Understanding Mortgages

family discussing mortgage loan at bank

Most people will need a mortgage to finance the purchase of a home. 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 home buyers to understand exactly what goes into a mortgage and what will be required from the prospective home buyer 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 upon what type of loan you took out. Most homeowners go with 15-year or 30-year mortgages.

When you send your payment to your lender each month, your dollars will go toward paying off several pieces of your mortgage. There is the principal balance, of course. This is the amount of money you borrowed. If you borrowed $200,000 to pay for your home that $200,000 is your principal balance.

You will not only be paying down this balance, though, each time you send in a check. Some of your dollars will go toward paying off your mortgage's interest. Interest is how lenders make money on your loan. If you take out a 30-year fixed-rate loan of $200,000 with an interest rate of 3.96 percent, you'll pay $142,080 in interest alone if you pay off the loan at maturity. The reason this figure is so high is that $200,000 is a lot of money, and interest payments add up over time.

Part of your payment, depending on the arrangement you made with your mortgage lender, might also go toward paying off your annual property taxes and homeowners insurance premiums. Both of these costs vary. In some parts of the country, homeowners might face yearly property taxes of $10,000 or more. In other parts of the country, that figure might be as low as $2,000. The Federal Reserve Bureau says that the average cost of an annual homeowners insurance policy ranges from $300 to $1,000 depending on the part of the country in which you live and the size of your home.

Types of mortgages

You can choose from several different types of mortgages. Each comes with its positives and negatives.

The two most popular loan types are the 30-year fixed-rate mortgage and the 15-year fixed-rate mortgage. As their names suggest, the interest rate attached to these loans never changes, hence the "fixed rate." The difference between the two loan types is their duration. In a 30-year mortgage, you'll make loan payments for three decades to pay off your loan completely. In a 15-year mortgage, you'll pay for just 15 years.

The monthly mortgage payment attached to a 30-year fixed-rate mortgage is lower than it is with a 15-year fixed-rate mortgage because payments are spread out over a longer number of years. However, 15-year fixed-rate mortgages typically come with lower interest rates, which means that homeowners pay less interest during the life of such loans.

Homeowners can also choose an adjustable-rate mortgage also. Again as the name suggests, the interest rate on these loans changes during the loan term. Often, the loan will have a fixed rate for a certain number of years, say five or seven. The rate will then adjust based on a host of economic conditions, meaning that the rate can either go up or down.

The benefit of an adjustable-rate loan is that the initial interest rate is usually lower than are the ones attached to traditional fixed-rate loans. The risk, though, is that the rate will rise significantly after the fixed period ends.

Escrow accounts

When you buy a home, you'll have to pay property taxes, and if you are taking out a mortgage, you'll also need to purchase homeowner's insurance. Homeowners can either pay these expenses on their own when they are due, or lump them into their monthly mortgage payments and have their lender pay them on their behalf. If your down payment is less than 20% of the home’s purchase price, you will also be required to buy PMI (private mortgage insurance) which the lender automatically adds to your monthly payment.

With an escrow account, property taxes and insurance are lumped into your monthly loan payment. Consider property taxes: If your property taxes are $6,000 a year, you can add $500 a month into your monthly mortgage payment. Your lender will then put this money into an escrow account and withdraw from it to pay your property tax bill when it is due. It is a good option for homeowners who do not want to save the large amount of money they'd need each year to cover their property tax bills.