Loan 101 For First-Time Homebuyers: What Is a Mortgage and How Does It Work?

You’ve always heard that 20 percent is the gold standard for a down payment - making home buying feel more like a dream than a reality for many. Yes, 20 percent is still a good number to aim for. But having less than that doesn’t mean you can’t afford to buy a house. In today’s market, you can often put down significantly less to get out of your rented space and into a new home.

Below, we’re going over the ins and outs of obtaining a mortgage - and what you should expect your monthly mortgage payments to look like.

What Is a Mortgage?

A mortgage is a secured loan used to buy a house or piece of property. As a reminder, a secured loan requires collateral from the borrower, such as a house, car, or other form of property.  

The most common length for a fixed mortgage is 30 years, with about 90 percent of homebuyers utilizing this option. 15-year loans are the second most popular - six percent of homebuyers choose this length.

How Does a Mortgage Work?

If you choose to use a mortgage to purchase your home, the lender (your bank, credit union, or other financial institution) will actually own the home outright. You will make regular payments (typically monthly) to the lender for a predetermined length of time. As mentioned, the most common loan lengths are 30-year and 15-year fixed loans. These payments will include the principal amount and interest. It may also include other expenses like property taxes, private mortgage, and homeowner’s insurance. 

Your mortgage’s interest rate is typically determined in one of two ways - fixed or adjustable.

Fixed-Rate Mortgages

Just as it sounds, a fixed-rate mortgage offers an interest rate that will not change over the lifetime of your mortgage. From year one to the final payment, you can expect to pay the same interest rate for the entirety of the loan. 

Adjustable-Rate Mortgages (ARMs)

Unlike a fixed-rate mortgage, an ARM has varying interest rates over the loan's lifetime. With an ARM, the lender offers a set interest rate for the first few years (typically anywhere from the first three to 10 years). Once that time has passed, the interest rate could increase, increasing the borrower’s monthly payments.

While ARMs usually offer a lower initial interest rate than fixed-rate mortgages, the borrower is taking a chance on whether or not that rate will eventually rise. Though ARMs are typically not encouraged, they could be useful for those who plan on selling the home sooner rather than later or those who know they will be refinancing their mortgage before the rate increases.

How Is a Mortgage Payment Calculated?

Suppose you’re taking out a 30-year fixed-rate loan for a $200,000 house. Here’s what your mortgage payment will likely include:

• The principal amount is how much you bought the property for, minus your down payment. If you bought a $200,000 home and put down $20,000 (10 percent) upfront, your principal amount for the loan would be $180,000. For a 30-year loan, we’d divide that amount into 360 monthly payments - about $500.

• The interest: If you’re obtaining a fixed-rate mortgage, your interest rate will not change over the life of the loan. If your annual interest rate is four percent, you’d need to divide that amount by 12 to determine how much you’ll be paying in interest per month. In this case, you’d be paying 0.33 percent per month. 

• Private mortgage insurance (PMI): If you plan on making a down payment of less than 20 percent when buying a home, you will likely be required to pay a monthly PMI (private mortgage insurance) premium. In most cases, this insurance will no longer be required once you have paid up to 20 percent in mortgage payments. According to Freddie Mac, you should be prepared to pay between $30 and $70 per month for every $100,000 borrowed.2

• Property taxes: It’s common for your lender to establish an escrow account in which property taxes are collected. That’s why they are often included in your monthly mortgage payments. When the government collects the amount, your lender will pay the amount on your behalf using what you’ve already put into escrow.

• Homeowners insurance: Most lenders will require a borrower to obtain a homeowners insurance policy, which will typically be lumped into that monthly mortgage payment. 

If you’re considering purchasing a home, it's important to do your homework first. Speak to your financial professional and research mortgage types and rates before visiting your first open house. This can help eager homebuyers like yourself stay level-headed and realistic about what you can afford.

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