What are Mortgages and How are they Used?
When buying a home, few individuals have enough money upfront to purchase the home. As a result, the majority of homeowners use a special loan called a mortgage to purchase their home. Mortgages are long-term loans, usually between 15 and 30 years long, which include the principal and an interest rate.
The principal of a mortgage is the term used to describe the total amount of the mortgage. For example, if you used a mortgage to purchase a $150,000 home with no down payment, the principal of the mortgage would be $150,000.
The interest rate of a mortgage is the way the bank or other loan holder makes their money. When you take the time to consider how much interest you pay on a home, it can sometimes cover the cost of the home several times, but this is the cost of not having enough money to buy the home upfront without a loan.
Fixed Rate Mortgages vs Adjustable Rate Mortgages
Depending on the type of mortgage, the interest rate is either fixed or adjustable. In a fixed rate mortgage, the interest rate remains the same for the entire length of the loan.
In an adjustable rate mortgage, the interest rate is adjusted, using the current interest rates as a metric, periodically over the course of a loan. Most adjustable rate mortgages have an interest rate that is adjusted once every 2 or 3 years, although this can vary, with some being adjusted every year and others only being adjusted once every 5 years.
Typically, an adjustable rate mortgage offers a lower initial interest rate and if the market is not preforming well, it is even possible for the interest rate to be lowered when it is adjusted, although this is not something you would want to bank on. Instead, it is a good idea to plan for the interest rate of an adjustable rate mortgage(ARM) to increase each time it is adjusted.
One very important part for prospective homeowners to consider when evaluating an ARM is how frequently the interest rate is adjusted, how much the interest rate can be adjusted each period, and how much the interest rate can be adjusted over the entire course of the mortgage.
Fixed Rate Mortgages, on the other hand, usually have a slightly higher interest rate, but offer the advantage of remaining the same for the entire length of the mortgage.
The Importance of Using Amortization Tables
When evaluating options and trying to find the best deal on a mortgage, it is important to view an amortization table for the mortgage. An Amortization Table breaks down each payment for the entire length of the mortgage, showing how much the payment is and how much of the payment is going towards interest.
Over the course of the mortgage, the first several years go towards paying the interest of the mortgage. So, for several years, the overwhelming majority of each months payment is going towards interest. After about 5 to 10 years, this reverses and more of each payment is going towards the principal of the mortgage. By looking at an amortization table, you can tell when this switch will occur.
Using an online Amortization Table Generator, which most banks offer on their websites, can be an excellent tool not just for understanding the loan itself, but also for seeing how things like extra payments can affect the amount of interest you pay over the course of the loan.