Understanding a Mortgage and Preparing You for Home-Ownership.

So you want to dive into home-ownership? Good for you! After-all isn’t that the American dream? Home-ownership can be rewarding provided you go about it the right way. But even then, there is still risk that it doesn’t work out. Though don’t let that scare you. There is something magical about being able to stand on your own piece of dirt and in a building that you own (or will own). Most people jump into home-ownership with a mortgage.

A mortgage is most likely the biggest debt that you will sign up for, and understanding how it works can go a long way in providing peace of mind.

So, I know there are a few questions. First let’s tackle the two biggest ones.

How much house can I afford?understanding a mortgage

Don’t make the rookie mistake of going to the bank and asking this question. They will give you a number so large that your head will begin spinning. You’ll feel like you won the lottery (you didn’t), and you’ll be amazed that anyone would lend you such a large amount of money.

What you should do, is start with two numbers.

One: what you can reasonably afford per month for a mortgage payment (which will include taxes and insurance). This number should be roughly 25% – 30% of your take-home pay. Unless you have loads of other debt. In which case, you need to get that other debt paid down before you commit to even more debt!! Look at your budget and compare to what you currently pay in rent. This should give you a good starting point.

Two: what you have available for a down payment. A thousand dollars is a good start, but is not nearly enough for a good down payment. Depending on what part of the country you’re in, a reasonable down payment could be anywhere from $10k to $100k. Or 10-20% of the total purchase price.

Note that your emergency fund is not a down payment. You’ll need it when you move into your new house. Things will break, that you are now responsible to fix. The landlord is now you. So don’t spend your rainy day fund as the down payment.

Take your monthly payment number (that you’re comfortable with) and your down payment number (that you actually plan on saving or already have) and head over to Zillow to their home affordability calculator.

For instance: when I plugged in a monthly payment of $1200 and a down payment of $30k, it told me that I could afford a house that cost: $199,736.

What’s the best way to go about purchasing the house of your dreams?

Assuming you don’t have enough money to pay in cash, you will have to get a mortgage. As with anything money related, you should understand what you are signing before you actually sign.

The worst thing you could do is rush into a large purchase without understanding exactly what you’re getting into. After-all, you could be paying this mortgage for a third of your life! You will eventually hate it – especially if you didn’t understand it to begin with.

Home-ownership is not for the faint of heart. Many times we have this fairy tale idea of what home-ownership is like. I had this notion in my head before we bought our first house. I thought it would be the answer to our growing families troubles. But we weren’t ready, and I didn’t fully understand what I was getting into.

Related: My Financial Story and First House Mistake

Understanding the terminology.

Some of these terms can be confusing. Don’t sound like a putz when you go to the bank to apply for your mortgage.

  • Mortgage – loan from either a private bank or other lender for the express purpose of buying a house. There are many different flavors of mortgages.
  • Term – amount of time you will have to re-pay the loan in full. This is usually measured in years or maybe months.
  • Principal  – this is the amount you borrow.
  • Interest – the amount of money you will pay to the bank for the privilege of borrowing their money. Your credit and income will impact the interest rate you receive.
  • Amortization –  simply put, this is the repayment schedule of paying back the loan. This will include principal and interest combined into one payment. The interest is usually much more than the principal initially.
  • Monthly payment – this is the amount of money you will pay each month for the duration of the loan. This will include principal (P) and interest (I) or P/I. It may also include taxes and homeowner’s insurance.
  • Escrow – This is a separate account that the lending bank sets up on your behalf. A part of your monthly payment is placed in “escrow” to be used to pay insurance premiums and property/school taxes. This is above your P/I payment.
  • Down payment – This is a percentage of the purchase price. Or cash you put down to secure your house purchase. Could be as little as 5% of the purchase price.
  • Equity – This is the amount of the house you actually own. In other words, it’s the difference between what you paid for your house and your loan balance at any time. At the time of purchase, your equity equals your down payment.
  • PMI – private mortgage insurance – this is insurance you are required to buy if you put less than 20% down.
  • Closing/Closing costs – The closing is when you “close” on the deal, and actually sign the mortgage contract. The costs associated with the closing (title search, origination fees, appraisal fees) are captured with the closing costs. Before you get to the closing, your bank or lender will give you an itemized list of all the closing costs they expect you to pay at the closing.

There are many other terms, but the ones listed above are the most important.

