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Home Mortgage Basics

Buying a home is the largest single purchase most people will ever make. Few can afford to pay cash so a mortgage to finance a home purchase must be obtained from a bank or other lender. Mortgage terminology and the home loan process can be puzzling. These home mortgage basics should help clear up any confusion.

Common Mortgage Types

There are a few types of mortgages. The most common are fixed rate, adjustable rate and those with a balloon payment due at some predetermined future date.

A fixed rate mortgage has set payments spread evenly over a specific period of time. The term "fixed" refers to the interest rate, which does not change over the entire life of the loan. The most common is the 30-year fixed although terms of 15, 20, 25 or even 40 years are available in some instances. The main advantage of a fixed rate mortgage is that the payment never changes. For homebuyers who intend to remain in the home for several years, a fixed rate mortgage is usually the best option.

An adjustable rate mortgage (ARM) has an initial rate that changes at predetermined intervals during the loan period. The initial interest rate is usually low, resulting in a lower monthly payment required during the first phase of the loan. Once the loan adjusts, according to the specified timeframe, the monthly payment can increase significantly. ARMs usually have a limit on how much the interest rate can increase during an adjustment and how much total increase in interest rate is allowed over the life of the loan. A common allowable increase is no more that 2% at any one time and no more that 6% during the entire loan period. Homebuyers considering an ARM need to fully understand the terms of the mortgage in question.

With a balloon mortgage, the monthly payment is usually calculated based on a 30-year schedule. After a specified period, typically five or seven years, the entire balance of the loan becomes due. Homebuyers considering a balloon mortgage usually intend to sell before the balloon payment must be paid. Those who decide to keep the home may be able to refinance or negotiate other terms. Balloon mortgages should be approached with extreme caution.

Pre-qualification and Pre-approval

Pre-qualification and pre-approval are not the same thing. Pre-qualification merely indicates the price range of homes to consider while a pre-approval actually commits the lender to a specific loan amount. A pre-qualification is often free while a service fee is usually charged for pre-approval. The advantage of being pre-approved is that the homebuyer is ready to make an offer when the desired home is found.

Qualifying vs. Affording

Before approaching a lender or looking at a single house, homebuyers should realistically assess what they can afford. Being pre-approved or pre-qualified for a given amount is not the same as being able to make the payments on the loan. Lenders will usually limit the amount of a loan so that monthly mortgage payments are less than 30% of the homebuyer's gross income. There are many factors, however, that a lender does not consider. The homebuyer needs to take responsibility to borrow no more than the amount that can be comfortably repaid.

Down Payment and Private Mortgage Insurance

Most home loans require a down payment, typically 20% of the purchase price of the home. Homebuyers who cannot put a full 20% down are usually required to pay for private mortgage insurance, known as PMI, to protect the lender in the event of loan default.

Other Considerations

Annual real estate taxes and mandatory hazard insurance can be several thousand dollars each year. Money to cover these expenses are often calculated with the mortgage payment and held in an escrow account by the lender who then pays the bills when due. Clarify whether the lender is collecting these expenses each month or if the homeowner is responsible to pay the tax collector and Insurance Company directly.

Beware of troublesome loan types that may still be available. Any mortgage with the option to pay interest only, or a negatively amortized loan in which the initial payments do not even cover the interest each month, are impending disasters that should be avoided.

Study the Fine Print!

With the variety of mortgage options available, understanding the terms of the mortgage chosen is imperative. Thoroughly read the fine print. If anything is unclear, get clarification. Do not sign any documents until a complete understanding is achieved.