There are countless joys of becoming a homeowner – reinventing your own space, paint colors, furniture, and the list goes on. It’s likely one of the biggest purchases you will ever make. In order to make that significant purchase, you’ll most likely turn to a mortgage loan. And, when it comes to first-time homebuyers, the mortgage loan terminology alone can be overwhelming.
Start below to better understand some common terminology relating to mortgage loans. If you have mortgage loan questions, check out our recent blog post for more.
Understanding the difference between 15-year and 30-year mortgage loans
While there are numerous mortgage loan options, the most common are 15-year or 30-year. Determining which loan is better for you will depend on your financial situation.
The most obvious difference with these two options is the loan term, also known as the length of time to repay the loan. Similar to how auto loans commonly have 3-year and 6-year terms, 15-year and 30-year terms are most common for mortgages and some lenders even offer 10-year, 20-year or even 50-year terms.
- 30-year mortgage loan: The majority choice among American homeowners with mortgages, a 30-year mortgage provides homebuyers with stable, more affordable (lower) monthly payments. On the flip side, homeowners end up paying more interest throughout the life of the loan and tend to see higher interest rates as well.
- 15-year mortgage loan: A 15-year mortgage is appealing to homeowners as it has a shorter loan term meaning you’ll pay off the loan faster along with having typically lower interest rates. However, homeowners need to be prepared for higher payments each month, which isn’t always an option for all homebuyers.
Understanding fixed and adjustable mortgage loan rates
An important component in your mortgage is understanding the interest rate. Most often, mortgage interest rates are fixed (locked), adjustable (it can be adjusted, obviously) or possibly a combination.
- Fixed-rate mortgage loan: Traditionally the more stable (and simple) option with loan interest rates, fixed-rate mortgages keep the same interest rate for the entire length (term) of the mortgage loan. In other words, the interest rate is fixed and will not change. This option allows homeowners to better plan their budget by knowing their ongoing monthly payments. Buyers might be concerned with higher interest rates up front with a fixed-rate mortgage, but when rates are low, you can lock it in for the life of the loan.
- Adjustable-rate mortgage loan: Adjustable-rate mortgage loans (also known as ARMs) tend to provide buyers with lower interest rates and monthly payments up front. The biggest risk of an ARM is a higher interest rate down the road which would be transferred to them from the lender. This option can be appealing to buyers but does pose risk for interest rate changes, especially if the rate significantly increases. According to millionacres.com, adjustable-rate loan rates tend to change every two, three, five or seven years.
- For example, our 3-year ARM program starts off with the lowest interest rate available and is fixed for the first three years, but you need to be comfortable with the risk that after the first three years of the loan, your interest rate and payment could rise. To help protect from major increases in the interest rate, our ARM programs do have caps that prevent the interest rate from rising or falling by more than 2% per annual adjustment, or by more than 6% over the life of the loan.
Understanding mortgage amortization, principal and interest
Upon locking in a mortgage, you’ll begin the long process of paying off the loan. Making payments on time is a crucial piece of the puzzle to pay down the mortgage loan (getting the balance closer to zero) in order to build home equity and in turn own more of your home than the lender.
A few key terms to know before signing:
- Principal is referred to as the original amount of money borrowed from a lender, in this case, for your home.
- Interest is the charge by the lender for you to use their funding for the mortgage loan.
- Through the amortization schedule, homeowners pay back the entire mortgage (original principal and accrued interest), not just the initial money borrowed. Make sense yet?
- Mortgage amortization is the process of eliminating debt through consistent payments over time based on a set schedule. (The definition of amortize = gradually paying off debt over time.) With a formula all its own, the mortgage amortization factors in the percentage of payments that go towards interest and principal (keep reading for more on this).
- Escrow is a legal agreement with a third party, that can help reduce risk, where money is temporarily held until certain conditions are finalized. There are different types of escrow accounts based on its purpose either for the home buying process or for taxes and insurance throughout the loan.
The abundance of new terminology for your homeowner vocabulary can be overwhelming (and this is only the beginning). It is important to consult a lender to discuss what mortgage loan options are available and make sense for your individual financial situation when buying a home. Find a trusted expert who can answer your questions (terminology included).
While owning a home is a long-term investment, improves credit and can offer family stability, future buyers must make an informed decision. Consider the options, understand the mortgage terminology and weigh the pros and cons that fit your circumstances.