Are you trying to “find your place”? Not in life – we assume you’ve already done that. We mean “your home”. Are you looking to buy a home? Do you need a home mortgage? Do you know how home mortgages work? We do – and we’d like to share our knowledge with you.

We’re going to show you, in simple terms, exactly how mortgages work. If you look at the history of home mortgages, you’ll see that the principles haven’t really changed throughout the years. And those principles are fairly basic. We’ll break it down for you, so you can get a good grip on what you need to know. So sit yourself down, relax, and take in all you need.

What are the basic parts of a mortgage?

Let’s start with the actual definition of a mortgage. It’s a legal contract that says if you don’t repay your home loan, including loan fees and interest, the lender can take your home away. When you get a mortgage, although you’re listed as the “owner” of the home, the lender actually holds the title until the debt is paid in full.

There are four basic parts of a mortgage. They’re known as PITI, standing for Principal, Interest, Taxes and Insurance. Let’s look at each part individually.

Principal: The principal is the total amount you borrow, not including any down payment you make.
Interest: The interest is the amount the lender charges you for the convenience of having the loan.
Taxes: Part of your property taxes are added to your monthly mortgage payment and held in escrow, that is, in the hands of a third party, until they are due.
Insurance: You have several different types of insurance you need to buy for your home, including hazard insurance, flood insurance, mortgage insurance, etc.

Finding the right type of mortgage can be confusing

There are several types of mortgages and it’s important that you get the right one to fit your situation. Making the wrong choice can cost you a lot of money down the road. So you need to have “all your ducks in a row”. We’ll line them up for you by examining your options. Below is a list of some of the more popular mortgages, with their advantages and disadvantages.

Fixed-rate mortgage: A fixed-rate mortgage is exactly what it sounds like – the interest rate doesn’t change throughout the entire life of the mortgage. Most fixed-rate mortgages are for a 30-year term, which makes the payments low, but the interest high. This is good if you’re not planning to move. You can also get a 20-year or a 15-year term, but keep in mind that the shorter the term, the higher the payment, but the lower the interest.
Adjustable-rate mortgage (ARM): Adjustable-rate mortgages are very popular these days. Their interest rates change with market rates and economic trends. For example, you can get a 5/1-year ARM that has the same interest rate for the first 5 years, then changes every year after that. Or a 3/3-year ARM has a fixed rate for the first 3 years, then changes every 3 years after that. The initial rate is usually quite low, but can get very high if market rates go up because they’re tied together closely.
Balloon mortgage: With a balloon mortgage, the interest rate is very low for 5-7 years, but then you have to pay one “balloon” payment that pays off the remaining loan in full. This would be a good choice if you’re planning on selling, paying off or refinancing your home before the balloon payment is due.
Reverse mortgage: The reverse mortgage is a fairly recent creation of lenders. To qualify, you must be over the age of 62 and you must live in your home. Then you can borrow against the equity in your home, getting a line of credit or regular payments. This, obviously, is great for retirees, but you need to be careful of the interest rates – they’re usually quite high.

How much is my mortgage going to cost me?

This is a huge question, with huge repercussions if you don’t find out. There are some actual costs of the mortgage which will be added to your home mortgage loan. These are called “closing costs”, and are usually 3%-6% of the total mortgage. To give you an idea of what to look for, here’s a list of some of those costs:

Processing fee: The processing fee includes the lenders initial costs, including the application fee and fees for accessing your credit report.
Appraisal fee: The appraisal fee is to pay for the appraiser, a trained professional, who determines the current value of the property.
Origination fee: The origination fee covers the costs of the lender’s additional work in preparing your mortgage. It could be either a flat fee or a percentage of the mortgage.
Discount points: When you buy discount points, you buy down your interest rate. One discount point is equal to 1% of the amount of the loan. Discount points are paid either when the loan is approved, or at closing.
Document preparation fee: The document preparation fee is self-explanatory. There’s a huge pile of documents that go into preparing your mortgage and you have to pay for that, usually as a flat rate.
Attorney fee: You’ll have to pay for both the lender’s and your own attorney fees, which include the costs of drawing up all the documents and making sure that everything is “above board”.
Home and pest inspections: The home and pest inspections will probably be a requirement of the lender, to make sure that the home is structurally sound and isn’t infested with termites or other destructive insects. You may also be required to have a water inspection. And again, you have to pay for this.
Homeowner’s and hazard insurance: You must have homeowner’s and hazard insurance, and the premiums must be paid at the time of closing.
Private mortgage insurance (PMI): If your down payment is less than 20% of the value of the home, you’ll probably be required to buy mortgage insurance. This is designed to protect the lender because your equity will be low for the first few years, which makes the lender’s risk high in the case of an early default.
Surveys: A lender may have an independent surveying company conduct a survey of the property to make sure there haven’t been any changes on the property since the last survey. Remember, any changes can affect the value of the property.
Prepaid interest: Your first payment may not be due for 6-8 weeks, but interest is charged from the closing date. So you have to prepay whatever interest accrues during that time.

So you can see that you’ll incur a lot of costs before you even move into your home. You need to prepare for that. And don’t forget your moving costs and your down payment. They should all factor into your decision when you’re figuring out how much you can afford to pay for a home.

Interest – your biggest cost

Amortization is a big word, but it can mean big costs to you if you don’t understand it. It’s just a fancy term meaning the lender spreads the interest on your mortgage over hundreds of payments so that the overall loan is as affordable as possible. But this interest isn’t spread out evenly. Your first payment consists of mostly interest and not much of the principal. Your last payment is the opposite. Bankrate.com has put together an illustration showing the pattern of the principal and interest involved in a $150,000 mortgage, with a 7.5% interest rate. Click here to check it out – the figures will amaze you.

Time to go shopping

Now you know why it’s so important for you to shop around when looking for a mortgage. All those costs can vary from one lender to another. And there are many out there. But if you take your time, do your legwork, then do your homework, you’ll be able to sit down quietly and calmly and come up with your best option.

Getting a home mortgage can seem intimidating. But don’t let it be! Review this simple explanation of how home mortgages work and it’ll all come clear. And have fun in your new home!

About The Author

Gareth Marples is a successful freelance writer providing valuable tips and advice for consumers purchasing free affiliate programs, free credit score and dream house floorplans. His numerous articles offer moneysaving tips and valuable insight on typically confusing topics.

This article on "How Home Mortgages Work" reprinted with permission.

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