Mortgage Basics: The Best Way To Buy A Home


Are you considering to buy your first home and wondering about the options?

Well, you’re not alone. Many people exist in the same situation, and the dilemmas are more or less common to all of them.

Is a mortgage a good decision? What is it and what are the different types? How does it work?

These are all very good questions and if you are a first-time buyer, you are right to ask. In this article, I will give my best to explain mortgages so that you can understand the way they work.

Overview Of Mortgages

To begin with, mortgages are long-term loans that banks give to home buyers. The property you want to buy is used as a collateral (protection if you don’t pay). Most borrowers use mortgages to purchase properties.

Mortgages are considered amortizing loans. This means that you will have a schedule and the monthly payments will stay constant throughout the whole term of the loan. Depending on the type of issuer we have mortgages given by private lenders (e.g. banks) and loans guaranteed by government agencies. Also, depending on the interest rate, we have adjustable and fixed-rate mortgages.

Upon closing, you have to pay a down payment. It varies significantly – from 3% up to 25% of the total value of the property. The down payment will depend on the type of loan as well as your finances.

You owe a fixed payment each month. It consists mainly of two things: principal payment and interest payment. Sometimes (there is a whole paragraph dedicated to this), you can have additional portions added.

It’s good to know that there are banks that offer one payment every two weeks (twice a month). If this suits you, go to your lender and ask about all the details.

What Is Escrow?

Simply said, escrow is an arrangement in which a third party keeps the money paid by the borrower. This is also called a deposit and the buyer gives the money prior to sealing the deal. Usually the deposit ranges from $1000 to several thousand dollars depending on the property’s price. The most common third parties are real estate agents.

Sometimes, lenders pay your taxes and insurance. This is the reason why upon closing the deal, the lender will open an escrow account. This account will have some money to make sure you make regular tax and insurance payments. It’s usually about 10% of the total amount of taxes and insurance.

Mortgage basics - the best way to buy a home

Monthly Payment

This is the amount of money you owe your lender each month. It consists of two main components: principal and interest. The principal payment is the amount of money that goes towards the principal of the loan. The interest portion is the money which the lender has charged you for using their money. These are the two mandatory parts of the monthly payment.

Sometimes, however, depending on the loan, your payment might include other portions: taxes, insurance and Private Mortgage Insurance.

Types of Mortgages

There are various types of mortgage loans depending on different criteria. Nevertheless, the main classification we use is based on the type of interest rate and the type of lender. Thus, we have fixed-rate and adjustable-rate mortgages. Regarding the type of lender, we have mortgages issued by government agencies or private lenders. Below you will find more information about each type (See how to find the best mortgage lender).

Fixed-rate Mortgages

These are mortgages whose interest rate remains the same during the whole term. If your rate is 7.5%, it will not change even if interest rates hike. This is a particularly good choice if at the moment of closing the rates are very low. So whatever happens tomorrow (most probably rates will go up again), these changes will not affect your mortgage payment.

Occasionally, the monthly payment might change in the future.


Remember the escrow account? If you have to pay more taxes on your property, therefore the money in the escrow account will increase making the monthly payment slightly higher.

Adjustable-rate Mortgages

Unlike fixed-rate loans, in adjustable-rate mortgages the bank will change their rates during the term. These specific details will be part of the agreement so make sure you know all of them. For instance, usually, the rate is fixed for the first several years. Then, after this period, the lender changes it and recalculates your monthly payments.

The lender will use an index to recalculate the old interest rate. Despite that, there will be limits on how much the rate can vary. Let’s look at an example illustrating this.

For instance:

You have a mortgage at a 6% rate for the first three years and an annual cap of 2%. This means that the following year (after the first three), the rate cannot be more than 8%. There is also a percentage cap that shows how much the rate can increase during the whole term. If in the above-mentioned example this cap is 5%, it means that the highest rate you can ever have is 11%.

Conventional Mortgages

If a loan is not secured by a government agency (for instance, FHA or VA), then we call this mortgage conventional. Because of the lack of government protection and guarantee, usually banks impose stricter approval criteria. One of the things the lenders might want is a higher down payment – up to 25%. In addition, if the borrower cannot afford this, the bank will require a Private Mortgage Insurance. This is how the lender makes sure their money is protected in case of a default.

The PMI can reach up to 20% of the property’s value, but you don’t have to pay it at once. The lender will include it as a part of your monthly payment.

Mortgages Insured by the FHA

An FHA mortgage is a loan which is insured by the Federal Housing Administration. These loans usually have more affordable terms. Bear in mind that the FHA does not lend you the money but rather insure the property. Most private lenders offer this type of mortgage.

Borrowers can qualify even if their credit score is lower than 600 and make a very small down payment – below 5%. Although the requirements are less stringent, often the home buyer should pay a 3% cash contribution.

Check the FHA’s official website as well as your bank’s and make sure you know all the requirements and details.

Mortgages guaranteed by the VA

Just like FHA loans and unlike conventional mortgages, this type is guaranteed by a government body – the Department of Veteran Affairs (aka VA).

If you are a veteran, active-duty service personnel or even veteran spouses, you can qualify for a VA loan. What are the biggest perks of this type of mortgage?

No other loan on the market goes with 0% down payment. This is a huge advantage since many people have no cash whatsoever. In addition, overall the terms are much better than those of conventional loans.

Mortgages Guaranteed by The Rural Housing Service

The Rural Housing Service (RHS), which is an agency part of the US Department of Agriculture (USDA), also offers affordable mortgages to people who live in rural areas. These loans have low interest rates and people with relatively low income can benefit from them. The most common program is called Single Family Direct Home Loans or Section 502.

Usually, local banks in association with the USDA offer this programs to borrowers.

In order for borrowers to qualify, they need to have low income. In addition, families should not have a house. Some of the benefits include an extended term up to 33 years and no down payment.

Things To Consider

There are a couple of things to pay attention, especially if it’s your first time:

Down Payment

Down payment is the amount of money a borrower should pay when closing their mortgage. Usually, banks require no less than 20% of the property’s value. Unfortunately, many people cannot afford this amount of money, therefore pay less. Your bank, consequently, will consider you a riskier borrower and will require additional protection. This will also mean worse terms on your mortgage.

If you pay less than 20% down payment, you will have to pay a Private Mortgage Insurance, which may be up to 20% of the home’s value. This money will be equally distributed each month and included in the monthly payment. There is good news. Once you pay off 78% of the property’s value, this insurance will drop off.

Additional Costs

Depending on the city and state in which you buy the property, you will have to pay various statutory costs. Some of these expenses might include transfer taxes, pro-rate taxes, local mortgage fees and others.

Prepare yourself to pay also additional, which we call third-party, costs. If you work with an attorney, you have to pay attorney fees. Attorneys usually charge a small percentage of the property’s price. Other than that, if you have worked with a real estate agent, be ready to pay them a commission. Just like the attorney’s fees, it’s a percentage of the selling price. Some of the lenders can require from you to pay the insurance premium for the first year in advance.