Homebuying 101: What is a Mortgage and How Do They Work?

The home financing industry introduces its own lingo and (what can feel like) a complicated process into a home purchase. If mortgages feel intimidating, keep reading for True Homes’ Homebuyer 101 – our first-time homebuyer tips where we’ll break down the basics.

What is a mortgage?

A mortgage is the type of loan you can get to purchase your home. Your home is used as collateral, meaning you’ll forfeit it if you fail to make your payments as agreed.

Because homes are such a large investment, most homebuyers use a mortgage to purchase one. In a typical scenario, a purchase amount is negotiated for a home. The homebuyer pays a down payment, or percentage of the purchase price outright, then finances the remainder through a mortgage. The deed is transferred to the mortgage lender until the mortgage is paid in full.

How are mortgages repaid?

You will have a monthly payment that will consist of four primary components – principal, interest, taxes and insurance. Mortgage lenders refer to this as PITI:  1) Principal is the portion that pays back your loan; 2) Interest is what you pay the lender in exchange for loaning you the money and servicing your loan; 3) Taxes are forwarded to your local government to pay for real estate taxes; and 4) Insurance will cover your homeowners insurance, which protects your investment in the case of disaster. With down payments of less than 20% of the home’s value, which are considered riskier for the lender, the insurance portion also includes mortgage insurance that protects the lender in the case of default.

How are the principal and interest payments set?

In addition to the size of your loan, how much you pay in principal and interest each month will depend on three primary factors – the term of your loan, the type of loan you have, and your interest rate.

The term of your loan is the length of time set for repayment. Most mortgage loans are 30-year terms, though 15-year mortgages are also common. The majority of homeowners do not have their mortgages for the full terms because they move or refinance. The longer the term, the smaller the principal portion of the payment.

Mortgages are either fixed rate or adjustable rate. Fixed rate loans, where you pay the same interest rate fore the life of the loan, are the most common. In this scenario, the principal and interest portion of the monthly payment remain the same the entire loan term, and the ratio of principal to interest gradually shifts as time passes. In the beginning, because the loan amount is high, you pay the most interest. As you pay more principal and the borrowed amount is reduced, you’ll pay less interest each month. That frees up even more to go toward the principal.

The most common type of adjustable-rate mortgages is actually a hybrid. It offers an initial low rate, and after an agreed-upon amount of time, typically 5, 7 or 10 years, it adjusts to the market interest rate and becomes a fixed-rate loan. The payment amount changes when the new interest rate is applied.

Finally, the amount of the monthly principal and interest portion of the payment depends on the loan’s interest rate. Interest rates are set according to many factors, including the borrower’s credit worthiness, the down payment amount, the property type, and index rates, which are what the lenders themselves are paying to borrow money.

Are mortgages different for new homes?

Some new homes may require the homebuyer to get a construction loan. This may occur in situations like True Homes’ Build On Your Own Lot program. In these cases, an initial loan is made to the homebuyer, with draws at certain junctures during the construction process. When the home is complete, the loan is converted to a permanent mortgage loan.

Depending on the lender and the homebuyer’s choice, the construction and permanent financing may be separate mortgages or combined into one package.

This Homebuyer 101 introduction to mortgages is True Homes’ effort to offer basic mortgage facts and first-time homebuyer tips to make the new homes search easier. Understanding home financing is the first step to becoming a successful homebuyer.

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