3 Mortgage Terms to Know: Principle, Interest, Down Payment
A mortgage is a loan that you take out to buy a home. When you get a mortgage, the home you are going to be purchasing will generally be used as collateral. If you fall behind on your repayments, the lending institution will have the right to take your house. There are different mortgage terms that can help you understand the process. These terms are principle, interest and down payment.
What Are Principle, Interest and Down Payment?
Principle, interest and down payment are different parts of the mortgage that you will be responsible for paying.
What Is Principle?
The first of the mortgage terms you need to know of principle, interest and down payment is principle. The principle of your payment is what goes to the actual price of the home. Principle refers to the initial size of a loan and it also means the amount still owed on a loan. For example, if you take out a $100,000 mortgage then the principal is $100,000. If you pay off $30,000 of the principle then the $70,000 is also called the principle.
At first, when you are making monthly payments on your loan, your payments will likely go toward interest. Then the remainder applies to your principle. When you pay down the principle of a loan then you can also reduce the amount of interest you pay each month.
Besides making your mortgage payment on time, there can also be other methods in order to reduce your mortgage principle, provided that you are allowed to prepay or your mortgage permits additional payments. For example, if you make one additional payment per year then you can reduce the principle enough to pay off the mortgage sooner, five years sooner actually and can save additional money in interest.
What Is the Interest Rate?
Out of the principle, interest and down payment, one of the main concerns that many soon-to-be-homeowners have is about interest rates.
What Will Impact Mortgage Interest Rates?
There are different things that will impact mortgage interest rates. You may think that daily mortgage rates don’t matter all that much but they do. It matters what the rate is today and what it might be tomorrow or next week. However, you aren’t able to control what the market does or what could be impacting the housing market. What can you do is be educated on interest rates and focus on the things you can control, such as your credit score and down payment.
Your Credit Score
One of the biggest factors for the interest rate you get on your mortgage is your credit score. Lenders will use your credit score as an indicator of how likely you are to pay back your loan. If you have difficulty paying back a loan and your credit score reflects that then you are more likely to have trouble with paying down bigger debts like a mortgage.
Your Down Payment
If your credit score isn’t that high then one thing you can do to lower the interest rate is make a more sizable down payment. This works to show the lender you are capable of saving and it will lower the amount you are then getting from the lender.
Your Loan Term
Many mortgage loans are either 15-year or 20-year loans. Many homeowners will choose a 30-year option but shorter loan terms can be eligible for better interest rates. There are two reasons for this. The bank will recoup the investment faster with a shorter-term loan. The lender is also going to be getting a higher payment from you every month. If you are going this route to lower your interest rate then you need to make sure you can handle the higher payment.
The Interest Rate Type
There are two types of interest rates that homeowners will need to be aware of.
An adjustable-rate loan will still start off with a lower introductory interest rate. After a set period of time, the rates will adjust to being more in line with the current market interest rates. At this time, your monthly payments change accordingly.
Fixed rates can be higher than adjustable ones but they stay the same over the entire length of the loan and ensure that you have the same payment each month. You can decide whether you get a fixed or adjustable rate but if you choose the adjustable-rate option you need to be prepared that your payment can go up.
Of course, every option has its disadvantages. It’s important that you know them before you decide. Unfortunately, here it all comes down to picking between two not so great things. Either you’re going to pay extra if you choose the fixed-rate option, since there are additional years when you pay interest. Or your going to risk paying much higher interest than initially, if you choose the adjusted-rate option.
What Is the Down Payment?
The last thing you need to know about the main mortgage terms of principle, interest and down payment is what a down payment is. The down payment is the upfront payment you make when you purchase a home. The down payment is the portion of the purchase price that you pay for yourself out of pocket instead of borrowing. In most cases, the money will typically come from your personal savings and you can pay with an electronic payment, credit card, or check.
