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The Basics of Mortgages


Because of the high cost of most real estate, very few people can purchase a home with savings alone. Therefore, if you are like the vast majority of people, you will be borrowing money from a financial institution to purchase the property you want. Called mortgages, these loan products can be quite complicated. Knowing the basics of how mortgages work can help guide you to the loan that is most appropriate for you.
 
Mortgage Terms
 
How long is it going to take you to repay the loan? That depends on the term of your mortgage. A term is the number of years that you agree to pay back the amount you borrow.
The term also affects the cost of your mortgage payments. Shorter repayment periods mean higher monthly payments but less interest you pay over the life of the loan, while longer terms will give you lower payments but will cost more over the long run. The traditional mortgage term is 30 years, but they can range from ten to 40 years.
 
Types of Mortgages
 
There are several types of mortgages available, with the most common being fixed- and adjustable-rate loans.
 

Fixed-rate mortgages come with an interest rate that remains constant over the life of the loan. 30-year mortgages are the most common, but you may also choose a 20-year, 15-year, and even 10-year fixed-rate mortgage. In certain high-cost areas some mortgage lenders are even offering 40 year-loans. Though the mortgage interest rates tend to be higher than for other loan types, the rate is fixed and your principal and interest payment won’t change. This stability makes them the most secure type of mortgage for buyers.
 

Adjustable-rate mortgages (ARMs) have a period of fixed interest, but after that the payment changes based on the index the loan is tied to. The period of fixed interest may be three, five, or seven years. With a 5/1 ARM (the first number stands for the number of years in the initial fixed period, while the second indicates how often the rate will adjust), for example, the initial interest rate remains fixed for the first five years, and then adjusts annually for the remaining term.
 

There are several types of caps that may apply to an ARM: an overall cap limits how much the interest rate can increase over the life of the loan; a periodic cap limits the amount the interest can increase from one period of adjustment to the next; and a payment cap limits the amount the monthly payment can increase at each adjustment.
 

While ARMs are less secure than fixed-rate mortgages, they tend to have lower initial rates and therefore lower monthly payments. They can be a good option if money is tight in the early years, as long as you are confident you can meet future interest and payment increases.
 

Certainly there are benefits and drawbacks to each mortgage type. Long before you borrow, consider each option carefully to know which is most appropriate for your situation. With so much money at stake, making the best mortgage decision is important.

Preparing Your Finances for Homeownership

As exciting as buying a home is, it’s also a serious decision that requires quite a bit of planning. Therefore, long before you make an offer on a home, know how much you can afford to pay for housing costs, accumulate enough cash for pre-purchase expenses, and make sure your credit history and score is attractive to lenders.  
 

Determine a comfortable monthly housing payment
One of the most important steps in preparing for homeownership is understanding how much you can afford to pay for monthly housing costs. Many people jeopardize their financial security by overestimating the amount they can realistically handle.
 

Determine your comfort zone by analyzing your cash flow. List and total your monthly expenses, then subtract that figure from your monthly net income. If you’re like most people, you’ll need to track your spending for at least a few months to be accurate.
 

Your mortgage payment plus all related housing costs should fit easily into your budget. Project for maintenance and increased utility expenses, especially if you intend to move into a larger home than you’re in now. As a rule of thumb, total housing costs (mortgage, property taxes, homeowner’s insurance, utilities, upkeep, etc.) should be no more than 35 percent of your net pay. Therefore, if your household income is $8,000 per month, a safe figure is $2,800. If its $10,000 a conservative sum is $3,500 per month. 
 

Save for pre-purchase expenses
Before you buy, you’ll need enough cash for a down payment, closing costs, and at least a few months’ worth of mortgage payments in reserve. Consider what you may need for such extras as moving costs, repairs, and furniture, too.
 

In most cases, the down payment will be your biggest expense. While putting 20 percent of the purchase price down may not be required, the more you put down, the less your mortgage payment will be and the better loan you may get. If your down payment is less than 20 percent, you may either have to purchase mortgage insurance until you build up 20 percent in home equity, or obtain a second loan to cover the remaining 20 percent. Closing costs are often between three to five percent of the purchase price.
 

It can take months or even years to accumulate enough for the home you want, so if you don’t have what you need saved now, start setting aside money on a regular basis. Break down the goal amount by your purchase time frame.
 

Get your credit in order
Your credit rating is a primary factor in qualifying for a mortgage, so pull copies of your report from Experian, TransUnion, and Equifax at least three months before you intend to buy. You can get a free copy of your credit report from each of the bureaus once every 12 months from Annual Credit Report Request Service (www.annualcreditreport.com/877-322-8228). Read each report carefully to make sure all information is accurate. Errors can significantly impact your ability to get a desirable home loan. If there’s incorrect information on your reports, immediately dispute it with the bureaus. This process can take several months.
 

Also know your credit scores. The most commonly used score is the FICO®, which was developed by Fair, Isaac and Company. It ranges from a low of 300 to a high of 850. In general, the higher your score, the easier it’ll be for you to get a mortgage loan with a low rate of interest.
 

To access your scores, either purchase them as you get your free reports from Annual Credit Report Request Service, or pay for them when you buy your reports from the credit bureaus:

If the information on your report is negative but accurate, take action to improve your credit. It may make sense to delay your home purchase until your credit report looks positive to lenders. You can make a major difference to your score in as few as 12 months by using credit regularly, paying all accounts on time, repaying any collection accounts you may have, and keeping balances at zero or well under the credit limit each month

After you know what you can afford to spend on a household payment, you’ve saved enough for the property you want, and your credit is attractive to lenders, you’re ready to begin shopping for that special piece of real estate!

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