Few homebuyers can afford to purchase a property entirely out of pocket. In most cases, they’ll need to turn towards lending institutions, such as banks or credit unions, to finance part or the entirety of their new property. However, mortgages are a big commitment, so understanding how it works is crucial when purchasing a home. Of course, mortgage loans come in many different forms, and understanding the vocabulary may get confusing. Therefore, we’ve outlined everything you need to know about mortgages to help you better understand how financing a home works.
What is the Difference Between a Loan and a Mortgage?
A mortgage is a loan specifically designed to purchase a property. The mortgage term is often significantly longer than other types of loans (typically 15 to 30 years.)
More importantly, while financial institutions rely solely on a borrower’s credit score and assets to approve a loan, mortgages also use the property to be purchased as collateral. In other words, if the borrowers were to default on their monthly payments, the lending establishment can repossess the property and sell it to recoup its loan.
Costs Associated with Mortgages
Your monthly payments include several costs that you will need to consider to decide on your mortgage.
· Principal: Part of your payment includes the amount of money you need to pay back to the lender to pay off your loan. Each time you make a payment, part of the money goes towards repaying the debt you contracted, while the rest goes towards the interest. It can also refer to the amount you still owe on the money you initially borrowed. If you want to reduce your debt faster, you can make additional payments towards the principal only.
· Interest: The interest rate is often referred to as the cost of borrowing money. The mortgage rate you will need to pay is determined by your lender, your credit score, the type of mortgage, and so on. At the beginning of the life of the loan, most of your payment will go towards paying off the interest rather than the principal.
· Taxes: Some lenders require borrowers to pay off part of their property taxes each month along with the principal and interest payment. They keep the money allocated toward taxes in an escrow account and pay off the town when the tax bill is due on your behalf.
· Insurance: Lending institutions may also require borrowers to pay the premium for homeowner insurance along with the home loan payments. Besides, lenders typically demand that borrowers subscribe to mortgage insurance if their down payments are lower than 20% – either private mortgage insurance (PMI) or mortgage insurance for government-backed loans such as FHA or USDA.
Loan Types
There are many different types of home loans. Here are some of the most common ones.
· Fixed-Rate Mortgage: Most house loans have fixed mortgage rates: the interest rate does not vary during the life of the loan. Therefore, your monthly payment will remain stable until you pay off your mortgage.
· Adjustable-Rate Mortgage: According to the terms of an adjustable-rate mortgage (ARM), your interest rate will be periodically re-evaluated. Depending on the market, your mortgage rates – and, therefore, your monthly payments – may go up or down.
· FHA Loans: FHA loans are government-backed loans insured by the Federal Housing Authority. They allow qualified buyers with a credit score as low as 580 to purchase a home with a low down payment of 3.5%.
· VA Loans: VA loans are guaranteed by the Department of Veterans Affairs and available only to U.S. veterans, active-duty military personnel, and some surviving spouses. They typically do not require a down payment, and credit score criteria are lower than those required for conventional mortgages.
Understanding mortgages is a critical step to buying a home. It will determine how much you can afford but also which property you can buy since lenders have requirements when it comes to houses as well. Since borrowing criteria differ depending on the lenders, you may need to shop around before finding the right one. For more information on mortgages or the homebuying process in general, contact our team!