Down payments are usually not part of a loan. However, you may see zero down offers where no down payment is required. Even if you don’t have to have a down payment, there are benefits of having one. The down payment will cover a meaningful part of the total purchase price. For example, if you are buying a home for $200,000 and have saved $40,000 as the down payment then you only have to mortgage $160,000.
There are debates about how big of a down payment you should have. You can often choose how large the down payment should be but the decision isn’t always that easy. Some people believe that a larger down payment is better, while others think that it’s best to keep the down payment as small as possible.
What Are the Benefits of a Bigger Down Payment?
A larger down payment will help you borrow less. The more you pay upfront, then the smaller your loan will be. This means you will have a smaller principle but larger interest costs over the life of the loan. You could benefit from lower payments.
You may qualify for lower interest rates if you put more down. Lenders will usually like to see a larger down payment since they can easily get more of the money back if you default. When you reduce your lender’s risk then you can also reduce your interest charges.
Avoid Mortgage Insurance
When you are purchasing a home, you can avoid private mortgage insurance and other fees with a larger upfront payment. On FHA loans, mortgage insurance costs will decrease with a larger down payment. You may be stuck with private insurance throughout the life of the loan unless you refinance at some later time when you have paid more on the home.
Smaller Monthly Burden
A lower monthly payment can make it easier for you. If your income changes due to a job change or loss then a lower payment can give you more wiggle room, which is always helpful. You can also save more for an emergency fund or other improvements to the home.
Future Borrowing Power
A lower payment makes it easier to qualify for additional loans in the future. Lenders will want to see that you have more than enough income to meet monthly obligations and will evaluate finances with what is called a debt-to-income ratio.
Occasionally you can borrow against an asset such as your home and use the asset as collateral. If you put down more than 20% of the home you can enjoy price appreciation and may be able to pull funds out of a home equity loan.
What Are the Benefits of a Smaller Down Payment?
A smaller down payment appeals to a lot of people because you don’t have to come up with as much money.
Allows You to Buy Sooner
When you are trying to save 20% for a home purchase it can take a while. For some, this can take even decades and this may not work in your situation.
If you are able to save up a significant amount then it can be scary to part with all that money. You may be wondering what you will do if something happens, such as health problems or if your car breaks down. Putting all your free cash into the house means your money is tied up in something that can be hard to sell.
Resources for Improvements
When you have a smaller down payment, you get to use the cash you keep to help with inevitable improvements and repairs.
You may want to use the funds for other purposes, such as growing your business or retirement savings.
The decision about whether or not you choose to go with a larger or smaller down payment will depend on different factors. The best scenario is you have a solid emergency fund to deal with any surprises and you aren’t robbing this fund to make your down payment.
What about Lender Requirements for a Down Payment?
Lenders can set minimum requirements for down payments but you can always choose to go with a larger down payment. Remember that a larger down payment will reduce the risk for the lender.
Down payments can also have a psychological impact. A larger down payment shows lenders that you have more skin in the game because you have more of your own money at stake. This means you may be more likely to keep making payments. For home purchases, 20% is a significant number. When you pay at least 20%, you can avoid paying for mortgage insurance.
How Does a Mortgage Work?
Besides knowing about principle, interest and down payment, it also helps to know how a mortgage works.
Finding a Lender
When you are searching for a mortgage and rate shopping as a first-time homebuyer, you should look around and compare different lenders before you start to look at houses. It’s recommended to get a pre-approval letter and find out how much banks are willing to lend you and determine how much you will be able to afford. This way, when you find a house you have the ducks in a row to submit the offer.
Many new buyers will rely on their real estate agent for information about the mortgage process since few people will go through the home buying process more than once or twice in their lives. The realtor’s priorities are to get fast approval and not to negotiate the best interest rate. If you want to minimize your mortgage payments then it’s recommended that you shop for a mortgage and compare rates from at least three different lenders.
