Loan 101: What Is a Mortgage and How Does It Work?
January 28th, 2022
You’ve always heard that 20 percent is the gold standard for a down payment - making home buying feel more like a dream than a reality for many. Yes, 20 percent is still a good number to aim for. But having less than that doesn’t mean you can’t afford to buy a house.
Below we’re going over the ins and outs of obtaining a mortgage - and what you should expect your monthly mortgage payments to look like.
What Is a Mortgage?
A mortgage is a secured loan used to buy a house or piece of property - meaning it is a type of loan that requires collateral from the borrower ( house, care, etc.). A fixed mortgage is typically 30 years, with 6% of homebuyers choosing 15-year loans.
How Does a Mortgage Work?
If you choose to use a mortgage to purchase your home, the lender (your bank, credit union or other financial institution) will actually own the home outright. You will make regular payments (typically monthly) to the lender for a predetermined length of time. These payments will include the principal amount and interest. It may also include other expenses like property taxes, private mortgage insurance and homeowner’s insurance.
Your mortgage’s interest rate is typically determined in one of two ways - fixed or adjustable.
Just as it sounds, a fixed-rate mortgage offers an interest rate that will not change over the lifetime of your mortgage. From year one to the final payment, you can expect to pay the same interest rate for the entirety of the loan.
Adjustable-Rate Mortgages (ARMs)
Unlike a fixed-rate mortgage, an ARM will include varying interest rates over the lifetime of the loan. With an ARM, the lender will offer a set interest rate for the first few years (anywhere from the first three to 10 years typically). Once that time has passed, the interest rate could increase. In turn, this would increase the borrower’s monthly payments.
While ARMs usually offer a lower initial interest rate than fixed-rate mortgages, the borrower is taking a chance on whether or not that rate will eventually rise. Though ARMs are typically not encouraged, they could be useful for those who plan on selling the home sooner rather than later, or for those who know they will be refinancing their mortgage before the rate increases.
How Is a Mortgage Payment Calculated?
Let’s assume you’re taking out a 30-year fixed-rate loan for a $200,000 house. Here’s what your mortgage payment will likely include:
The principal amount: This is how much you bought the property for, minus your down payment. If you bought a $200,000 home and put down $20,000 (10 percent) upfront, your principal amount for the loan would be $180,000. For a 30-year loan, we’d divide that amount into 360 monthly payments - about $500 per month.
The interest: If you’re obtaining a fixed-rate mortgage, your interest rate will not change over the life of the loan. If your annual interest rate is four percent, you’d need to divide that amount by 12 to determine how much you’ll be paying in interest per month. In this case, you’d be paying 0.33 percent per month.
Private mortgage insurance (PMI): If you plan on making a down payment of less than 20 percent when buying a home, you will likely be required to pay a monthly PMI (private mortgage insurance) premium. In most cases, this insurance will no longer be required once you have paid up to 20 percent in mortgage payments.
Property taxes: It’s common for your lender to establish an escrow account in which things like property taxes are collected. That’s why they will often be included in your monthly mortgage payments. When it comes time for the government to collect, your lender will pay the amount on your behalf using what you’ve already put into escrow.
Homeowners insurance: Most lenders will require a borrower to obtain a homeowners insurance policy, which again will typically be lumped into that monthly mortgage payment.
If you’re considering purchasing a home, it’s important to do your homework first. Speak to a mortgage broker and begin researching mortgage types and rates before visiting your first open house. This can help eager homebuyers like yourself stay level-headed and realistic about what you’ll be able to afford.