Q:

How does a home mortgage work?

A:

Quick Answer

A mortgage is a loan from a financial institution taken out for the purpose of buying a property. Each month, some of the mortgage payment goes to paying off the principal and some to interest.

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Full Answer

The principal is the amount of money borrowed from the lender. The interest is a charge levied by the lender for loaning the money. The monthly payment is likely to also include additional amounts for insurance and taxes. Each time a payment is made toward the principal, more equity or ownership of the home is established, according to the US Consumer Financial Protection Bureau (CFPB).

How Interest Rates Are Calculated
A "good" interest rate on a mortgage is one that is not much higher than the prime rate, or the interest that banks pay for borrowing money from each other. However, mortgage Interest rates are based on a number of factors. One of these is the amount of time allowed for paying back the loan. Interest rates tend to be lower on loans with 30-year terms, in comparison to 10- or 15-year loans. Interest rates can also be lower if the borrower's credit rating is 740 or above or if a large amount of money is put down as a down payment. Before shopping around for a mortgage, a borrower should find out his or her credit score from credit bureaus. On the other hand, expect to pay higher interest rates if this is a first-time home purchase, or if the amount of money borrowed exceeds a certain "jumbo threshold." Other factors that come into play include the location of the home, the amount of points the borrower is willing to purchase and the presence of a co-signer. Mortgage points are fees paid directly to the lender in order to reduce interest rates. Each point costs one percent of the amount of the loan. A final determinant in loan calculation is whether a borrower is taking out a fixed-rate, variable-rate or adjustable-rate mortgage, according to Credit.com.

Fixed-Rate Mortgages
With a typical fixed-rate mortgage, the amount paid each month will not vary, nor will the interest rate. Over time, however, more of the payment will be applied to the principal and less will go to interest because the amount owed toward the principal will go down. At the very end of the mortgage, the majority of the payment will be applied to principal, a process called amortization, notes the CFBP. Calculators are available online from the CFBP and on many other websites for determining the monthly principal and interest charges for different loan amounts, loan terms and interest rates.

Variable-Rate and Adjustable-Rate Mortgages
With a variable-rate or adjustable-rate mortgage (ARM), in contrast, the interest rate can change due to market forces. A borrower might pay a lower interest rate at the start of the mortgage if prime rates are low but pay higher interest later on if prime rates rise. The main difference between a variable-rate mortgage and an ARM is that with an ARM, as the interest rate changes, so does the monthly payment due. Someone might choose an ARM if he or she does not expect to own the property for very long but anticipates that prime rates will remain low, advises Credit.com.

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