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Taking out a mortgage is one of the most substantial financial decisions most of us will ever make. So, it’s essential to understand what you’re signing on for when you borrow money to buy a house.

A mortgage is a loan from a bank or other financial institution that helps a borrower purchase a home. The collateral for the mortgage is the home itself, meaning that if the borrower doesn’t make monthly payments to the lender and defaults on the loan, the bank can sell the home and recoup its money.

How does a mortgage work?

A mortgage consists of two primary elements: principal and interest.

The principal is the specific amount of money the homebuyer borrows from a lender to purchase a home. If you buy a $100,000 home, for instance, and borrow all $100,000 from a lender, that’s the principal owed.

The interest is what the lender charges you to borrow that money, says Robert Kirkland, senior home lending advisor at JPMorgan Chase. In other words, the interest is the cost you pay for borrowing the principal.

Borrowers pay a mortgage back at regular intervals, usually in the form of a monthly payment, which typically consists of both principal and interest charges.

“Each month, part of your monthly mortgage payment will go toward paying off that principal, or mortgage balance, and part will go toward interest on the loan,” says Kirkland.

Depending on your mortgage agreement, your monthly payment may also include some of the following charges:

  • Property taxes

The lender may also collect the annual property taxes associated with the home as part of your monthly mortgage payment. In such cases, the money collected for taxes is held in an “escrow” account, which the lender will use to pay your property tax bill when taxes are due.

  • Homeowners insurance

Homeowners insurance provides you with protection in the event of a disaster, fire or other accident. In some cases, a lender will collect the premiums for your insurance as part of your monthly mortgage bill, place the money in escrow and make the payments to the insurance provider for you when policy premiums are due.

  • Mortgage insurance

Your monthly mortgage payment may also include a fee for what’s known as private mortgage insurance (PMI.) This is a type of insurance required by many conventional mortgage lenders when a buyer’s down payment  is less than 20 percent of the home’s purchase price.

Types of mortgages

There are several types of mortgages available to consumers.  They include conventional fixed-rate mortgages, which are among the most common, as well as adjustable-rate mortgages (ARMs), and balloon mortgages. Potential homebuyers should research the right option for their needs.

Fixed-rate mortgage

The name of a mortgage typically indicates the way interest accrues. In the case of a fixed-rate mortgage, for instance, the interest rate is agreed upon at the time you close on the purchase and stays the same for the entire term of the loan.

Fixed-rate mortgages are available in terms ranging up to 30 years, with the 30-year option being the most popular, says Kirkland. Paying the loan off over a longer period of time makes the monthly payment more affordable.

But no matter which term you prefer, the interest rate will not change for the life of the mortgage. For this reason, fixed-rate mortgages are good choices for those who prefer a stable monthly payment.

Adjustable-rate mortgage  (ARM)

Under the terms of an adjustable-rate mortgage (ARM), the interest rate you’re paying may be raised or lowered periodically as rates change. ARMs may a good idea when their interest rates are particularly low compared with the 30-year fixed, especially if the ARM has a long fixed-rate period before it starts to adjust.

“Some examples of an adjustable-rate mortgage would be a 5/1 ARM and or a 7/1 ARM,” said Kirkland. “In a 5/1 ARM, the 5 stands for an initial five-year period during which the interest rate remains fixed while the 1 indicates that the interest rate is subject to adjustment once per year.”

During the adjustable rate portion of an ARM, the interest rate charged is typically based on a standard financial index, such as the key index rate established by the Federal Reserve or the London Interbank Offered Rate (Libor).

“Adjustable-rate mortgages (ARMs) track a selected benchmark index and adjust the loan’s payments based on changing interest rates,” says John Pataky, executive vice president at TIAA Bank and head of the bank’s consumer lending and mortgage division.

Balloon mortgage

Under the terms of a balloon mortgage, payments will start low and then grow or “balloon” to a much larger lump-sum amount before the loan ends.

This type of mortgage is generally aimed at buyers who will have a higher income toward the end of the loan or borrowing period then at the outset.

It also may be a good approach for those who plan to sell the property prior to the end of the loan period. For those who don’t intend to sell, a balloon mortgage may require refinancing in order to stay in the property.

“Buyers who choose a balloon mortgage may do so with the intention of refinancing the mortgage when the balloon mortgage’s term runs out,” says Pataky “Overall, balloon mortgages are one of the riskier types of mortgages.”

FHA mortgage

An FHA loan is a government-backed mortgage insured by the Federal Housing Administration.

“This loan program is popular with many first-time homebuyers,” says Kirkland. “FHA home loans require lower minimum credit scores and in some cases lower down payments, with the average down payment being 3.5 percent.”

Although the government insures the loans, these loans are offered by FHA-approved mortgage lenders.

VA mortgage

The VA loan is a loan guaranteed by the U.S. Department of Veterans Affairs that requires little or no money down. It is available to veterans, service members and eligible military spouses.

The loan itself isn’t actually made by the government, but it is backed by a government agency, which is designed to make lenders feel more comfortable in offering the loan. As a result of the government backing, lenders often offer these loans without requiring a down payment and with looser credit parameters.

How to find the best mortgage

It’s important to understand as you shop for a mortgage that not all mortgage products are created equal, so doing your research is essential, says Kirkland.

“Some have more stringent guidelines than others. Some lenders might require a 20 percent down payment, while others require as little as 3 percent of the home’s purchase price,” he says.

Identifying the mortgage that’s best for your situation involves assessing your financial health, including such factors as your income, credit history and score, employment, and financial goals.

In addition to understanding the various mortgage products, spend some time shopping around with different lenders.

“Even if you have a preferred lender in mind, go to two or three lenders—or even more—and make sure you’re fully surveying your options,” says Pataky of TIAA Bank. “A tenth of a percent on interest rates may not seem like a lot, but it can translate to thousands of dollars over the life of the loan.”

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