What is a Mortgage?
A mortgage is a loan. It enables you to acquire a home that you would otherwise not be able to afford. This home can be a condo, a house, a ranch, or even a houseboat. Getting a mortgage for your home is quite common; most Americans use a mortgage to acquire their home because of the large sticker price; folks normally do not have enough money to buy their home outright.
The are many different types of mortgages. What makes mortgages different can be the length (term) of the mortgage, and the frequency at which the interest rate on the loan changes.
The term is simply the length of the loan. This is expressed in time. For example, I have a 30-year fixed rate mortgage. This means that it will take me 30 years to pay off the loan – assuming that I took out the loan today (and that I don’t make any pre-payments). There are also 15-year fixed rate mortgages, and less common 20-year fixed and 10-year fixed terms. Terms that denote the entire length of the loan refer specifically to fixed-rate mortgages, and not adjustable-rate mortgages (ARMs). ARMs are also known as floating-rate mortgages.
The Interest Rate on Your Mortgage
In exchange for charging interest on the loan, a bank (or credit union) will allow you to borrow money to buy your home. The interest rate charged by the lending institution varies by the type of mortgage chosen. (The higher the interest rate, the more money you pay the bank.) So, choose your type of mortgage wisely. You’ll want to pick the option that pays as little money to the bank as possible BUT still works within your budget AND doesn’t surprise you later down the line. We’ll explain what the surprise exactly is in our next post (hint: ARMs).
When it comes to fixed rate loans, the longer the time period, the higher the interest rate. A higher interest rate means you’re paying more money for the privilege of borrowing the bank’s money. This higher interest payment shows up not just every month (pay period), but drastically over the course of the entire loan. This means that while a higher interest rate will make some difference in the size of your monthly mortgage payment (i.e. you monthly payment will be a little bit bigger with a higher interest rate), it will make a huge difference when multiplied by 360.
Assuming a mortgage loan of $250,000, look at the difference that the length of the loan makes when it comes to how much money you pay in interest:
|Term||Rate||Monthly Payment||Interest Paid in 1st payment||Total Interest Paid|
|10||2.50%||$ 2,357||$ 521||$ 32,810|
|15||3%||$ 1,726||$ 625||$ 60,762|
|20||3.50%||$ 1,450||$ 729||$ 97,976|
|30||4%||$ 1,194||$ 833||$ 179,673|
Sometimes, it may make sense to pay the higher interest rate. For example, while it would be nice to pay just ~$32,000 in interest on a $250,000 loan (for a 10-year fixed), electing a 30-year fixed rate mortgage makes the payments comparable to what you’re probably paying in rent right now. That’s a scant ~$1,200 a month payment relative to ~$2,350 – almost twice the difference.
When the time period for the loan increases, the monthly payment decreases. The consequence is that you pay more in interest. The other way to get the monthly payment down is by decreasing the interest rate.
Fixed Rate Mortgages
So, everything we’ve covered deals with fixed rate mortgages. The cliff notes are:
• Monthly mortgage payments remain the same for the life of the loan
• Lower interest rates (but higher monthly payments) are available with a shorter term mortgage loan
• You can get a lower monthly payment by paying more in interest over a longer mortgage term
With a fixed rate mortgage, the amount of your monthly mortgage payment is the same the first month as it is the last month. Fixed mortgages are predictable; you always know what you are going to pay each month.
For the comfort and security of a predictable payment schedule, you do pay a premium – in the form of a higher interest rate. That is, the interest rate on a fixed-rate mortgage is almost always higher than on a floating rate mortgage (at least at first). At this point, you may be wondering:
A higher interest rate!? Why would I want to pay that?
Hold on Sparky! We’ll get to that – in our next post . . .