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Mortgage Basics that Newbie Homebuyers Should Know

March 9, 2015
Banking
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If you want to buy a home, you’ll probably need a mortgage to pay for it. And for many people, that means shouldering a 30-year commitment of making monthly payments to repay your lender.

There are a few things to consider, though, before taking that leap and applying for a loan.

Fixed and adjustable rates

As with other loans, borrowers pay interest on mortgages. On some, the rate is fixed, so the payments stay the same. But with other types of loans, the interest rate can change, either going up or down depending on a market index, such as the prime rate. This means the monthly payment can also rise or fall.

A fixed-rate mortgage, with its more stable monthly payments, can be a more straightforward option for people with relatively stable incomes, especially if interest rates are expected to rise. If rates go down, though, you’ll have to refinance the loan to benefit from the decline, and that process can be expensive.

Your monthly payments for an adjustable-rate mortgage, or ARM, meanwhile, can change in sometimes as little as a month, depending on the loan’s adjustment frequency. Often, these types of loans are easier to qualify for and offer lower introductory rates, which can make them more appealing to first-time homebuyers. If interest rates go down, you’ll be able to pay less without having to refinance. But if rates rise quickly, you may end up with a much larger payment than expected.

Often, lenders offer what’s called a hybrid ARM, with an initial number of months or years during which the rate is fixed. After that term ends, the rate starts to adjust periodically as market rates change.

Different financial institutions sometimes offer variations on these models. With some loans, you can defer interest payments, and with others, you can make additional payments on the principal, or the original amount borrowed, in advance.

Generally, you’ll end up paying less in interest on loans with shorter durations, like 15 years, and more with longer mortgages. Remember to read the terms of a loan carefully before signing, so you know what to expect.

Big-picture budgeting

Your mortgage’s principal and interest payments won’t be your only expenses. Property taxes and homeowner’s insurance are generally also tacked onto the monthly bill. Typically, the money for taxes and insurance goes into an escrow account used by the lender to cover those costs.

If your down payment was less than 20% of the property’s value, you’ll usually have to pay for private mortgage insurance, or PMI, which covers the lender for the remaining balance if you don’t pay back the loan. In most cases, you’ll also have to pony up about 2% to 5% of the purchase price to cover closing costs and other expenses when you finalize the deal.

Factor in all these costs when calculating what you can afford to borrow. Even if you can qualify for a larger mortgage, it’s usually a good idea to take a smaller one to reduce expenses.

Closing the deal

To get approved for a mortgage, your monthly debt obligations generally need to be 43% or less than your gross monthly income, which is called the debt-to-income ratio. Reducing your debt before looking for a mortgage may make it easier to get a good deal.

An excellent credit score can also make it easier to qualify for more-favorable terms. You can boost this number by paying off credit balances, staying current with bills and keeping your existing accounts open.

It’s always a good idea to save for a down payment to minimize borrowing. By putting at least 20% down, you won’t have to spend money on PMI, and you’ll save a bundle on interest. With a little budgeting and planning ahead, you’ll pay a lot less for the home you buy.