Getting a mortgage for the first time might seem like an overwhelming process. I know because I’ve been through it myself. But, once you know the mortgage basics, you’ll start to see that getting your first mortgage is more straightforward than you think. Really, it’s all about being informed, learning the lingo, and making sure you’re financially ready for this big next step.
How Does a Mortgage Payment Work?
A mortgage is a loan from the bank for the house you buy. Because the bank isn’t in the habit of losing money, they will lend you money and you will put the house up as collateral (fancy word for security).
The house is collateral for the banks protection. For whatever reason, if you stop paying your mortgage, the bank wants to make sure they’re not losing money. If you can’t pay your mortgage, they will take the house back and resell it to get their money back.
The bank will also charge you interest on the amount they’re lending you. You’re responsible for paying this amount back over a certain amount of time (years) in equal installments.
Essentially, a mortgage is like any other loan, except for the security you give to the bank, which protects them in the event of default (i.e. not paying).
What’s in a Mortgage Payment?
A basic mortgage payment is made up of two parts: (1) principal and (2) interest. In the beginning, the interest portion is bigger than the principal. The more you pay it down, the more principal you pay off. Eventually the principal is bigger than the interest.
The amount of interest and principal you pay will change slightly every time you make a payment. On a typical mortgage, each time the interest gets a little smaller, the principal gets bigger. Eventually, once you pay off your mortgage, you own your house free and clear.
The amount you pay on every payment doesn’t change. The make-up of that amount does.
Here’s a quick example of a mortgage payment:
Let’s say you have a $100,000 mortgage, an interest rate of 5% and you are making $581.60 in monthly payments.
The first payment will be $581.60
The interest from that payment will be $412.39 and the principal will be $169.21.
The second payment will be $581.60.
The interest will be $411.69 and the principal will be $169.91.
The third payment will be $581.60.
The interest will be $410.99 and the principal will be $170.61.
This goes on and on for the life of your mortgage until the interest rate changes at the end of the term.
As you can see, your payment to the bank doesn’t change, but the amount of interest starts to shrink with each payment.
How Often Do You Pay Your Mortgage?
There are a few ways to pay your mortgage. They are weekly, bi-weekly, semi-monthly and monthly options.
Which one is right?
Everyone gets paid a certain way and budgets a certain way. It’s best to figure out what’s right for you.
Personally, I like bi-weekly. It makes for 26 payments so it’s like paying an extra month on your mortgage each year. Plus it’s easier to budget for if you’re also paid bi-weekly. Others prefer monthly. When a mortgage is calculated it’s usually done on a monthly basis. Bi-weekly ends up speeding up your payments, but it does cost more over the year.
Using our previous mortgage example, the monthly payment would be $581.60, the semi-monthly and bi-weekly payment would be half of that, or $290.80.
The advantage is, if you want to pay your mortgage down faster, bi-weekly means you make two extra payments a year.
The disadvantage is, you’re paying more money through the year which can be harder on your budget.
How Long Does a Mortgage Last?
Mortgages vary in length. In the US they can go up to 30 years, and in Canada the maximum is 25 years.
There are two words you need to know when if comes to your mortgage as far as the length of the mortgage goes.
Those words are amortization and term. Many people get confused between amortization and term, so let’s clear it up quickly.
Amortization, which your monthly payments are based on, is the entire length of the loan.
For example, most first-time buyer mortgages are a 25-year amortization. This means when the bank calculates your payment, they will take the life of your mortgage (25 years) and use that to calculating your monthly payment.
As we mentioned, the payment will be a combination of interest and principal. The two are combined to provide you with your total monthly repayment.
Term is the length of time you’ve agreed to hold your mortgage with a particular bank or financial institution. This practice is common in Canada, where terms will vary depending on the mortgage (in Canada, this is most often 5 years). 10-year terms are available, but rare, and less than five years is also fairly uncommon.
Let’s hypothesize that you’ve agreed to hold your mortgage with a certain bank for five years. At the end of that five years, you’ll need to either pay out the mortgage, re-negotiate another term with that same bank, or sign a new term with a different bank or financial institution.
In the US, you typically keep your mortgage at the same bank unless another bank acquires your bank or you decide to refinance your mortgage to a different financial institution. Typically, in the US, you can refinance your mortgage at any time with any other bank or institution that approves you. Keep in mind, though, that there are fees to refinance and if you’re not going to live in your house for a several more years, it might not be worth it to pay those fees.
A Few Other Notes on Mortgage Terms
In Canada, if you want to get out of your mortgage term early (in the event you sold your house, came into some money and wanted to pay off the mortgage, or for any other reason) there will likely be a penalty that will need to be paid.
It’s important to know what these penalties are before you agree to the mortgage terms. You’ll likely never find a mortgage in Canada that doesn’t have a penalty for breaking the term early, but you should know for your own peace of mind what the penalties are and make sure they’re not unmanageable.
You’ll often find the institutions offering the lowest rates have the harshest penalties. Every financial institution has their own equation to figure out these penalties, so it’s important not to assume anything. Three months interest is usually a common benchmark, so use that as a comparison when evaluating penalties.
In the United States, some mortgages, but not all, have what’s called a pre-payment penalty. If you know you want to pay off your mortgage early or simply want the freedom to refinance whenever you want, make sure the mortgage you get doesn’t have this clause in it.
Either way, it’s a good idea to ask about these penalties before you sign.
Make sure you ask: “Are there costs/penalties involved to get out of this mortgage?”
What Are the Different Types of Mortgages
(Before we begin with this section it’s important to know that the mortgage rules are constantly changing. This section is designed to give you a high level view of mortgages and rules so that you can start understanding mortgages better.)
