going to mathematically benefit from purchasing points, then they're not a deal - even though they might appear to be in the advertising.
Similarly, it's asking for trouble only to look at interest rates when comparing mortgages. One company may offer no points, but will charge several thousand dollars worth of origination fees and activation costs that end up making them more expensive than their competitors who require discount points. Part of the reason why APRs are so helpful is that they take these costs into account when calculating the adjusted interest rate you'd actually pay. Make sure that, realistically, you're able to pay off your mortgage. A suspiciously low interest rate on a big house can be a trap that can turn into a debt-producing nightmare down the road.
5. Be Realistic About What You Can Afford
It can be tempting to start house hunting as soon as you get the impulse, but it's important to remain realistic about what you can afford to pay. Many people dream of their ideal house, but will not be able to afford it in their first round of home ownership. Lenders typically advise that most people can afford a house that is worth about three times their gross annual income, but you should always do your own budgeting before taking that number at its word; can you truly afford to spend 30-45 percent of each month's income on your mortgage bill? Are you also paying off other loans, like student loans or car payments?
If you do decide to apply for a mortgage loan, the lender will look at your credit history to determine what they can offer you. If you have a great credit history, you may qualify for a lower interest rate; if you have a low credit score, the lender may either give you a very large interest rate or just deny you the loan. It's also important that you're able to pay for a portion of the house's value upfront; a down payment of at least 10 to 20 percent is standard.
For help in finding a great mortgage option, complete our online mortgage loan solutions form and our free matching service will instantly locate the highly rated solutions available. You can also call AmOne toll-free at 1-800-781-5187 to speak with one of our financial search specialists. Our offices are open Monday through Friday from 9:00 AM to 9:00 PM and on Saturday from 9:00 AM to 5:00 PM Eastern time.