Are you considering buying a home someday? Unless you have all the cash to buy that home outright, chances are you will end up borrowing some money. A mortgage is a loan specifically used to purchase a home. Consider it the middle man if you are not buying the home with 100% cash. The mortgage company pays the cash for the home, and you pay back the borrowed money along with interest to the mortgage company over time. You become mortgage-free once you pay off the full loan or when you sell the home and return what is owed to the mortgage company.
Zillow data from 2016 revealed that 42% of US homeowners are mortgage-free, meaning the majority of Americans still rely on mortgages to pay for their homes. If that majority includes you, it’s a good idea to get acquainted with some mortgage key terms.
Mortgage Key Terms
- Down Payment. Why bother with saving money when you can just borrow the money to purchase a home? In most cases, you will still be asked to put a portion down at time of purchase, known as a down payment, to show the mortgage company that you are serious about the purchase. If a borrower tries to flee and dodge payback responsibilities, at least the mortgage company can minimize losses through the down payment they received. The amount required for a down payment can vary with different qualifying programs, typically ranging anywhere between 5%-20% of the home purchase price.
- Interest Rate. The downside to choosing a mortgage over cash is that you pay more for the house in the long run, due to interest that you must pay on top of the principal loan amount. However, interest rates on mortgages tend to be lower than other loans, such as credit cards. Depending on IRS rules, mortgage interest may even be tax-deductible, so you might be paying less interest than you think. Rates are subject to change, so consider locking the interest rate when you are approved for a loan. The type of loan can be a fixed rate mortgage or adjustable rate mortgage, or ARM for short. If you don’t want to risk the possibility of increased interest on your loan, a fixed rate mortgage will allow you to keep the same interest rate for the life of the loan. If you believe interest rates could decrease, so that you pay less interest during the life of your loan, you would opt for an ARM.
- PMI. PMI stands for private mortgage insurance and applies to mortgages with less than 20% down payment. This pays for the mortgage company’s insurance in the event that a borrower becomes delinquent on payments, and the mortgage company is left with a debt to pay. If you have PMI because your down payment was less than 20%, not to fret. You can call your mortgage company to eliminate PMI once you reach 20% equity on your home. Equity is how much of the home you own.
- Mortgage Term. The term on your mortgage is how many years you are expected to pay back the mortgage company until you return 100% of the loan. The most common terms are 15 years or 30 years.
- Impound Account. Mortgage companies allow borrowers to bundle their property tax and homeowner’s insurance payments into the monthly mortgage payments. It’s entirely your choice whether or not to use an impound account, and there is no interest charged for doing so. Property tax and homeowner’s insurance bills typically hit once or twice a year. For many people, it’s easier to have the money collect in a fund to pay for these bills, rather than keeping track on their own how much to save throughout the year, so that they can afford to pay a big chunk once or twice a year.
- Foreclosure. This is a worst case scenario, in which a borrower cannot keep up with mortgage payments, and the borrower loses the home to the mortgage company. Unlike credit cards, which allow the borrower to pay a portion of the total charges each month, a mortgage payment must be paid in full and on-time each month.
- Refinance. If you already have a mortgage, but want to change the term or want to pull money out of home equity or interest rates are lower, you might consider a refinance. This just means you are changing one or more factors on the loan.
A mortgage will factor in the principal loan amount, interest rate and mortgage term to dictate a monthly payment. Most mortgage companies will only qualify borrowers who can prove that the mortgage payment is 35% or less of their income. Your credit score, or trustworthiness, also plays a factor in how much you are qualified to borrow.
Although they are not to be taken lightly, mortgages help many live their dreams of becoming homeowners. Sometimes mortgages allow people to afford homes that make money when the homes are sold. Other times, mortgages allow people to pay off their homes and never make another payment to live there. Whatever the reason, a mortgage can be a great tool to reach those dreams!
Homework: Use an online mortgage calculator to view sample monthly payments by entering a home purchase amount, down payment, interest rate, and term. If you (or your parents) have an existing mortgage, examine the mortgage statement. Is it time for a refinance?