Mortgages 101: What You Need to Know
How Mortgages Are Structured
With a mortgage, you’ll pay the principal, interest, taxes and insurance–all of which are commonly referred to as PITI. Note that unless you are a high-risk borrower, you can choose to pay taxes and insurance separately from your mortgage, which will give you a lower mortgage payment. Just remember that it’s up to you to save that money month to month, so you can pay the annual bill when it comes! Banks largely prefer to collect the tax and insurance money in escrow because they pay only a little to maintain the account and have access to those funds.
Here’s how each component of PITI works:
Principal: This is the original amount that you borrowed to pay your mortgage. The bank decides how much it will lend you based on factors like income, credit and the amount you plan to give for a down payment. If your down payment is less than 20% of the home’s price, the bank may consider you to be a riskier lender and either charge you a higher interest rate or require that you purchase private mortgage insurance, commonly referred to as PMI. (More on that below.)
Interest: This is essentially the cost of borrowing money. When you take out a mortgage, you agree to an interest rate, which will determine how much you pay a lender to keep lending. It’s expressed as a percentage: 5% to 6% is considered somewhat standard, but the rates depend strongly on a person’s situation–income, credit–as evaluated by the lender. Since a higher interest rate means higher monthly mortgage payments, lower rates might mean that you can afford to borrow more money or pay the loan off faster.
Taxes: Property taxes go toward supporting city, school district, county and/or state infrastructure, and you can pay them along with your mortgage. They’re expressed as a percentage of your property value, so you can roughly estimate what you’ll pay by searching public records for the property taxes for nearby homes of similar value. If you’re a high-risk borrower, your lender might establish an escrow account to hold that money until it’s paid to the proper recipient–in this case, the government.
Insurance: Any payments reserved for homeowner’s insurance to protect against fire, theft or other disasters are also held in an escrow account. (Again, this is something that you can opt out of escrowing, unless you’re a high-risk borrower.) If you’re a high-risk borrower–or if you lack the 20% down payment–you’re also required to have private mortgage insurance (PMI), which helps guarantee that the lender will get money back if you can’t pay it for any reason. After you’ve paid off a certain amount of your mortgage, you’re sometimes allowed to cancel the PMI (although this depends on your situation). Remember that PMI is meant to protect the lender, not the borrower–so it won’t bail you out if you default on your payments.
Escrow: A bank account held by a third party to keep money safe before a deal is finalized or “closed”; also used for holding payments earmarked for annual expenses
Fixed Rate Mortgage (FRM): A type of mortgage in which the interest rate is established upfront and remains the same throughout the duration of the loan.
Adjustable Rate Mortgage (ARM): A type of mortgage in which the interest rate is readjusted periodically to reflect the market rates.
Mortgages are structured so that the proportion of your payment that goes toward your principal shifts as the years pass. At first, you’re paying mostly interest; eventually, you’ll pay mostly principal. Your actual payments will be the same, but they will be distinguished on the lender’s end in a process known as amortization.
Types of Mortgages
There are a few different forms of common mortgages:
This is the most popular payment setup for a mortgage. It means that the borrower will pay a “fixed” interest rate for the next 30 years. It’s an appealing prospect because homeowners will pay the exact same amount every month. Fixed mortgages are best for homebuyers who buy when interest rates are low or on the rise, are counting on a predictable payment and who plan to stay in the home for a long time.
These mortgages carry a lower interest rate, and only take 15 years to pay off. These are best for homeowners who want to pay off their mortgages and build equity quickly. Interest rates for 15-year fixed mortgages usually also carry lower interest rates than 30-year mortgages.
Adjustable Rate Mortgages (ARM)
The interest rates on adjustable rate mortgages are adjusted at predetermined intervals to reflect the current market. Some mortgages are a combination of fixed and adjustable: for the first three, five or seven years, the rate will stay fixed, and then be adjusted annually for the duration of the loan. In this case, the original fixed rate tends to be lower than usual, but it may become more expensive than a 30-year fixed rate once the adjustable rate kicks in. This type of loan may be right for you if you plan to live in your home for approximately the same length of time as the original fixed term.
- Long before you actually apply for a mortgage, you can start building your credibility by establishing good credit, and accumulating savings for a down payment.
- A reliable, reputable lender is more important than a lender with unbelievably cheap rates–if it seems unbelievable, it probably is.
- A mortgage is a debt, but it’s considered good debt. It doesn’t hurt your credit.
Are you looking to get a mortgage? For a step-by-step guide, head over to our checklist: I Want to Get a Mortgage.