Jumping into the world of homeownership can be a whirlwind experience. The financial terms used and their perceived complexity can keep many people from pursuing homeownership.
Don’t let the technical jargon hold you back. From the very basics to the more complex, here are the home finance terms you need to know before buying.
A mortgage is a type of loan that uses real estate as collateral and is the basis of all other home finance terms. There are many different types of mortgages, but in general, you’ll pay principal and interest over a set number of years, and once payments are complete, you’ll be the outright owner of your home.
Principal is simply the amount you’ve borrowed to purchase the home. This amount does not include interest or insurance costs, and only a portion of your monthly mortgage payment is used to pay back the principal. As the principal continues to be paid off, interest obligations will reduce as well.
Interest is what makes the arrangement beneficial to the lender. A set percentage of your principal loan amount will be paid each month in exchange for the loan, and interest payments will not lower your overall debt obligations. Although rates are at historical lows, you’ll still pay a lot in interest throughout the loan.
Down payments are typically 20% of the home’s asking price and are usually due at the time of closing. Making a larger down payment will decrease the principal due and make your monthly payments lower, but sometimes it can be advantageous only to put down the minimum. Many buyers will invest money they would’ve put down on their home and seek returns that are greater than the difference in monthly payments.
PMI stands for private mortgage insurance and is typically required for buyers who can’t afford to put down a standard down payment of 20% or more. PMI is added to your monthly payments and adds a security level for the lender in case of default. Private mortgage insurance can be quite expensive each month, but it has opened the door for many homebuyers who can’t afford down payments above 20%.
There are two basic types of mortgage rates. Fixed-rate mortgages will cost you a set percentage of interest each month without changing throughout the loan. This is an excellent option for buyers who want less uncertainty and think mortgage rates will go up over time.
Adjustable-rate mortgages, or ARMs, have interest rates that will change over the loan’s life, typically quarterly or annually. These mortgages will offer lower rates than fixed-rate loans for an introductory period and then move as rates rise or fall with the markets. If you don’t anticipate significant rises in rates, take advantage of an ARM.
“Closing costs” is one of the most misunderstood terms in home finance. These costs are what is due to the lender in exchange for completing the loan. They can catch many buyers by surprise and typically cover things like appraisals and inspections. Closing costs vary widely by location and lender, but it’s recommended you earmark at least 5% of the asking price for these costs.
Another often misunderstood term is “escrow.” Escrow accounts simply hold funds for taxes and insurance so that payments can be made monthly instead of in one large lump sum. Many lenders will include escrow payments into your monthly obligation to ensure you have enough money for these necessary expenses. Taxes and homeowners insurance can add up quickly, so consider an escrow account for peace of mind.
Mastering these basic home finance terms will have you ready for each step of the homebuying process. Agents and lenders are always willing to help, but having a strong base of knowledge will only make finding the home of your dreams easier.
Finances FYI is presented by 1st Security Bank.
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