A Basic Guide to Mortgage Financing

Financing a house or condominium is a necessity for most Americans, as the typical household does not have enough cash available to pay for a house upfront. The fact that mortgage financing is so commonplace should be a source of comfort, because while some of the processes and terminology involved can seem daunting, always remember that hundreds of thousands of people have been through this successfully before you.

Mortgages are loans that use the property being financed as collateral, or security for repayment of the loan. If the borrower fails to make the mortgage payments, the lender can take possession of the house. This makes house financing a very serious business, and the better you understand it, the more chance you will have of succeeding as a home owner.

The following are some key elements of mortgage financing, and how they work:

Mortgage Financing Basics

Mortgage financing is so complicated that even seasoned professionals never stop learning, but there are a few key concepts you should focus on to get started:

  1. Loan principal. This is the amount you owe. Initially, it is the amount you are borrowing, and then over time it is reduced as you pay down your balance. This process is called "amortization."
  2. Interest rate/APR. The interest or mortgage rate represents what you are charged for borrowing money. The APR, which stands for Annual Percentage Rate, is similar except that it includes both interest and certain other expenses associated with the loan. Loans can be configured in different ways, so knowing the APR is essential to making apples-to-apples comparisons between lenders.
  3. Fixed or adjustable. Some mortgage rates stay constant over the life of the loan, and these are known as fixed rates. Adjustable or variable rates move up and down as financial markets change. While you can benefit from adjustable rate mortgages (ARMs) if market rates fall, you could also end up paying more if market rates rise. Adjustable rates carry the risk that mortgage payments that were affordable when the loan began could become unaffordable as market rates rise. 
  4. Loan term. This is the length of time you have to pay back the mortgage. Most mortgages these days have 30-year terms, though 15-year loans are also fairly common. Shorter loans generally entail higher monthly payments because you have to pay back the loan over a shorter period of time, but they will cost you less in interest because they usually have lower mortgage rates and you will be charged interest over fewer years.
  5. Down payment. This is the amount you put towards the purchase of the home at the very beginning. While some mortgages do not require a down payment, lenders generally prefer one because it helps ensure that the value of the property is worth more than the amount of the loan.

Options for Financing a Home

Here are some different options you may have for obtaining a mortgage:

  1. FHA mortgages. FHA mortgages are insured by the Federal Housing Administration. This program allows buyers to buy a house with as little as a 3.5 percent down payment, but borrowers have to pay a mortgage insurance premium over at least part of the loan term, and there are dollar limits on how much can be borrowed. Though FHA loans are insured by a US government agency, they are obtained through private lenders.
  2. Qualified mortgages. Qualified mortgages are those that meet certain government standards and therefore make it easier for lenders to sell those loans later on. Being able to sell a loan is an important risk management and profitability issue for lenders, so you will have the best chance of getting a mortgage if it meets certain standards with respect to your ability to repay, the size of the down payment, and the length and structure of the loan.
  3. Jumbo mortgages. These are mortgages larger than the government-backed maximum. They often (but not always) carry higher interest rates.
  4. Sub-prime mortgages. These are loans for people whose credit ratings do not meet government standards. You may be able to get a mortgage with substandard credit, but expect to pay a higher interest rate.

Though there may seem to be a lot of unique jargon involved in financing a home, don't let it intimidate you. You'll get a feel for it as you go through the process, and when in doubt, don't hesitate to ask. Again, understanding the process is a major step towards succeeding at it.

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