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Today's mortgage options make home ownership an option for more people than ever before. Understanding what those options are, and which will best suit a person's individual needs, is the first step anyone considering buying their first home should take:
Setting a Budget
Before prospective homeowners begin their property search it is important that they determine just how much home they can realistically afford. Most lenders will finance buyers whose monthly house payment (including loan payment, property taxes, and insurance) does not exceed 28 percent of their verifiable gross monthly income.
There are a number of mortgage calculators available that can help determine a proper budget but they are only accurate if potential homeowners input realistic expenditure figures and leave nothing out.
Choose a Lender First
Those wishing to purchase a home should choose a lender before they actually begin looking for property. Doing so will mean that home-buyers go into the house hunting process with a clear idea of what they can afford, the loan options that will be available to them and a pre-qualification letter that will make them a far more appealing prospect to any home seller.
Mortgage Types and Options
Although there are a number of variations mortgage loans can be broken down into two basic categories – fixed rate mortgages and adjustable rate mortgages also known as ARMs. Which an individual chooses depends on any number of different factors but some of the most important considerations include:
- A borrower's current financial situation as well an idea about how that might change in the future.
- Whether or not a borrower finds it important that their monthly mortgage payment be the same every month.
- How quickly the borrower wants to accrue equity in the property they are financing.
Here are some of the basics about each mortgage option:
Fixed Rate Mortgage Loans
With a fixed rate mortgage the interest charged on the principal will not change for the entire term of the loan. A home-owner's principal and interest charges are the same every month, regardless of what the current market interest rates might be. Slight changes in property taxes and home-owner's insurance may alter the total payment slightly, as these are both built into a mortgage payment, but on the whole the amount due every month is a predictable constant.
The biggest advantage of a fixed rate mortgage loan is predictability, which makes budgeting and responsible financial planning easier. On the downside the principal and interest payments on a fixed rate mortgage are often higher, in the beginning at least than those attached to an adjustable rate mortgage loan.
Fixed Rate Mortgage Terms
Fixed rate mortgages can be further broken down by just how long a home-owner wants to extend the time they have to repay their mortgage loan in full.
A 30 year fixed rate mortgage will provide homeowners with the lowest possible monthly payment available on a fixed rate loan. On the downside this will also mean that those taking out a 30 year fixed rate mortgage loan will pay far more interest over the life of the loan than they would with many other mortgage options. This time of mortgage is perhaps best suited to those who intend to stay in their home for a the foreseeable future.
A 15 year fixed interest mortgage loan halves the interest that will be paid on the principal over a 30 year loan but of course this does mean that monthly payments are effectively doubled. A 15 year mortgage will help the equity in a home accrue far more quickly as well.
Monthly Payment Alternatives
Whether a buyer home buyer opts for a 30 Year fixed rate mortgage or for a 15 year fixed rate mortgage by opting to make bi-weekly instead of monthly payments they will be able to shave years off the life of the loan as well as save on interest owed.
Buyers who opt for a bi-weekly arrangement make half of their monthly payment every two weeks, which effectively adds up to making 13, rather than 12 full monthly payments every year. By doing this on a regular basis a borrowers can shorten a 30 year loan by several years.
Adjustable Rate Mortgage Loans
In the beginning, an Adjustable Rate Mortgage – aka ARM – offers a lower monthly payment and can be easier to qualify for based on that fact. The interest rate is however – as the name suggests – variable , and will go up or down according to the prevailing current market rates. There is also an additional consideration, the margin, to be dealt with as well.
When these adjustments to the interest charge will be made is clearly defined in the original mortgage loan contract. This can result in significant increases to the monthly payment, although there are some rate caps over the term of the mortgage that may prevent these increases from becoming financially debilitating to the borrower.
In the case of an adjustable rate mortgage the risk involved with changing interest rates is shared between the lender and the borrower. But there are certain elements of every adjustable rate mortgage that should be understood:
Initial Interest Rate: Typically, the initial interest rate attached to an adjustable rate mortgage will be 2-3% lower than those charged on a fixed rate mortgage for a similar amount.
Index – This is the guide that determines the changes that are made to the interest rate you are charged at various points over the term of the loan. Although it will vary one common index used is the profit on a one year treasury bill. As that number rises, so will the interest rate charged on your mortgage loan.
Margin – These are percentage points added to the base index that establishes the actual final interest rate charged. This margin does not fluctuate however, it is a fixed figure.
Adjustment Interval – This is the period of time that will elapse between interest rate changes. For example, a three year adjustment interval will mean that the interest rate, and therefore the total monthly payment owed, will change very three years.
Mortgage Loan Hybrids
Some mortgage lenders have developed mortgage loans that are a hybrid of both fixed and adjustable rate mortgage loans. These are not available to everyone and in all areas though, and a lender is the the only person who can advise a home-buyer if such options are available to them.
Monthly Mortgage Payment Breakdown
The total amount of a monthly mortgage payment is made up of several basic elements that break down as follows:
Principal – This is the actual amount of money that is borrowed at the time of closing. Usually this figure is equal to the final sale price of the home minus the amount that was paid as a down-payment. As each repayment is made the figure decreases. Only a certain percentage of each monthly mortgage payment is applied to the principal though.
Interest – Interest is the "cost" attached to having borrowed the money to pay for a home in the first place. Over the course of the first few years o the life of any mortgage loan most of any monthly payment is applied towards this interest, not to the principal.
Escrow – In most cases a certain portion of every monthly mortgage payment is paid by the lender into an escrow account. From this account taxes and homeowners insurance will be paid, as will mortgage interest if it was required by the lender at the time of closing.