Financing And Closing Costs 101
When it comes to financing your new home, there are three important things to educate yourself about: mortgages, government programs, and closing costs.
Mortgages can seem intimidating, especially for the first-time buyer. Once you’ve qualified for a mortgage, there are some basic decisions you will have to make: Mortgage term, amortization, interest rate and type of mortgage. Read on to find out what all of that means, or use our handy Mortgage Calculator to estimate what your payments would be.
Mortgage Term and Amortization
The mortgage term and amortization period affect the amount of money you can borrow (and thus the price of the home you can buy) and dictate how much your monthly payment will be.
A mortgage term is the amount of time a lender will loan you money for – typically from 6 months to 5 years. When the term is up, the remaining amount is payable in full unless you arrange new financing for another term.
Choosing a mortgage term is tricky and requires you to be knowledgeable about trends in the marketplace, as well as having a sense as to the amount of risk you’re willing to endure. If you choose a six-month term, and interest rates increase drastically in that time frame, will you still be able to afford your home?
Few (if any) of us can pay off the entire principal of a large mortgage in a six month or even a five-year term. Imagine how big your payments would be! To help you out, lenders calculate or amortize, the mortgage payments over a much longer time, often as long as 25 years. They aren’t loaning you the money for a single 25-year period–they’re just calculating the payment schedule as if it will take you that long to pay back the principal plus interest. You will probably renew the mortgage several times during the amortization period, and you always have the option to change the amortization depending on market conditions or your financial situation. The longer the amortization period, the lower your individual payments will be – but this also means you’ll be paying more in interest.
Most mortgage payments consist of two parts: principal and interest. This is known as a blended mortgage payment. Each payment reduces the balance owed on the mortgage by the portion of the payment that is credited to the principal. Over time, the proportion of your payment that reduces the principal balance will increase. The faster you can pay down the remaining balance, the less total interest you’ll pay. There are many ways you can pay down your mortgage faster, from accelerating your payments (i.e. 26 payments per year instead of 24) to making lump sum payments on your mortgage; your lender can help define the right strategy for you.
The interest rate is one of the biggest contributing factors to how much you end up paying for your home both on a monthly basis and over the life of your mortgage.
Interest is the cost of borrowing money. Interest rates fluctuate with the economy. The interest rate you commit yourself to at the beginning of the term can have a significant effect on the amount you pay each month for your mortgage. There are two basic types of interest rates used in mortgage products: fixed-rate and variable-rate.
- Fixed-rate mortgage– Essentially, this means committing to a single interest rate that will not change for the term of your mortgage. This strategy equalizes how much of your monthly payment repays the principal vs. interest. Fixed-rate mortgages are great in an economy where interest rates are going up, as you never have to risk paying higher interest rates. But in an economy where interest rates are going down, you could be stuck paying more in interest than the going rate.
- Variable-rate mortgage– With a variable rate mortgage, your monthly payments are fixed for a specific term, while the interest rate portion of the payment floats in relationship to the bank’s prime interest rate. If rates go up, more of your payment is applied to interest and less is applied to the principal. If rates drop, more of your monthly payment is used to pay off your principal and your mortgage is paid off sooner. Variable rate mortgages can protect you if interest rates are high at the time you arrange your mortgage; when rates fall, you’re not stuck with high-interest payments and more of your payment is applied to the principal. But if interest rates increase, that could mean more of your payment is being applied to interest than you bargained for. In some instances, lenders will allow you to convert to a fixed-rate mortgage in this kind of situation.
Types of Mortgages
- Conventional mortgage – Aptly named because they are the most common type of mortgage. The lender will loan you up to 80% of the appraised value or purchase price of the property (whichever is lower) and you generally need to come up with the other 20% as a down payment.
- Second (and third) mortgages– These are additional financing arrangements behind an existing mortgage, also secured by your property. Secondary financing is generally arranged at a higher interest rate and for a shorter term than the first mortgage.
- High ratio mortgage– When you don’t have the 20% down payment required to get a conventional mortgage, a high ratio mortgage can advance you up to 95% of the home’s appraised value or purchase price. However, since you are borrowing more than the usual 80%, the government insists that the mortgage is insured against default and that you pay the cost of the insurance. That cost can be a few percent of the mortgage amount, and is added to the mortgage principal.