Show of hands: who learned what a mortgage is when they were younger? In high school? In college? Yeah, me neither.
Mortgages and home buying are not exactly a topic Sesame Street covers, and it’s likely something you’ve never discussed with your parents either. So when it’s time to buy a home, where do you get all of your information on how to actually afford it? Lack of a practical financial education is a problem that many of us have to overcome. It has been thoroughly mocked and meme-ified for Millennials, but the buck stops here — so to speak. Mortgages can seem terrifying, but the concept is actually really straightforward. But don’t worry: unlike high school English, there’s no pop quiz at the end of this lesson!
Mortgages: The 101
According to Zillow, the typical American home costs $216,000. However, if you’re living in urban areas, this number can go up drastically. Many of us don’t have that much cash just laying around, so instead of robbing a bank, most people take out a mortgage. A mortgage is essentially a loan. When you put a down payment on a home, it pays for part of the home’s cost (typically 20%). A bank or mortgage company loans you the rest of the money to pay for the home. You then set up a series of payments to pay back the loaned money, along with interest, for a fixed term. The catch is: to ensure you pay back the money, your newly purchased house becomes collateral, meaning if you don’t pay, your house goes away.
That’s the simple definition of a mortgage, but there are a lot more details and specifics that are important to learn about before rushing into getting one. It’s crucial to your financial health to also know what can happen if you sign up for a mortgage you’re not going to be able to pay. Your new house will be foreclosed, you’ll have trouble getting another mortgage in the future, you could get a huge tax bill, and your credit score will drop significantly. Before you take the plunge, make sure you have thoroughly researched your chosen lender and the structure of the mortgage, so you’re not hurt later on because you took on something you couldn’t afford.
Options, Options, Options
There are two main types of home loans that you can choose from: a fixed-rate mortgage or an adjustable-rate mortgage. A fixed-rate mortgage functions exactly how it sounds. Your interest rate will remain fixed and will not change during the life of the loan. Additionally, your monthly payment, including both principal and interest, stays the same. Sounds like a great deal right? Well, the drawback is that the interest rates on fixed-rate loans are typically higher than the rates on adjustable-rate mortgages. So you could end up paying a bit more for the security of knowing that your payments will never change.
Now if your goal is to save money in the short-term, you might want to consider an adjustable-rate mortgage or ARM. These home loans have a lower initial interest rate compared to fixed-rates but could adjust after a set period of time (typically five to seven years) depending on changes in market rates. That means your monthly payments could increase or decrease based on how the interest rate changes. While you’re rolling the dice with these types of loans, they can end up saving people a lot of money, which you can invest back into paying off your debt.
If you’re trying to decide between a fixed-rate or ARM, one very important thing to consider is, what are your future plans? Fixed-rate repayment plans last either 15 or 30 years. Yes, you read that right: 30 years! So if you have no plans to pack up everything and move across the world on a whim, a 15 or 30-year fixed-rate mortgage could be the right fit for you.
But if you can’t be tamed and want to keep your long-term options open, Lance Davis at Bankrate notes that “[Adjustable-rate mortgages] offer a cheaper way for borrowers who don’t plan on living in one place for very long to buy a house.” If you’re a first-time homebuyer, but are young and constantly on the move, an ARM could be a great option.
Ready to Get Going?
Once you’ve determined what type of mortgage fits you and if you’re ready to buy a home, it’s time to apply! But how do you actually go about doing that? Well, before you fill out an application, you’ll need a few things first, including: know what type of mortgage you want, which lender you want to work with, check your credit score, get preapproved for a loan amount, and gather all your paperwork.
If you have the first two items ready to go, the next step is to check your credit score. Your credit score could impact whether you will qualify for a loan and the rate you will be offered. You’ll want to have your credit score and debt-to-income ratio, in excellent shape to qualify for the best loan possible. What is debt-to-income ratio? This measures the amount of monthly debt you have compared to your monthly income.
It’s recommended to check these numbers before you apply to get pre-approved because mortgage pre-approvals evaluate your financial history to see how big of a loan you can qualify for. With Turbo you can easily check your numbers to see if you might be financially ready to buy or if you still need time to improve where you stand.
Make sure you don’t skip over the preapproval process, because pre-approval letters can actually help you in the home loan process. A mortgage pre-approval is like a golden ticket: not only does it show that you’re a serious buyer, but it can put you ahead of other buyers who are looking at the same home as you. One word of caution: don’t do this unless you are ready to buy and your credit score is fabulous. Once you’re ready, this letter will help you find a lender who can work with you to find the loan that best suits you. If you’re in the market to get pre-approved, try Rocket Mortgage or SoFi.
Helpful hint — now that you’re well versed in what you should do when applying for a mortgage, you should also be aware of what not to do, so you aren’t caught in an awkward situation later.
And that’s it! You’ve passed this mortgage lesson with flying colors.