What is a Fixed-rate Mortgage

These type of mortgages come in several different flavors. The interest rate, like the name implies, is fixed for the life of the loan. You can get a 10, 15, 20 30, or even 50 year mortgage. The most common is a 30 year mortgage. Despite what you might think, the 30 year mortgage has not been around forever. It was created in the 1930’s. Before that, the common mortgage was only 5 years or so.

For more information about the history of mortgages, check out this story.

This is the most common and best type of mortgage. The interest rate is fixed, so your payment (P/I) will always be the same.

This is the mortgage you should get.house in winter

The interest rate will be lower for shorter term loans, but the monthly payment will be higher. Aim for as short of a term as possible.

Adjustable-Rate Mortgages or ARMs

These mortgages came out of the 1980s. As the name implies, the interest rate adjusts both up and down depending on the market rate at the time. This is great when the interest rates are going down. But not so good if they are going the other way although there is usually a cap. If you have an adjustable rate mortgage, refinance NOW. Interest rates are on the rise, and will only continue to go up.

If you are looking at getting an adjustable rate mortgage, don’t be fooled by the low-interest rate. It will suck you in if you’re not savvy. This is often an introductory rate that will certainly adjust upwards after a few years.

Sometimes, banks will structure these mortgages with a balloon payment at certain intervals or at the end. This means a large sum or a balloon will be due. These balloon payments can be trouble if you’re not ready. Most will try to re-finance at this time as well.

These can also have several different terms – 10 to 50 years – though most re-finance long before that. The main purpose of the adjustable rate mortgage is to open up the housing market to those who might not otherwise be able to afford a house. But because of the uncertainty of the interest rate, this is a very risky type of mortgage to sign up for.

FHA Loans / VA Loans

FHA mortgages are insured by the federal government (FHA – Federal Housing Authority) and have specific stipulations. I’m not planning to discuss these types of mortgages in detail.

However, if you want more info, here’s a great resource for FHA loans. FHA.com

VA loans are available to members of the military. I don’t know much about them, though I have relatives who recently purchased a home using a VA loan.

One of the key tenets of the VA loans are the 0% down payment. In my mind, this doesn’t sound like a good idea, but again, I don’t know much about the other requirements and stipulations.

Take-Aways

So what do you think? Are you ready to take the plunge into home-ownership? Don’t think that you have to buy a house, just because everyone else is.

It’s a great step toward building wealth, but it’s not for everybody. Please make sure you understand what you’re getting into before you sign.

I’ve owned two houses, and both have had their share of issues. But I always had a hard time renting. There was just something about walking my own land/house instead of someone else’s.

What about you? Is home-ownership for you? Are you planning on getting a mortgage soon?

Let me know in the comments, and if you found value in this post, would consider sharing.

-Chris

Author

Chris is the original Cash Dad. He's a father of 3 and a mechanical engineer by trade.

8 Comments

  1. I always get equity and escrow mixed up so thanks for clarifying that. I am sure that I will ask you again in the future what those things mean. And I agree with you, there is something awesome about owning your own piece of land. Hopefully, it will officially be ours on paper very soon.
    Love you,
    Kare

  2. Man, I wish I would have read this before my wife and I purchased our first home 10 years ago. I was told, “buy the most you can afford, It’s an investment!” we are still recovering from this mistake. Great article with tons of good information!

  3. We have an ARM with fixed low rate for five years. We have sightly over two years left in those five. We have been aggressively been paying off the mortgage, but have begun to worry about what will happen when the period is up. May be a refinance? We can’t touch it now because the interest rates are much higher right now.

    • Chris Reply

      Thanks for commenting.
      It sounds like you’ll be ok for now. But knowing you’ll have to refinance because the rates will surely adjust up once the first five years are up. Can you afford the new payment with a higher rate? Since you’re paying extra already, you probably can.
      But I would worry too, and recommend that you get to a 15 year fixed as soon as possible after the rate adjusts at or past the fixed rate level. You’ve already paid 5 years at that point. Why stretch it out another 30 years? ?

      • We can afford the higher rate, just is a waste of money. Our plan is to pay it off in three more years after that. When we refinance, we will probably just look at the lowest rate of interest, nothing else.

  4. Great article! I have multiple mortgages (investment properties) and have been through the lending process many times. But even still, this article is a great read.

    Cheers!

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