Houses are expensive. Like really expensive. Owning a home outright requires cash that most people will never have. Yet 67% of the population are home-owners, thanks to mortgages.
Weirdly, although the majority of people live in homes they or their family own, very few people totally understand what a mortgage is, how it works and what it can do. Typically, mortgages are explained in figures and percentage points and with very technical (read: completely confusing) jargon. Here’s what you need to know about mortgages.
Instead of bombarding you with jargon, maybe this example will help instead:
Frank is 30 years old IT consultant. He is married to Sarah and they have a baby on the way. They live in a rented two bedroom apartment that isn’t quite right for a growing family.
Frank and Sarah find a beautiful house with the not so beautiful price tag of $500,000. They don’t have that kind of cash lying around (who does?) so they look into their options – mainly, a mortgage.
A mortgage is basically a bank loan that uses the property (house, condo, land…etc) as collateral.
With a mortgage, the bank will loan Frank and Sarah money for the house upfront, and they agree to repay the bank over the course of a certain number of years.
Here’s how it works:
The bank won’t lend money to just anyone (despite what you’ve heard). You have to put up cash as a down payment. The lowest down-payment recommended is 20%.
Frank & Sarah put down 20% of $500,000 ($100,000). They’ve been saving for years, so this fits into their budget.
The bank will loan them the remaining $400,000 balance. They’ll have to pay back the loan with interest. Think of interest as the price Frank and Sarah pay in order to borrow the money from the bank. They’ll be able to pay back the mortgage over the course of any where from 25-40 years. That timeframe may sound scary (40 years in the same house!) but don’t worry, they are not obligated to hold onto for that all that time – Frank and Sarah can sell it at any time.
Now that you have a very basic understanding of mortgages, here are the 5 things you need to know:
1. Your house is the Collateral
The bank is willing to lend you that much money because your house is your collateral. If you can’t make your payments, the bank will takeover your home, simple as that.
2. You have to put some money down
The bank will not give you the entire amount of the purchase price. They will normally give you a big chunk of it, only after you show them that you can put in the remainder from your own savings (or any other way). This amount is called the down-payment. In their case, Frank and Sarah put down 20% (keep in mind the minimum down-payment in the US in 2010 was 3.5% though). The higher your down-payment, the lower your monthly payment and less interest you’ll pay.
3. The interest rate on a loan can be either fixed or variable
Since a mortgage is a loan, the bank will charge you interest. The interest can be a fixed amount – it will not change until the term is over. If you go with the variable interest rate option, the rate moves with the prime rate monitored by the US government. So if the interest rate is low this year, it does not mean that it will be low next year. Variable interest rates are harder to gauge.
4. The Mortgage Payment
The payment that make on your mortgage loan is a mixture of interest and the original amount borrowed. Banks work by charging more interest than the borrowed amount (the principal) in the early years of the loan, while gradually changing the weight of where the money goes over the life of the mortgage.
5. The difference between life and term
Two important dates you need to be concerned with are the “life” and the “term”. The life of your mortgage is the total time you need to pay back the loan. As we talked about above, that life can be anywhere from 25-40 years. The term is the length of the current interest rate period. Let’s say you get a 4% interest, that term is valid for 3-5 years, after which you’ll have to renegotiate a new interest rate.
Bonus: An unsaid 40% Rule of Thumb
Legend has it that in order to get approved for a mortgage loan, your credit score should be above 650, and your mortgage payments should not be more than 40% of what you make before tax per month. Shhh… don’t tell anyone we told you so.