The Beginner’s Guide to Financing
This is a very basic explanation of what financing is in the housing world.
When someone doesn’t have enough money to purchase a good or service, such as a home, they typically look to someone who does who is willing to lend that money to them.
In exchange for the use of someone else’s money, the borrower pays a small premium in the form of an annual interest rate.
For example, at the time this was written, interest rates were found to be around 4% to 5% annually. In other words, if you borrow $100,000 at 4% per year, that means that you will pay your lender approximately $4,000 in interest for the first year.
Your payments each month consist of up to 4 parts which are paid to either the bank you borrowed the money from, or the company that your lender hired to collect your payments (servicer.)
(1) One part is called the principal which represents the amount that you owe, and (2) one part is the interest, which is paid to the lender in exchange for borrowing the money. The (3) third payment is a semi-annual (that’s twice per year) property tax payment. The home owner is responsible for paying those taxes, but in most cases, the lender requires that your payment include enough to cover the semi-annual tax payment, and they end up paying the tax bill for you out of what’s known as an impound account. Sometimes there’s a (4) fourth part, and that’s called Mortgage Insurance. If you purchase home with less than 20% down (in other words, $20,000 in this example), then the lender will require that you pay an insurance premium every month. They do this to ensure that they get paid if you fail to make your payments.
At the beginning, MORE of the payment is interest, and less is principle. As time goes on, the interest paid every month decreases, because it is calculated based on the amount you still owe, which is also decreasing. By the time you reach the half way point, usually 15 years, the amount you pay in interest and the amount you pay towards the loan is nearly the same. Later in the life of the loan, you will be paying much more on the loan, and much less in interest.
This is called amortization (the death of a loan) and lenders do this to ensure that they get most of their investment back at the beginning, rather than at the end.
I can’t stress enough how beneficial it will be to you and your family to only consider 15-year fixed rate loans. Anything else will cost you much more and be much more of a risk to your financial well being.