First-time homebuyers are often inundated with information about what kind of home they should buy and whether they should use a realtor, leaving some of the important aspects of homeownership behind. While many people understand the basics of a mortgage (i.e. the bank gives you money, you pay them back), they often don’t take time to learn the details before getting locked in to a long-term commitment.
To really understand what buying a home means, you first need to get a gist of what a mortgage is and how it works. Follow along in this post to see if you have anything to learn.
Bare Basics: What is a Mortgage?
A mortgage is a loan that a homebuyer receives from a bank or lender in order to purchase a residential property. Payments are made in installments (bi-weekly or monthly) until the loan is paid in full.
As with most loans, a mortgage accrues interest over time, adding to the initial purchase price. Your bi-weekly or monthly payments include interest payments on top of the base amount.
- Usually, a mortgage is paid over 15-30 years.
- Whether or not you qualify for a mortgage depends on your credit, job history, down payment, and your income-to-debt ratio.
- Mortgages are usually provided by banks.
Mortgage Interest: How Much is it?
Generally, most mortgages start out on what is called a fixed interest rate and then, after a certain period of time, move to an adjustable or variable rate.
This means that for the first 2-5 years, borrowers pay a consistent interest rate, say 2-5%. After the 2-5 year period has ended, your mortgage turns into what is called an ARM, or adjustable rate mortgage. The interest rate that you are charged after the fixed rate period varies depending on the market and the economy.
Once your fixed rate is up, you do have the option of talking to your bank to resign on a new fixed rate for another period of time if you wish.
Fixed rate mortgages are good for people who need to really plan their budget and monthly payments. Since the interest rate affects how much you put towards your mortgage every month, some people prefer to have consistent payments. If the industry rate increases, fixed rate borrowers are not affected.
On the other hand, since a fixed rate does not go down based on the economy, borrowers who continue with a fixed rate could miss out on lower rates and payments.
Many ARMs allow for you to pay off your mortgage in full or make larger payments than necessary without penalty, but be sure to talk to your bank to ensure you fully understand the terms of your mortgage each and every time you renegotiate a rate change.
Do I Need Mortgage Insurance?
Mortgage insurance is how banks and lenders ensure that if you, the borrower, default on the loan, they are protected.
Whether or not you need to pay for mortgage insurance depends on how much of a down payment you have saved. Generally, if you have less than 20% of the mortgage to put down up front, the bank or lender will require you to pay mortgage insurance.
Mortgage insurance is usually about 0.5-1% of the loan annually. For example, if your mortgage was $100,000, you could pay anywhere from $500-$1000 each year.
You can cancel mortgage insurance, but it usually has to be once you have reached paying off 20% of your original purchase price (meaning you have 80% left of your mortgage to pay). Be sure to talk to your bank about how to cancel and when, as you have to be up-to-date on your payments and you may be required to file a written request.
While it can be tempting to get a mortgage with a lower down payment, mortgage insurance can become quite pricey as time goes by, so weigh your options carefully and consider what is best for you to do.
Pre-Approval vs. Pre-Qualified
We’ve all received offers to get credit cards in the mail that we have been “pre-qualified for up to $1000” addressed to “Current Resident”. But does that actually mean that you’re getting an offer for $1000 credit card, no questions asked? Not quite.
As with these credit card offers, mortgages work in a similar way. There is a difference between pre-qualification and pre-approval, and it’s important to understand what each means.
When you are casually looking at taking on a mortgage, you first need to know if your bank will even give one to you. At this point, you should look into what is called a pre-qualification. This is a simple process that can be done over the phone or online. It takes into account your debt, income, and assets only. Based on this information, the bank will give you an estimate on what amount you may be able to qualify for.
This amount is not a guarantee or promise, it’s simply a brief look at whether or not you should take the next step, which is pre-approval.
Pre-approval is when the bank takes a more in-depth look at your financial situation by looking at your credit rating and financial background as opposed to just your current standing. They will also require that you complete a mortgage application and submit it to them.
If you qualify for a home loan, they will provide you with an exact amount in writing, which then allows you to look for a property within that amount. The amount is the actual amount that you will be allowed to use to buy a home, and it is a guaranteed amount, barring some pre-conditions.
Am I Ready to Buy a Home?
Buying a home is a big step, and the better that you understand how it works, the more comfortable and confident you will feel in your decision. Whether you decide it is the right time for you to buy or not, you will have made an informed choice that best suits your personal finances and home-buying goals.
If you have questions, your friends, family members, and bank can provide you with valuable advice and insight that can help you along the way.
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