Nobody likes the idea of debt.
However, when it comes to big expenses like secondary education or buying a home, debt is sometimes necessary.
For most people, buying a real estate property is one of the biggest purchases they will make in their lifetime. There’s a lot of money involved, and the truth is that many people can’t afford the purchase upfront.
That’s where the option of taking on debt in the form of a mortgage comes in.
A mortgage is a long-term loan given by a lender to finance a real estate property. The property is used as collateral in exchange for the money that is borrowed.
Through mortgage loans, many individuals are able to afford a property and pay it off over a certain period of time. In this article, we’ll cover all the basics of what makes up a mortgage and the different types that are available to borrowers.
What is a mortgage?
A mortgage works similarly to other loans. When you take out a mortgage, you’re agreeing to pay back the money you borrowed plus interest over a set period of time. In exchange, the lender (usually a bank) pays the upfront cost of the property. The home or building is used as collateral to protect the lender in the scenario that the borrower stops making mortgage payments.
What are the parts of a mortgage?
There are several different parts of a mortgage. Most of the loan will be paid over a period of time, but there is also the upfront cost that comes with buying a property called a down payment. Almost every lender will require this. Usually, the down payment will be about 20 percent of the overall cost of the property. The other 80 percent is paid off with the loan.
Following an initial down payment, the borrower is responsible for paying for a percentage of the mortgage each month. There are four components that make up this monthly payment:
The principal is the total amount borrowed. This makes up the bulk of what is owed each month. The higher the principal, the more you owe. Depending on the type of mortgage, this amount may change over time. We’ll touch more on this later.
In exchange for the loan, the lender charges a certain interest rate. This amount is included in a monthly mortgage payment in addition to the principal. Interest is the profit the bank makes by giving you the loan.
Taxes and insurance
Most lenders will require the borrower to open an escrow account for property taxes and insurance. This way, the property owner sets that money aside and doesn’t have to worry about it. The lender is responsible for paying these fees on the borrower’s behalf.
Types of mortgages
Different people are in different financial situations. For this reason, there are different types of mortgages to accommodate the unique needs and circumstances of each borrower.
Next, we’ll go over the most common types of mortgages:
A fixed rate mortgage has the same interest rate throughout the entire term of the loan. Since the interest rate is locked in, this is a popular choice for homebuyers. It offers stability because the rate doesn’t run the risk of increasing as time goes on. Fixed rate mortgages often start at a higher interest rate than the other options.
An adjustable-rate mortgage (ARM) has an interest rate that can change throughout the loan’s lifetime. Since the interest rate is variable, the monthly mortgage payments will also fluctuate. Although this option is riskier for buyers, most ARMs come with caps that prevent the interest rate and monthly payments from shifting too dramatically. Additionally, this type of mortgage often starts at a lower interest rate than others.
Government-backed home loans are regulated by the U.S Department of Housing and Urban Development. They help in-need real estate buyers by offering benefits such as lower interest rates and down payments.
There are three main types of government-backed loans:
- FHA loans are backed by the Federal Housing Administration. They offer lower down payments and are available to borrowers with low credit scores. While these loans are popular among first-time and low-income buyers, they are not restricted to these groups. Anyone who meets the qualifications can apply.
- VA loans are administered by the Department of Veteran Affairs and are available to veterans of the United States Armed Forces.
- USDA loans serve people who live in rural areas. They’re backed and administered by the United States Department of Agriculture.
With an interest-only mortgage, buyers don’t have to pay principal until a certain time. This is a desirable option for homebuyers who are concerned about making monthly payments that include principal and interest. There's an inherent risk in delaying principal, especially because this kind of loan encourages people to buy properties they can’t immediately afford. That being said, it’s still a popular option for many.
Buying a property is a big deal and choosing the right way to finance it is equally as important. Every homebuyer has unique financial circumstances, so it’s important to know the basics of a home loan before jumping into it.
If you're looking for more ways to brush up on your real estate knowledge, check out this complete glossary of important terms to know.