What Is a Mortgage?
A mortgage is a loan taken out to purchase a home. As a borrower, you’re making a legal agreement to repay your loan, with interest, over a set amount of time.
There are two components to your mortgage payment—principal and interest. Principal refers to the loan amount. Interest is an additional amount (calculated as a percentage of the principal) that lenders charge you for the privilege of borrowing money that you can repay over time.
During your mortgage term, you pay in monthly installments based on an amortization schedule set by your lender.
Another factor involved in pricing a mortgage is the annual percentage rate (APR), which assesses the total cost of a loan. APR includes the interest rate and other loan fees.
The Types of Mortgages
Not all mortgage products are created equal. Some have more stringent guidelines than others. Some lenders might require a 20% down payment, while others require as little as 3% of the home’s purchase price.
To qualify for some types of loans, you need pristine credit. Others are geared toward borrowers with less-than-stellar credit.
Mortgage terms, including the length of repayment, are a key factor in how a lender prices your loan and your interest rate. Fixed-rate loans have a set interest rate for the life of the loan, usually from 10 to 30 years.
If you want to pay off your home faster and can afford a higher monthly payment, a shorter-term fixed-rate loan (say 15 or 20 years) helps you shave off time and interest payments. You’ll also build equity in your home much faster.
Opting for a shorter fixed-term mortgage means monthly payments will be higher than with a longer-term loan. Crunch the numbers to ensure that your budget can handle the higher payments. You may also wish to factor in other goals, such as saving for retirement or to build an emergency fund.
Fixed-rate loans are ideal for buyers who plan to stay put for many years. A 30-year fixed loan might give you wiggle room to meet other financial needs. However, if you have the appetite for a little risk and the resources and discipline to pay your mortgage off faster, a 15-year fixed loan can save you considerably on interest and cut your repayment period in half.
Adjustable-rate mortgages are riskier than fixed-rate ones but can make sense if you plan to sell the house or refinance the mortgage in the near term.
Adjustable-rate mortgages (ARMs) have a fixed rate for an initial period of up to 10 years. Once that period expires, the rate fluctuates with market conditions. These loans can be risky if you’re unable to pay a higher monthly mortgage payment once the rate resets.
Some ARM products have a rate cap specifying that your monthly mortgage payment cannot exceed a certain amount. If so, crunch the numbers to ensure that you can potentially handle any payment increases up to that point.
Don’t count on being able to sell your home or refinance your mortgage before your ARM resets because market conditions—and your finances—could change.
ARMs are a solid option if you don’t plan to stay in a home beyond the initial fixed-rate period or you intend to refinance before the loan resets. Why? Interest rates for ARMs tend to be lower than fixed rates in the early years of repayment. So you could potentially save money on interest payments in the initial years of homeownership.
Now that you have the basics about the different types of mortgages, you can start matching them with your dream home. A savvy next step is to sit down with a mortgage professional and discuss your finances and homeownership goals. Together, you’ll find the best loan—for your needs, your dream home and your specific real estate market.
How do I find the best mortgage?
Here are some steps you can follow to help you secure the best mortgage:
- Do your research: compare the best mortgage deals before you commit
- Find out which lenders offer the best customer service using our guide
- Use mortgage calculators: there are plenty of these available online to help you understand how changes in interest rates could affect your monthly repayments and the overall cost of the loan
- Make use of this guidance to improve your chances of getting a better deal
- Speak to a mortgage broker: ideally one that’s able to search the whole of the market rather than being restricted to a small number of lenders or products.
- Exclusive deals: some brokers will have exclusive deals that are only available through their company, so ask them about these
The Bottom Line
It’s important to get the type of mortgage loan that fits your financial situation best and allows you to make monthly payments that you can afford.
But no matter which loan type you choose, check your credit report beforehand to see where your credit stands. You’re entitled by law to one free credit report from each of the three main reporting bureaus each year through AnnualCreditReport.com.14
Then you can spot and fix errors, work on paying down debt, and improve any history of late payments before you approach a mortgage lender.
To further protect your credit report from errors and other suspicious marks, consider utilizing one of the best credit monitoring services currently available.
Also, it can be advantageous to pursue financing before you start looking at homes and making offers. You’ll be able to act more quickly and may be taken more seriously by sellers if you have a pre approval letter in hand.