Interest rates are at historic lows. When Ken bought his house in 1992, he and his wife were fortunate to get a loan at the lowest rate seen for close to 20 years: 9.25%. In the summer of 2019, Britta purchased a home at an amazing rate of 3.55%. The same bank is now offering the same mortgage at 2.96%. That is a reduction of 16% in the interest rate in just over a year.
If you’ve been wanting to stop paying rent and start building equity in your home, you may be thinking that it’s time to buy. For most people, that means getting a mortgage loan.
Before we get into some ins and outs mortgages and understanding what goes into your monthly payment, a word of caution. “When the bank tells you how much you can afford,” says Britta, “they’re not actually telling you how much you can afford. They’re telling you how much they can afford to bet that you won’t default.”1 What’s reasonable for you to borrow can depend on many factors the lender might not consider; your financial advisor can help you determine an amount that’s healthy for you.
What Is a Mortgage?
When people say a mortgage, they usually mean a mortgage loan.2 This is a loan secured by collateral like a house or other piece of real estate. In the event of default (the borrower failing to meet their repayment obligation), the lender has the right to take over the property from the borrower.
The most common length for a fixed mortgage is 30 years, with about 90% of homebuyers utilizing this option. About 6% of homebuyers select the second most popular option, the 15-year loan.3
How Does a Mortgage Work?
By using a mortgage to purchase your home, you’re giving the lender (your bank, credit union, or other financial institution) certain rights of ownership in the property. You will make regular payments (typically monthly) to the lender for a predetermined length of time (usually 15 or 30 years). Each payment includes a partial repayment of principal borrowed, plus accrued interest. Your monthly payment may also incorporate other expenses like property taxes, private mortgage insurance, and homeowner’s insurance.
When you borrow the money, you can select either a fixed-rate loan or one with an interest rate that adjusts periodically.
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 entire duration of the loan. The loan payments are predictable for many years to come and can smooth out your cash flow, which is why we typically recommend this type of loan.
Adjustable-Rate Mortgages (ARMs)
Unlike a fixed-rate mortgage, an ARM will include varying interest rates over the lifetime of the loan. With an ARM, the lender will offer a set interest rate for the first few years (anywhere from the first three to 10 years typically). Once that time has passed, the interest rate can change and could increase. This, in turn, would increase the borrower’s monthly payment.
While ARMs usually offer a lower initial interest rate than fixed-rate mortgages, the borrower risks that the rate will eventually rise. Though we typically do not encourage using an ARM, one could be useful for those who plan on selling the home just a few years after buying or for those who know they will be refinancing their mortgage before the rate increases.
How Is a Mortgage Payment Calculated?
Let’s assume you’re taking out a 30-year fixed-rate loan to buy your house. Here’s what your mortgage payment could include.
- Principal: This is your purchase price for the property, less the down payment. If you bought a $200,000 home and put down $20,000 (10%) upfront, your principal amount for the loan would be $180,000. You’ll repay a fraction of the principal with each timely payment.
- Interest: With a fixed-rate mortgage, your interest rate will not change over the life of the loan. To determine how much you will pay in interest each month, divide your nominal interest rate by 12. So, if your interest rate is 3%, the part of your payment that will be dedicated to interest will be your current principal balance multiplied by 0.25%. The rest of your payment goes toward the principal borrowed.
Principal and interest (P + I) are the parts of your monthly payment that are kept by the borrower. The principal returns what you borrowed to the lender; the interest compensates the lender for allowing you to use their money to buy your home.
The lender may require you to include other costs with your monthly mortgage payment.
- Property taxes: It’s common for your lender to establish an escrow account where they collect money to pay your property taxes. When it comes time for the tax to be paid, your lender will pay the amount on your behalf using what you’ve already put into the escrow.
- Homeowners insurance: Lenders require you to keep insurance on the property. Frequently, the premium is also included in the escrow portion of your monthly payment.
These four elements—principal, interest, taxes, and insurance—are abbreviated PITI, a term you may see during the application process
- Private mortgage insurance (PMI): If you plan on making a down payment of less than 20%, you will likely be required to pay a monthly PMI premium. In most cases, PMI payments stop once you have 20% equity in your home. According to Freddie Mac, PMI payments typically range between $30 and $70 per month for every $100,000 borrowed.4
Remember, it’s essential to do your homework first before taking out a mortgage loan. Speak to your financial professional and begin researching mortgage types and rates before visiting your first open house. Doing this can help eager homebuyers like yourself stay level-headed and realistic about what you’ll be able to afford.
Be sure to check out our most recent video, Ken And Britta Discuss: Should you change your portfolio in response to the election
"More Unmarried Couples Buy Homes Together,” Your Money Briefing, WSJ Podcasts. November 4, 2020, at 4:50.
Legally speaking, the mortgage is the document pledging the home or property as the security for the loan. The borrower is the mortgagor because they’re the one making the pledge. The mortgage lender is the mortgagee, the party that accepts the property as security for the loan. Colloquially, it’s a different story, with the loan itself being called the mortgage.