Mortgage 101

Even though renting an apartment or buying a home may be a long time off, by using a budget, learning a decision-making process, and taking steps to establish credit, people can be more prepared when the time comes. This video from our Personal Finance 101 Conversations series provides some of the basics when it comes to mortgages.

To provide students with online questions following each video, register your class through the Econ Lowdown Teacher Portal.
Learn more about the Q&A Resources for Teachers and Students »

Transcript

Right now, you’re probably focused on shorter term goals other than your first home, but have you thought about where you might want to live in 5 or 10 years?

Perhaps you picture yourself in a in a big city, maybe in a downtown, high-rise apartment or owning your own home with a backyard, garden, or maybe even on a beach.

While it seems like a long time from now, it’s a good idea to familiarize yourself with some important concepts that can affect your future housing choices. In this PF 101 conversation, we’ll go over several aspects of housing decisions.

Whether you decide to rent or own your own home, there’s a lot to consider. One of the best ways to prepare yourself financially is by using a budget—which you can start now. A budget can help you avoid financial stress, set aside some of your income for school, a vehicle, your first apartment, or even a house.

We’ll discuss renting now, then move on, to mortgages. Whether you decide to rent or own, the property manager or bank will examine your credit history—your payment activity over time.

Credit is using of someone else’s money, usually a bank or other institution, for a fee. The fee is interest and is generally expressed as a percentage. Banks and other institutions pay you interest for keeping money in accounts with them and they make loans to other customers.

You establish a good credit history by paying bills on time and not borrowing more than you can pay back. Good credit is one step to qualify for future choices such as renting an apartment or buying a home. Lenders use credit history to decide whether to extend credit and at what interest rate. Higher credit scores typically lead to more favorable interest rates because the risk of default is low, and vice versa. Lower credit scores typically lead to less favorable interest rates because the risk of default is higher.

Economics teachers are quick to point out, “There Is No Such Thing As A Free Lunch.” There are costs and benefits to renting or owning a home. When you’re making a big decision like whether to rent or buy a home, using a P.A.C.E.D decision-making grid can be helpful.

Here are some things to consider: In a rental you would most likely not have to pay for routine property maintenance and renter’s insurance is much less expensive than homeowners’ insurance because you don’t pay to insure the structure. It’s easier to move from a rental because you’ll probably have a 6 month or 1-year lease. You can give notice according to the lease terms and move out. If you own a home, you have to sell it or find another solution before you can move somewhere else. You’d probably pay more in property taxes, too, depending on the terms of the rental agreement, but there are many reasons people buy homes.

Home ownership is important to people for a variety of reasons. Some want to be able to garden, build a deck or tear down a wall, which may not be possible in a rental. There’s also the possibility of building equity, or value, in the home. Part of each monthly payment goes toward interest and part toward the principal—the amount originally borrowed. The value of houses can rise and fall, though, and that can affect the amount of equity in a home, too.

Once you’ve decided on the criteria, fill in the P.A.C.E.D grid, using +/- signs or a number system to help determine how well owning or renting will meet your needs. You can weight criteria if some things are more important to you than others.

For this example, let’s say you’re interested in buying a house—for that, you’ll need a mortgage—a loan for the purchase of a home or real estate. We’ll discuss some key terms in this segment:

• Collateral—Property required by a lender and offered by a borrower as a guarantee of payment on a loan.
• Down payment—an initial payment on a purchase that reduces the principal for the loan.
• Mortgage—a loan for the purchase of a home or real estate
• Principal—the original amount of a loan without any interest.
• Term—how long will you take to repay the loan.
• Interest rate or Rate—is the percentage of the principal that is charged for a loan.

When you apply for a mortgage, the lender examines your credit history, income sources, how much debt you have, and so forth, and uses this information to decide if you qualify for a mortgage, what interest rate you’ll pay to borrow the money, and how much you’ll have to pay as a down payment.

A good rule of thumb is to plan on paying 20% of the purchase price as a down payment. If you don’t have the 20%, there are different types of mortgages and programs, to help borrowers buy a home, but they typically require borrowers to pay for Private Mortgage Insurance. This is insurance you pay monthly that will compensate the lender if you fail to pay your mortgage.

Lenders might offer mortgages with varying terms like 10, 15, 20, or 30-years. The mortgage interest rate you pay depends on factors such as—the term of the mortgage, your down payment, your credit history, and score. Shorter term loans, such as 15-year mortgages tend to have lower interest rates and you will save money because you end up paying off the loan faster, but your monthly payment will be higher. Longer term loans, such as 30-year loans typically have higher interest rates but because it is stretched over a longer time your monthly payment will be lower.

Some loans have fixed interest rates, but some are variable, or adjustable. It’s important to know the difference. A fixed rate simply means the interest rate won’t change during the loan term. The actual home purchase takes place at a closing where the buyers and sellers sign the paperwork.

These documents include a promise to keep insurance on the property and make house payments. Otherwise, the lender will insure it—and charge the owner. The house is used as collateral to secure the loan. If buyers stop making payments, the lender can take the property back through a process called foreclosure. All terms and disclosures are discussed at the closing, including the terms and conditions of the loan and the rights of consumers.

There’s no one single option when it comes to mortgages as different loans, terms, and conditions serve people’s needs and circumstances. There are plenty of options, and again, using a P.A.C.E.D decision-making grid can help you make the best choice for you.

---

If you have difficulty accessing this content due to a disability, please contact us at 314-444-4662 or economiceducation@stls.frb.org.