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Chapter 2: Understanding Mortgages

If you are like the vast majority of people, you will need to take out a mortgage to purchase a home. Paying it back will likely be your largest monthly expense. But what exactly is that money used for?

Most of it goes towards repaying the mortgage loan. Loan payments can be divided into principal and interest. For the majority of mortgages, early payments consist primarily of interest. As you continue to make payments, a higher percentage goes toward principal. This is called amortization.

Use this calculator to see what the monthly principal and interest payments would be for loans of various amounts and interest rates.

Part of your mortgage payment may consist of money the lender collects on your behalf for property taxes, homeowners insurance, and, in some cases, private mortgage insurance (PMI). PMI protects the lender against loss if the borrower defaults on the loan and may be required for people with less than a 20% down payment. Every month, the lender puts aside the money for these expenses in an escrow account and pays them when they are due. This allows them to ensure that these important bills are not neglected. Together, the principal, interest, tax, and insurance payments are referred to as PITI.

If you purchase a condominium, townhouse, or other type of unit with a homeowners association (HOA), you will likely also have to pay HOA dues. This money goes toward property management, upkeep of the common area, and in some communities, certain utilities. You may pay the dues directly to the HOA or through your lender.

Mortgage types

  • Fixed-rate mortgage: Fixed-rate mortgages come with an interest rate that remains constant over the life of the loan. The interest rate is usually initially higher than for other types of mortgages. However, because the interest rate and monthly payment are fixed, they provide a stability that is appealing to many buyers.

  • Adjustable-rate mortgage (ARM): ARMs have a period of fixed interest, after which the interest rate and payment adjust at specific intervals. In general, the interest rate and monthly payment for an ARM start off lower than for a fixed-rate mortgage of the same amount. However, they often become higher once a few adjustments occur. An ARM may be a good option for people who plan to sell in a few years or expect their income to increase significantly, but it can be risky. If you cannot afford the payment increase, you may lose your home.

  • Interest-only mortgage: With an interest-only mortgage, you pay just interest for a specific period of time, usually 3-10 years. Once that period is over, the payment rises to include both principal and interest. The initial payment is lower than for a fixed-rate mortgage since you are not paying any principal. However, once the interest-only period is over, the monthly payment becomes higher because you are paying down the principal in a shorter period of time. Like with an ARM, there is a risk you will not be able to afford the mortgage once the payments increase.

Mortgage terms

The term refers to the length of the loan. The traditional mortgage term is 30 years, but it can range from 10 to 50 years. In general, the shorter the term, the lower the interest rate. You get a lower payment with a longer term, but you wind up paying more in interest over the life of the loan (not just because of the higher interest rate but also because you are borrowing for a longer period of time).

Government programs

Loans offered through federal government programs can come with more attractive features than conventional loans. The two most popular ones are:

  • VA loans: VA loans are insured by the Department of Veterans Affairs and are only available to eligible veterans. No down payment is required.

  • FHA loans: FHA loans are insured by the Federal Housing Administration, a division of HUD (the Department of Housing and Urban Development). A down payment of at least 3.5% is required.

Many states and cities have programs specifically for first-time homebuyers. They make it easier to buy a home by offering such things as down payment assistance, below-market-rate units, and/or low-interest loans. Contact your local housing authority for information about programs in your area.

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