Buying a home is often advantageous financial move, compared to renting. You’ll have more flexibility to maintain your own dwelling, and as you make payments on your mortgage, you’ll gradually establish equity—meaning a portion of your money will be contributed to your financial stake in the home. However, too many new homeowners get a loan and purchase a house before they’re fully familiar with the homebuying process. Home loans are straightforward on the surface, but there are many variables and components you need to consider if you’re going to manage your loan successfully.
What Is a Mortgage?
Let’s start with a high-level overview of what a mortgage is. A mortgage is a specific type of loan offered by a bank or lending institution to help you purchase a house. You’ll generally offer a “down payment” on your home, a percentage of the total sale price, as a way to limit the financial risk taken by the bank and as a way to establish equity in your home. This is variable, but the minimum in many areas is 5 percent, with many experts recommending as much as 20 percent.
You’ll borrow the rest of the money to finance the home purchase, with your home serving as collateral. You’ll be required to pay this loan back in installments meant to pay down your principal (the amount you borrowed) and your accumulating interest payments. If you ever fail to make these payments, the bank may foreclose on your home, selling it to repay what you owe. If you decide to sell your house, you’ll use the proceeds to pay off the remaining principal; you’ll be able to keep whatever remains from the transaction.
In many cases, your mortgage will also include an escrow account, meant to cover home-related expenses like your property taxes and home insurance. You’ll pay a small amount of these annual and semiannual expenses each month, along with your principal and interest payments, to make things simpler for both you and your bank.
Types of Home Loan Rates
One of the most important elements of your mortgage is the interest rate. The interest rate is the percentage of the principal you’ll owe as interest each year, and will vary depending on market conditions and your credit score. For example, if you borrow $100,000 to buy your home and you have a 4 percent interest rate, you’ll pay $4,000 in interest each year as you pay back the loan.
However, according to Loans.com.au, there are different types of interest rates available to homebuyers. A fixed rate is an interest rate that’s guaranteed to remain the same for the duration of your loan; if it starts as 5 percent, it will remain 5 percent indefinitely. A variable interest rate is subject to changes; it may start at 5 percent and drop to 4 percent, or rise to 6 percent, depending on market conditions. It’s also possible to have a loan with a split interest rate, which will be fixed for a set period and variable for another set period.
Generally, homebuyers are recommended to take the fixed rate when possible. A variable rate may be lower to start, but could increase over time. More importantly, it’s reliably consistent, so your payments won’t change much over time.
The Role of Credit
You also need to fully understand the role of credit as it pertains to your home loan availability. Your credit score is a number that reflects your financial reliability. The higher it is, the better your chances of securing a mortgage, and the more favorable that mortgage will be. If your credit score is “good” or “excellent,” you shouldn’t have an issue getting a mortgage, assuming you can afford it. If your credit score is “fair” or “poor,” you may have a more difficult time finding a lender. You may also be forced to take a higher interest rate, or pay for private mortgage insurance (PMI).
Lenders will also look at factors like other assets you have; if you have a robust investment account, for example, it can make you look more reliable as a lender. They will also check your income and job history to make sure you have a reliable performance as an employee, and enough money to cover the cost of the mortgage.
This guide covers the basics of how home mortgages work, and the most important elements to understand. However, mortgages are complex financial instruments, and you should do more research before moving forward with a home purchase. Your loan originator, the person responsible for helping you find and set up a loan with a bank, can help you with further questions.