Financing a Home Purchase
The biggest obstacle for most people considering home ownership is financing. A home is the largest single purchase most people will make in their lifetimes. Real estate prices vary dramatically according to location, from as low $50,000 to several hundred thousands dollars or more. Clearly, most people cannot afford to purchase a home outright. They must get a home loan, called a mortgage, and pay that loan off over time. The amount of time you are given to pay off a home loan is called the mortgage term. Typical terms are 15, 20, or 30 years duration with most mortgages ending up having a 30 year term. The benefit of a longer term is that the monthly payment will be lower, so you can buy a more expensive home. However, when you choose a longer term you will also pay more interest over the course of the loan, raising the total cost you pay. It is best to select a mortgage with the shortest term you can afford because you will pay less in interest that way and you will own your home outright that much sooner. If you cannot afford the payments on a 15 or 20 year loan, you should at least consider buying a less expensive home.
Understanding Mortgage Payments
Mortgages loans use the simple interest method to determine the amount of interest you pay. Interest is equal to the amount of money outstanding multiplied by the interest rate times the length of the loan. So, how much total interest you pay depends upon your interest rate and the length of time you keep the loan. The interest rate on a mortgage that is most frequently cited is the annual percentage rate (APR). This is the percentage of the amount you owe that you will pay to the bank as a fee. Since interest is express as a percentage, the more money you borrow, the more you will pay in interest. Additionally, the higher the interest rate, the more money you will have to pay.
The note rate is the interest rate used to calculate interest for the principal only. The APR is the effective interest rate after fees are included. Interest rates will vary, in general, according to Federal Funds rate (the rate banks charge each other to borrow money) but the specific rate a lender will offer you will depend largely on your credit rating. The better your credit, the better rate you will get. Since your interest rate will vary according to your credit, which you establish over time, there is little you can do in the short term to affect your interest rate significantly. You can, however, control the length of your mortgage. Choosing a shorter term will cost more money per month but will allow you to save money in interest over the life of the loan.
Fixed vs. Adjustable Rate Mortgages
Traditionally, most mortgages were fixed interest loans which required you to pay a fixed percentage of interest on the money borrowed throughout the entire period of the loan. Under this fixed scheme, your payments remain constant from month to month for the duration of the loan.
Fixed interest mortgages ofter the advantage of fixed payments which can be anticipated, but they can be expensive too. Interest payments on fixed mortgages are fixed for the life of the loan. This can work to the bank's disadvantage if the cost of making loans, and the rates offered on new loans, goes up substantially. As a means of compensating for this possibility, banks tend to set their fixed loan interest rates at higher levels than what they'll offer for a variable interest (e.g., adjustable rate) mortgage where they will have a chance in the future to correct (raise) what you pay.
Many of the mortgages made over the past twenty years were made according to an adjustable interest scheme rather than a fixed one. In an adjustable interest rate, the mortgage is made with a specific and fixed interest due during the first period of the loan. During the later part of the loan, however, the interest rate becomes variable and may rise and fall (at the bank's discretion, not your own!) according to market rates for interest. From a bank's perspective, a variable mortgages is a safer product to sell than a fixed rate mortgage, because with a variable mortgage they are able to raise the interest rate you pay (and make themselves more money) when their own cost of doing business goes up. They cannot raise your interest rate if you have a fixed mortgage.