Few home buyers are wealthy enough to pay the entire purchase price of a home up front. Instead, most pay a down payment, a percentage of the total purchase price of the home, and get a mortgage loan to cover the rest of the expense of buying the home. Mortgages work as follows:
- Loan: A lender, such as a bank, agrees to lend the home buyer an amount equal to the difference between the down payment and the full purchase price of the home. The amount of the loan is called the principal. If a home costs $200,000 and the buyer pays a 20% down payment of $40,000, the principal is $160,000.
- Repayment: The buyer must repay the lender over time through monthly mortgage payments. These payments typically pay down the principal plus interest. If the buyer fails to pay the mortgage, the lender can foreclose on the house, taking it back from the buyer.
In general, it’s best if the down payment covers at least 20% of the total purchase price. If you don’t have the funds to put down 20% of the purchase price, you can usually still get a mortgage, but you’ll likely have to cover some additional costs each month. Some first-time buyers may qualify for FHA (Federal Housing Administration) programs that require down payments of just 1–3%. Talk with a lender about whether you might qualify for FHA programs.
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Taxes and Insurance
The total monthly mortgage payment is often referred to as the PITI, which stands for principal, interest, taxes, and insurance.
Property taxes: Each monthly mortgage payment may include a prorated portion of the annual property taxes you owe. If your annual property taxes are $2,400, for example, each of your monthly payments may include $200 of property tax in addition to the principal and interest. But sometimes property tax payments are made directly by the homeowner and therefore are not associated with the monthly mortgage payment.
Insurance: Lenders typically require homeowners to purchase homeowner’s insurance, which covers both the home and its contents in the event of a flood, fire, or other damage. Though some lenders sell insurance themselves, homeowners most often purchase insurance from a separate insurance firm. In addition, buyers who can’t afford a down payment of at least 20% of the purchase price usually have to purchase private mortgage insurance (PMI), which protects the lender if the home buyer defaults on the mortgage. PMI can add $50–100 or more to the monthly mortgage bill.
Types of Mortgages
The two types of mortgages most commonly offered are fixed-rate and adjustable-rate mortgages.
Fixed-Rate Mortgages
Interest rates rise and fall over time. In the early 1980s, for instance, interest rates rose to almost 19%, whereas in 2006 they were at about 5%. A fixed-rate mortgage protects you from such fluctuations by locking you into a permanent rate when you take on the mortgage.
Advantages of Fixed-Rate Mortgages
Stability: The interest rate on a fixed-rate mortgage never changes, even if economic shifts cause interest rates to spike. That means your monthly mortgage payments will never change: if you’re paying $1,500 a month today, you’ll pay $1,500 a month a decade from now.
Disadvantages of Fixed-Rate Mortgages
Higher initial costs: Interest rates on fixed-rate mortgages are usually higher than the initial rates on riskier adjustable-rate mortgages. As a result, your monthly payments (at least during the first 3–10 years) will be higher with a fixed-rate mortgage.
Fixed-rate mortgages can cover terms of 15, 20, 30, or 40 years. The most common are the 15- and 30-year varieties.
Adjustable-Rate Mortgages (ARMs)
An adjustable-rate mortgage (ARM) has an interest rate that can change at certain points throughout the term of the loan. Most ARMs offer a fixed rate for a certain period of time (3, 5, 7, or 10 years), after which the rate adjusts to match the interest rates that the financial markets are offering at the time.
Advantages of ARMs
Lower initial costs: During the initial fixed term of an ARM, interest rates are usually lower than the permanent rates on fixed-rate mortgages. This results in lower monthly payments during the fixed-term phase of an ARM.
Disadvantages of ARMs
Risk: ARMs expose you to risk. Though your initial rates on an ARM will be lower than those for a fixed-rate mortgage, if rates rise when the fixed term ends, you’ll pay more.
Different ARMs adjust their interest rates in different ways. Some adjust only once, at the end of the fixed term, and then act like a fixed-rate mortgage at the new, adjusted rate. Other ARMs continue to adjust their rates every 6–12 months to match current rates. Like fixed-rate mortgages, ARMs usually come with 15- or 30-year terms.
Interest-Only Mortgages
Certain ARMs allow you to pay interest only—as opposed to interest plus principal—on the loan for a fixed period of time (usually 5–7 years). Since you don’t have to pay down the principal, monthly payments on these loans are much lower than those of standard fixed-rate mortgages or even other ARMs. However, when the interest-only period expires, you must either:
- Pay off the entire balance in a lump sum: This option typically requires tens or hundreds of thousands of dollars.
- Start paying off the principal within each monthly payment: This option causes monthly payments to rise dramatically, even if interest rates don’t rise. If interest rates do rise, your monthly payments could skyrocket.
Mortgages and Tax Deductions
The U.S. government encourages its citizens to buy homes by allowing people with mortgages to deduct from their taxable income the mortgage interest they pay each month. This deduction lowers the monthly mortgage payment by an amount based on your income tax bracket. For example, say you’re in the 28% tax bracket and have a monthly mortgage payment of which $1,000 is interest. After deductions you pay only 72% of that $1,000, or $720.
These tax deductions are especially beneficial in the early years of a mortgage because most mortgage payments are structured so that in the first few years you pay far more interest than principal. As a result of this arrangement, in the first months and years of a mortgage, nearly the entire monthly payment is tax deductible.
