For most, buying a home means borrowing money from the builder, a bank or another financial institution. This borrowed money is known as your “mortgage.” A variety of mortgage programs are available, with varying loan terms and interest rates, so it pays to understand what you’re getting into.
For context, a typical home loan is 30 years at a fixed interest rate. Over the life of your loan, you’ll be paying back the principal (the amount borrowed) plus interest. You should expect to be paying back the principal with monthly payments throughout the life of the loan. To fully grasp how a home loan works, you should understand the five components that go into a mortgage.
The Five Main Components to Your Loan:
There are five key components that go into your mortgage. Understanding each of these components will help you make an informed decision on what kind of loan you should choose when buying a home.
1. Principal: The amount of money that you’re borrowing, not including interest.
2. Interest: A fee that the lender charges for providing the loan. The borrower must repay this money in addition to the principal.
3. Private Mortgage Insurance (PMI): Insurance the borrower must pay to guard against a loan default. If your down payment is less than 20% of the principal, expect to pay for PMI.
4. Term: The length of the loan.
5. Escrow: A portion of your mortgage payment that goes to property taxes and insurance.
Common Mortgage and Loan Programs:
Fixed-Rate Mortgage (FRM): Although the interest rate tends to be higher than an adjustable-rate mortgage, fixed-rate mortgages have the advantage of an unchanging interest rate that proves to be ideal for long-term buyers. Because the interest rate on these loans is consistent throughout the life of the loan, an FRM is generally viewed at a safer long-term option.
Adjustable-Rate Mortgage (ARM): Unlike a fixed-rate mortgage, an adjustable-rate mortgage has an interest rate that can vary throughout the life of the loan. In contrast with an FRM, the initial interest rates on these loans tend to be lower. Although the adjustable interest rates make these loans riskier than FRMs, the interest rates are capped to limit the amount of potential increase.
Jumbo Loan: A loan is considered “jumbo” if it exceeds the conforming limits set by Fannie Mae and Freddie Mac. These high-balance loans generally have higher interest rates, stricter terms and larger down payment requirements than standard loans.
Government Loan: A government loan is any loan that is sponsored by the federal government. These loans offer lower interest rates because they’re secured by the backing of the United States government. Some examples of these loans include: