Mortgage Basics

Traditional belief is that 20% is the gold standard for a home down payment. Considering how much homes cost in this area, 20% can make home buying feel more like a dream than a reality for many. Yes, 20% is still a good number to aim for. But having less than 20% to put down doesn’t mean you can’t afford to buy a house. With good credit, you can often put down significantly less to get out of your rented space and into your very own home.

Below we’re going to dive into the ins and outs of obtaining a mortgage - and what you should expect your monthly mortgage payments to look like.

What Is a Mortgage?

A mortgage is best described as a secured loan used to buy a house or other piece of property. Quick reminder, a secured loan is a type of loan that requires collateral from the borrower. This collateral could be a house, car or other form of property.

The most common length for a fixed mortgage is 30 years, with about 90% of homebuyers choosing this option.¹ 15-year loans are the second most popular.

How Does a Mortgage Work?

When you use a mortgage to purchase your home, the lender (your bank, credit union or other financial institution) will actually be the one that owns the home outright. You will make regular monthly payments to the lender for a predetermined length of time. As noted above, the most common loan lengths are 30-year and 15-year fixed loans. These payments will include the principal amount and interest. It will likely also include other expenses like property taxes, private mortgage insurance and homeowner’s insurance.

Your mortgage’s interest rate is normally determined in one of two ways - fixed or adjustable.

Fixed-Rate Mortgages

Just as the name indicates, a fixed-rate mortgage offers an interest rate that will not change over the lifetime of your loan. From the first payment to the final one, you can expect to pay the same interest rate for the entirety of the loan.

Adjustable-Rate Mortgages (ARMs)

Unlike a fixed-rate mortgage, an ARM will have interest rates that change over the lifetime of the loan. With an ARM, the lender will offer a set interest rate for the first few years of the loan (typically anywhere from the first 3-10 years). Once the initial period has passed, the interest rate could increase. In turn, this would increase the borrower’s monthly mortgage payments.

While the lower initial interest rate offered on ARMs may seem very attractive, the borrower is taking a chance on whether or not that rate will eventually rise. Though ARMs are typically not widely encouraged, they could be useful for those who plan on selling their home sooner rather than later, or for those who know they will be refinancing their mortgage before the rate has an opportunity to increase.

How Is a Mortgage Payment Calculated?

For this calculation let’s assume you’re using a 30-year fixed-rate loan and your house cost $200,000. Here’s what your mortgage payment will likely include:

• The principal amount: This is how much you paid for the property, minus your down payment. If you purchased a $200,000 home and had a down payment of $20,000 (10%) upfront, your principal amount for the loan would be $180,000. For a 30-year loan, we’d divide $180,000 into 360 monthly payments - about $500 monthly.
• The interest: Being that we’re using a fixed-rate mortgage in our example, your interest rate will not change over the life of the loan. If your annual interest rate is 4%, you’d need to divide that amount by 12 to determine how much you’ll be paying in monthly interest. In this case, you’d be paying 0.33% per month.
• Private mortgage insurance (PMI): If you plan on making a down payment of less than the typical 20%, you will most likely be required to pay a monthly PMI (private mortgage insurance) premium. Typically, this insurance will no longer be required once you have paid up to the 20% in mortgage payments. According to Freddie Mac, you should be prepared to pay premiums between $30 and $70 per month for every $100,000 borrowed.²
• Property taxes: It’s very common for your lender to establish what is called an escrow account. An escrow account is where things like property taxes are collected. This is why they will usually be included in your monthly mortgage payments. When it comes time for your property taxes to be paid, your lender will pay the amount on your behalf using what you’ve already set aside in escrow.
• Homeowners insurance: Most lenders will require a borrower to obtain a suitable homeowners insurance policy. Again, this will typically be lumped in to that monthly mortgage payment.

When you’re considering purchasing a home, it is important to do your homework first. Speak to your trusted financial professional and begin researching mortgage types and rates before visiting your first open house. Having your ducks in a row will help you stay level-headed and rational about what homes are in your budget and what you can realistically afford.