- When shopping for a mortgage, financial institutions have products with an advertised APR, which stands for Annual Percentage Rate.
- But the APR doesn’t tell the whole story—make sure to understand the type of mortgage being promoted. Plus, there are a wide range of additional costs to consider, including insurance, taxes, admin fees and any penalty fees that may apply.
You’ll need to decide between a fixed-rate and an adjustable-rate mortgage
- Adjustable rate: An adjustable-rate mortgage (also known as a variable-rate mortgage) is based on a chosen index, so it changes throughout the term of your loan. The index is a benchmark that reflects changes in the national economy. If the index goes up, so does your rate and the amount of your payment. If the index goes down, so does your rate and the amount of your payment.
- Fixed rate: In a fixed-rate mortgage, the interest rate is set when you take out the loan and it does not change over time. The amount you pay monthly will stay the same for the entire term of your loan.
It’s a trade-off
- Fixed-rate mortgages are consistent and easier to budget for, but tend to have higher interest to counter the effect of rates rising in the future.
- Adjustable-rate mortgages usually have a lower advertised start rate, which is very appealing, but can be unpredictable and harder to budget for.
- Think about your income, your future, how long you plan to live in the home and your risk tolerance before deciding which type of mortgage is right for you.
How does the mortgage repayment work?
- An amortization schedule is how your loan repayment is broken down into regular installments over the term of the loan.
- The schedule shows you how much of each payment is going towards interest and how much of it is going towards the principal.
- Let’s say you have a $150,000 fixed-rate mortgage with a 3% annual interest rate amortized over a 25-year period. Your payment will be $711 per month.
- The monthly payment for a fixed-rate mortgage is the amount paid by the borrower every month that ensures that the loan is paid off in full with interest at the end of its term.
- This is how the interest is calculated for each payment: $150,000 x 3% = $4,500 ÷ 12 = $375.
- In your first payment, $375 will go towards interest and only $336 will go towards your outstanding balance. So even though you’ve made a payment of $711, your balance has only decreased by $336.
- The following month, because your outstanding balance is now $149,664, the interest portion of your monthly payment will be slightly lower and the principal portion will be slightly higher ($149,664 x 3% = $4,490 ÷ 12 = $374).
- A big chunk of your monthly payments go towards interest at the start of the term. Over time, more of your payment will go towards the principal than towards interest.
- That 3% interest rate may not seem like much, but after 25 years, you will have made $213,395 in payments on your $150,000 loan!
Understand before you sign
People get into trouble by committing to mortgages they don’t understand. All the more reason to know exactly what you’re getting into before signing anything.
A mortgage can be an empowering experience or a burden. It all comes down to your understanding of the mortgage products available, honesty regarding your personal finances and clarity about your life situation.
Sources: Amortization-Calc.com, United States Department of Labor (Bureau of Labor Statistics)