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Advantages and Disadvantages of a Mortgage
A mortgage will allow you to purchase a home without paying the full purchase price. Without a mortgage, not many people would be able to afford to buy a home. Having a mortgage in good standing on your credit score can actually improve your credit score and help you get better interest rates for other credit lines. There are also tax benefits to homeownership. You could be eligible to deduct the interest paid on your mortgage or more.
There are some risks with a mortgage. Since your home is collateral for the mortgage, you risk losing your home and the lender can take the home if you stop making payments. If the lender does take the home in a foreclosure then you also lose the money you have paid up to that point on the home. It is possible to lose everything you’ve built up if you go into foreclosure.
What to Do before Shopping for a Mortgage
Your knowledge about principle, interest and down payment can help with rate shopping for a mortgage but there are some things you will need to do before you begin.
Check Your Credit Score
Since this is one of the most important factors in getting approved for a mortgage, you need to check your credit score. The better your score, the lower the rate will likely be. Don’t forget you are entitled to a free credit report.
How Much You Can Afford
Your principle, interest, and down payment will likely take up a large chunk of your income so you need to know what you can comfortably afford. You can use an affordability calculator or finance calculator and add in your principle, interest, and down payment to see what your payments will be and make sure that you can comfortably add this to your budget.
What Are Some Common Mortgage Myths?
There are some mortgage myths you need to be aware of when shopping for a home.
You Need Perfect Credit to Get a Home
While your credit score is one key factor lenders will use when you apply for a mortgage, bad credit won’t always prevent you from getting a mortgage. A lower credit score may mean a higher principle, interest and down payment but it doesn’t mean that you can’t get a mortgage.
You Need to Have a 20% Down Payment
Conventional wisdom says you need to put 20% down when you purchase a home. A larger down payment can make it easier to get a home but there are many options for homeowners who have a smaller down payment.
If You Prequalify, You Will Get the Loan
The qualification process can give you an idea of how much lenders may give you based on your credit score, income and debt. However, this doesn’t mean that you will get the loan. Once you find a home and make an offer, the lender will request additional documentation, which can include tax returns and more. This process will then determine whether your loan will get approved. If you do have concerns that you may not get approved and want to know more before you start looking at houses, ask the loan officer whether or not you can get full credit approval.
Should You Refinance Your Mortgage?
Knowing about the principle, interest and down payment can also help you know about whether or not it’s time to refinance. Refinancing your mortgage means replacing your existing one with a new one. There are different reasons why you may want to refinance your mortgage, depending on your current principle, interest and down payment.
Getting a Lower Interest Rate
One of the best ways to refinance is to lower your interest rate on your existing loan. The rule of thumb is that refinancing can be a good idea if you can reduce your interest rate by 2%. However, some lenders will say that saving 1% gives enough incentive to refinance. Reducing the interest rate will not only help save you money but it can also increase the rate at which you build equity in the home and can decrease the size of the monthly payment.
Shortening the Loan Term
When you get a lower interest rate, homeowners can refinance the existing loan for not much change in the monthly payment and also have a shorter term.
Converting to a Fixed-Rate or Adjustable-Rate Mortgage
While an adjustable-rate mortgage can have a lower rate, the periodic adjustments can result in rate increases that are higher than those of a fixed-rate mortgage. When this happens, converting to a fixed-rate mortgage can offer you lower interest and also eliminate the chances that your rates increase again.
Converting to an adjustable-rate mortgage can also be a good financial strategy if interest rates are falling. If rates continue to fall then you can have smaller mortgage payments and it will eliminate your need to refinance every time rates drop further. However, if mortgage rates are rising then this may not be a good strategy. Converting to an adjustable-rate mortgage can be a good idea if you don’t plan on staying in the home for more than a few years. You won’t have to worry about future rates that are higher because you won’t live in the home long enough.
Tap Equity or Consolidate Debt
Homeowners may want to access the equity in the home to cover any major expenses, such as paying for college tuition or home remodeling. It can be easy to justify the cost of refinancing because things like remodeling can add value to the house and the interest rate on the loan can be less than getting a loan from somewhere else.
