Making any large investment demands serious consideration, but purchasing a home is typically the largest investment anyone makes. Finding the right home for an affordable price is only the beginning. The true test comes in securing a mortgage. Aspiring homeowners need to understand mortgage basics to avoid taking on too large a financial burden, which could turn their dreams into a nightmare.
A mortgage is simply a loan obtained from a bank to purchase a home and its attached land. The property acts as collateral on the loan. If the borrower fails to make regular mortgage payments to pay off the loan, the lender can assume ownership of the property to eliminate any existing debt.
A mortgage consists of the actual loan amount, known as the principal, and the interest accrued on the loan over the agreed upon term, or length, of the mortgage. Available interest rates may vary from bank to bank, with the exact figure based on current economic indicators. Since mortgages deal in large sums of money, the mortgage term will typically be either 15 or 30 years, allowing ample time to repay the loan. While longer terms lower monthly mortgage payments, the homeowner will end up paying more money over the course of the loan due to accrued interest.
Banks use a process called amortization to determine the borrower’s monthly mortgage payment. In amortization, initial mortgage payments mostly pay off the interest, with very little money going towards the principal. This doesn’t reverse until later in the life of the mortgage, when more money goes toward the principal. The homeowner’s monthly mortgage payment will also include the cost of insurance and any associated fees.
Banks tend to classify mortgages into two main categories -- those with fixed interest rates and those with adjustable interest rates. A fixed-rate mortgage features a predetermined interest rate over the entire term of the mortgage. Fixed-rate mortgages provide a steady, consistent monthly mortgage payment, allowing homeowners peace of mind and greater control when planning a household budget.
The interest rate in an adjustable-rate mortgage fluctuates throughout the loan’s lifespan. When compared to fixed-rate mortgages, adjustable-rate mortgages offer lower initial interest rates, resulting in smaller monthly mortgage payments. However, adjustable-rate mortgages are unpredictable, as the interest rate may rise and increase the monthly mortgage payment. The initial savings may not be worth the risk of higher payments later.
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