There are several options for first time buyers when it comes to mortgages. There isn’t necessarily one that is better than the other, but there might be one that’s the best fit for you.
Conventional (conforming) Mortgages
Conventional mortgages (otherwise known as conforming mortgages) are loans that conform to the guidelines established by the Federal National Mortgage Association/Federal Home Loan Mortgage Corporation (Fannie Mae and Freddie Mac ). Guidelines include the size of the mortgage, loan to value ratio and minimum credit score. Usually a conventional mortgage will get .25 or .5 of a percent better interest rate because of the stricter guidelines.
Requirements for a conventional mortgage:
- Must have a credit score of 620 or higher
- Maximum loan amount of $424,100 for a single-family home. Note: Fannie Mae and Freddie Mac have designated “high-cost” areas where limits are higher. So check your area to find out what your limit might be at loanlimits.org
- Down payment of 3-20 percent (the higher the down payment, the better your rate will be)
Federal Housing Administration (FHA) Mortgages
FHA loans are a government backed loan insured by the FHA. FHA loans are more flexible on lending requirements than conventional mortgages. The credit score requirements are lower and can have a down payment as low as 3.5 percent. To get the 3.5 percent option, you must have a credit score of 580. If your score is lower than 580, you’ll be required to put down 10 percent.
As a result of the more flexible lending requirements, the rate will be slightly higher than a conventional mortgage. It may also be required for the buyer to pay mortgage insurance premiums, along with their monthly mortgage payments with this type of loan.
Again, this is a result of the more flexible lending requirements, which in actuality create a higher risk for the lender. Even though nobody wants to have a higher cost of borrowing, many first-time buyers will end up with a FHA loan, simply because, most first time buyers are relatively young and have not had time to build up a high credit score or a large down payment.
Veteran Affairs (VA) Loans
VA mortgages are mortgages backed by the Department of Veteran Affairs. These loans allow eligible military service members to buy a home with little to no down payment. The approval process for these loans has been simplified for service members, veterans and their families, and because they are backed by VA, mortgage insurance isn’t required, which is a significant savings.
Who qualifies for a VA loan?
1) Active or retired duty members of the armed forces with at least:
- 90 days of consecutive service during wartime
- 181 days of service during peacetime
- 6 years of service in the national guard or reserves
2) Spouses of service members who died in the line of duty or as a result of a service related injury.
Fixed vs. Adjustable Rate Mortgages
Any of the above mortgages can be a fixed rate or adjustable rate mortgage. One is not necessarily better than the other, but one is probably better than the other for you. Consider your circumstances and future plans when deciding which type of mortgage to choose.
Fixed Rate Mortgages
A fixed rate mortgage is one where the interest rate stays the same for the life of the loan. Fixed rate loans are ideal for people wanting to stay in their homes for longer periods of time.
Terms for a fixed rate mortgages usually range from 10-30 years. The advantage of a fixed rate mortgage is that you’ll always know your payment amounts. It’s hard to put a price on that. (Paying a slightly higher interest rate might be worth it, so that you can sleep soundly knowing if interest rates rise, your payment will stay the same and your financial situation will be unaffected).
The disadvantage of a fixed rate mortgage is that there may be some substantial penalties if you ever want to sell or move before your term is up. Be sure to ask what the penalties are for breaking the term of your fixed rate mortgage before you sign. We all know how life has a way of altering even the best laid plans.
If you are looking for a way to figure out how much mortgage you can afford, check out our mortgage affordability calculator, or our simple mortgage calculator. Both can help you with the number side of things.
Adjustable Rate Mortgage (ARM)
Adjustable rate mortgages are generally 30-year mortgages where the first portion of the mortgage has a fixed rate and then the rate is adjusted periodically after that. These mortgages are usually described by their name.
For example: a 5/1 ARM would mean that the first 5 years of the mortgage is fixed and then the rate is adjusted once per year after that. Generally the fixed portion of these mortgages ranges from 3-10 years.
These are great mortgages for first time buyers. Often we don’t stay in our first home longer than 10 years, so we can benefit from the advantage of the fixed rate at the beginning while not being locked in for the entire term of the loan and forced to pay penalties if we move or sell. The rates will also be lower on this type of mortgage at the beginning so it allows you build more equity in your home.
Loan discount points are prepaid interest. 1 point is equal to 1 percent of the loan. By paying points up front, it will decrease the interest rate on your loan. Different lenders will have different options for what they offer by way of discount points. Whether it’s worth it for you or not depends on how long you’re planning to stay in a home.
It takes time to make the money back that you spend on points, and it may not be worth it depending on how long you stay in the house. For most first-time buyers, there is usually not a lot of extra money kicking around when closing on a home, so buying extra points is not often even an option.
What is APR?
APR stands for Annual Percentage Rate and provides a more complete analysis of the cost of borrowing. APR takes into account things like lender fees and mortgage points as well as the interest rate to provide you with a more complete understanding of the cost of borrowing.
The APR will be a higher percentage than the interest rate because it includes more considerations. It will provide you with a fairer assessment between lenders, as one lender might have a lower interest rate with higher fees, and another might have a higher rate with lower fees. In both cases the APR might be exactly the same.
How Quickly Can I Learn the Mortgage Basics?
You’ve just had a good overview of mortgage basics as well as some of the lingo that comes with buying a home. As mentioned, buying a home is relatively straightforward. There’s just a process to it, and it takes a little bit of time to learn it. Once you read more about it, save for your downpayment, and start looking for a house you love, buying a home can be a fun and exciting time in your life. Just be sure to educate yourself on the mortgage basics so you’re confident going into the home buying process.