Other homeowners refinance to consolidate debt. Replacing high-interest debt with a low-interest mortgage can be a good idea. You should only refinance to consolidate debt if you know you are able to resist the temptation to spend extra while refinancing relieves you from your debt.
There are times when it doesn’t make sense to refinance your mortgage and it’s not always about principle, interest and down payment. Remember that a no-cost mortgage loan doesn’t exist. This prospect can be enticing to borrowers but you will still pay for applicable fees and closing costs. If these fees are added on to the cost of the loan then your principle increases. You may think that you can refinance for lower monthly payments in order to save for a new home. There isn’t a problem with this decision but borrowers will need to calculate how much refinancing will cost them and how much they will be able to save every month in order to make the decision worth it.
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What Are Some Mortgage Tips?
There is a lot to learn about the principle, interest and down payment. However, there are also some mortgage tips to keep in mind.
The Value of Your Home on Paper May Be Secondary to the True Value of Your Home
When you have already committed to a mortgage then the goal is to pay it every month and be sure to take care of the new house. Watching for signs that the home has gone up or down in value will only impact property taxes. This is unless you plan on selling. Don’t be so hung up on the paper value as you pay off your mortgage unless you plan on turning your home into paper money. If you want to refinish the deck in the back because that’s what is best for your family then do so and don’t worry about trying to raise the resale value.
When Mortgage Interest Rates Are Low, Housing Prices Rise
Housing prices and interest rates do vary from market to market and even month to month. Since many people will base what you can afford on monthly payments, you are likely to take on more debt if the interest rate is good as long as you keep payments under control. Supply and demand say if people are paying more for housing then the housing prices go up.
Remember That You Don’t Need Perfect Credit to Apply
There may be no perfect time to get a mortgage and while you should spend some time to work on improving your credit score, this isn’t always possible. Loans for lower credit scores also exist. Lenders can take more into consideration than just the credit score.
You Won’t Know What Is Available Unless You Apply or Ask
Many mortgage loan statistics aren’t specific to you. You will still need to mortgage shop and think about what principle, interest and down payment are right for you. There are plenty of online lenders that want to earn your business and if you don’t like the level of service or the terms, those lenders likely won’t stay in business long.
Have Some Extra Cash in Reserves
Lenders will like to see a couple of months of mortgage payments in reserves since a lender doesn’t want to give a mortgage to someone who is depleting their savings and may not be able to pay the loan back. These savings can make it easier to qualify for a mortgage and the large amount in reserves could even make up for a bad credit score. The lender wants you to use these reserves to make sure you pay off the mortgage but you can also use the reserves to make home repairs or furnish your home after you receive the keys.
Don’t Forget Quotes from Multiple Lenders
If you aren’t shopping around, you are doing yourself a disservice. Even if you are sure on the lender, getting quotes from others can help you negotiate a better deal.
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The principle, interest, and down payment are three very important mortgage terms that you will need to know when mortgage shopping. All three items affect each other. The larger the down payment, the smaller your interest rates may be and the smaller your interest rates then the less you will be paying each month. The principle, interest and down payment will also affect your choices if you want to refinance your home. Knowing how a mortgage works can help you make the best decision about shopping around and knowing when it’s the right time to apply for a mortgage.
Kevin Strauss is a personal finance writer and homeowner based in the Los Angeles area. Being in one of the most expensive markets in the country, he’s learned to maximize resources to plan for both his monthly expenses and future financial needs. Kevin has a passion for helping those in a similar situation navigate the complex world of personal finance so they can pay down debt, plan for the future and live out their dreams. In addition to covering personal finance in depth on Loanry.com, Cashry.com, Debtry.com, Budgetry.com, Billry.com, Creditry.com and Taxry.com. Kevin shares his expertise with readers who want to create budget-friendly habits across the web.