Problem #51: I want to buy a house, but I want to understand mortgage terminology before taking the plunge into home-ownership.
So you want to dive into home-ownership? After-all isn’t that the American dream? What’s the best way to go about purchasing the house of your dreams? Assuming you don’t have enough money to pay in cash, you will have to get a mortgage. As with anything money related, you should understand what you are signing before you actually sign.
The worst thing you could do is rush into a large purchase without understanding exactly what you’re getting into. After-all, you could be paying this mortgage for a third of your life! You will eventually hate it – especially if you didn’t understand it to begin with.
Home-ownership is not for the faint of heart. If you are planning to buy a house without understanding the ins and outs of a mortgage, and the options available to you, then you have a PROBLEM.
Many times we have this fairy tale idea of what home-ownership is like. I had this notion in my head before we bought our first house. I thought it would be the answer to our growing families troubles. But we weren’t ready, and I didn’t fully understand what I was getting into.
Some of these terms can be confusing. Don’t sound like a putz when you go to the bank to apply for your mortgage.
- Mortgage – loan from either a private bank or other lender for the express purpose of buying a house. There are many different flavors of mortgages.
- Term – amount of time you will have to re-pay the loan in full. This is usually measured in years or maybe months.
- Principal – this is the amount you borrow.
- Interest – the amount of money you will pay to the bank for the privilege of borrowing their money. Your credit and income will impact the interest rate you receive.
- Amortization – simply put, this is the repayment schedule of paying back the loan. This will include principal and interest combined into one payment. The interest is usually much more than the principal initially.
- Monthly payment – this is the amount of money you will pay each month for the duration of the loan. This will include principal (P) and interest (I) or P/I. It may also include taxes and homeowner’s insurance.
- Escrow – This is a separate account that the lending bank sets up on your behalf. A part of your monthly payment is placed in “escrow” to be used to pay insurance premiums and property/school taxes. This is above your P/I payment.
- Down payment – This is a percentage of the purchase price. Or cash you put down to secure your house purchase. Could be as little as 5% of the purchase price.
- PMI – private mortgage insurance – this is insurance you are required to buy if you put less than 20% down.
- Closing/Closing costs – The closing is when you “close” on the deal, and actually sign the mortgage contract. The costs associated with the closing (title search, origination fees, appraisal fees) are captured with the closing costs. Before you get to the closing, your bank or lender will give you an itemized list of all the closing costs they expect you to pay at the closing.
There are many other terms, but the ones listed above are the most important.
What is a Fixed-rate Mortgage
These type of mortgages come in several different flavors. The interest rate, like the name implies, is fixed for the life of the loan. You can get a 10, 15, 20 30, or even 50 year mortgage. The most common is a 30 year mortgage. Despite what you might think, the 30 year mortgage has not been around forever. It was created in the 1930’s. Before that, the common mortgage was only 5 years or so.
For more information about the history of mortgages, check out this story.
This is the most common and best type of mortgage. The interest rate is fixed, so your payment (P/I) will always be the same.
This is the mortgage you should get.
The interest rate will be lower for shorter term loans, but the monthly payment will be higher. Aim for as short of a term as possible.
Adjustable-Rate Mortgages or ARMs
These mortgages came out of the 1980s. As the name implies, the interest rate adjusts both up and down depending on the market rate at the time. This is great when the interest rates are going down. But not so good if they are going the other way although there is usually a cap. If you have an adjustable rate mortgage, refinance NOW. Interest rates are on the rise, and will only continue to go up.
If you are looking at getting an adjustable rate mortgage, don’t be fooled by the low-interest rate. It will suck you in if you’re not savvy. This is often an introductory rate that will certainly adjust upwards after a few years.
Sometimes, banks will structure these mortgages with a balloon payment at certain intervals or at the end. This means a large sum or a balloon will be due. These balloon payments can be trouble if you’re not ready. Most will try to re-finance at this time as well.
These can also have several different terms – 10 to 50 years – though most re-finance long before that. The main purpose of the adjustable rate mortgage is to open up the housing market to those who might not otherwise be able to afford a house. But because of the uncertainty of the interest rate, this is a very risky type of mortgage to sign up for.
FHA mortgages are insured by the federal government (FHA – Federal Housing Authority) and have specific stipulations. I’m not planning to discuss these types of mortgages in detail.
However, if you want more info, here’s a great resource for FHA loans. FHA.com
Things to Know?
Determine how much house you can afford. Check out this calculator. Take the monthly payment number and compare it to your budget. You might not be comfortable with signing up for 30 years of payments using the amount you can afford. Remember, just because you can afford it, it doesn’t mean you should buy a house that expensive.
You will also need to save up a good down payment, which would be 20% or more of the purchase price. Take your time to save your money. Don’t rush into a purchase as large as a house.
Your emergency fund is not a down payment. You’ll need it when you move into your new house. Things will break, that you are now responsible to fix. The landlord is now you. So don’t spend it as the down payment.
Always apply for a fixed rate mortgage. An adjustable rate mortgage with the interest rate adjusting up can scare even the hardiest of budgeters. This will make your payments more than you perhaps planned initially.
You also need some extra money to cover the closing costs. Closing costs usually range from 2% – 5% of the purchase price depending on the lender. This money should be on top of your down payment and emergency fund.
Once you have all this in place, you’re ready to take the plunge into home-ownership. It’s a great step toward building wealth, but it’s not for everybody. Please make sure you understand what you’re getting into before you sign.
I’ve owned two houses, and both have had their share of issues. But I always had a hard time renting. There was just something about walking my own land/house instead of someone else’s. But don’t think that you have to buy a house, just because everyone else is.
What about you? Is home-ownership for you? Are you planning on getting a mortgage soon?
Let me know in the comments, and if you found value in this post, would consider sharing.