Buying a home is a major expedition, so it is important to have a plan to guide you. When it comes to purchasing property, you most likely need to seek a mortgage.
However, you don’t want to lock yourself into a bad mortgage because you didn’t understand what you were signing up for. First time home buyers are often overwhelmed by the mortgage process and all the vocabulary that comes with it.
Understanding how mortgages work, what home equity is and how the two relate is an important part of becoming a homeowner.
However, the decisions do not stop once you purchase the home. You have multiple options with your mortgage and your property post-purchase, such as refinancing your mortgage or taking out a home equity line of credit.
Below you can find insight into the basics of having a mortgage, as well as the options you have once you acquire one.
What is home equity?
First time home buyers may be confused by the concept of home equity. Buying a house with a mortgage loan does not mean you own the home outright.
Since you borrowed the money to purchase your home, the lender holds the property as collateral. However, holding your home as collateral does not mean the bank owns the home either.
Rather, the bank can take possession of your home if you fail to make your mortgage payments.
As you pay off the principal balance, you continue to gain equity, or ownership, of the home. Once you fully pay off your loan, you own the property outright and have complete equity over it.
How much equity you have impacts your overall personal financial status, since having more equity means you have more to bargain with in your assets. It contributes to your total net worth, and you can pass it on to children and grandchildren.
NOTE: Any down payment you make contributes directly to the equity of your home. The larger your down payment, the more equity you hold upfront.
What is a mortgage?
Most of the time, buying a home means getting a mortgage. Banks issue mortgages while holding the value of the home as collateral.
Rather than paying the seller one lump sum, you can give the bank monthly payments for a set amount of time to gain equity in the home.
Typically, when you sign a mortgage there are three payments you have to track: the monthly payment, the down payment and the closing costs.
Mortgage closing costs and fees vary, but typically end up between 2 and 5 percent of the total mortgage value.
They can include appraisal fees, home inspections, application fees, assumption fees, attorney’s fees and the loan origination fee, among others. You may also be required to pay some property taxes upfront.
Your monthly mortgage payment consists of the payment towards the principal and the payment towards your interest.
Most loans are designed so that your monthly payment does not change, while the percentage of your payment towards the principal increases over time.
Therefore, making regular payments over time helps you gain ownership of your property and pay off the mortgage.
Your down payment is the lump sum payment you present when first purchasing the home. The size of this payment can affect the cost of your mortgage, which gives you other factors to consider as well.
If you submit a smaller down payment, you may be required to pay for private mortgage insurance (PMI). In most cases, this requirement remains in place for the lifetime of the mortgage, adding $100 or more to your monthly payment.
It is worth noting that homeowners do not have to stick to the same terms for payment for the lifetime of the mortgage.
Banks commonly offer the ability to refinance a mortgage to change the interest rate and terms of payment. However, not everyone is approved for this option.
Refinancing a mortgage allows a home buyer to change the terms of their payment — for instance, changing from a 30-year mortgage at 5.75 percent to a 15-year mortgage at 5.5 percent.
The exact terms that change may vary. Nevertheless, getting a home refinance is generally a good tactic for homeowners who want to bring down their monthly mortgage payments to gain ownership of their home faster.
Learn About Mortgage Options After Building Equity
Once you have built up sufficient equity in your home, you can do a number of things with your mortgage depending on your financial needs.
For example, you can take out a home equity loan or a home equity line of credit. A loan is paid out in a lump sum, while a line of credit operates more similarly to a credit card.
A home equity loan may be a better option if you have a specific project in mind that you want a loan for, and you know approximately how much it will cost.
Additionally, regardless of whether you choose a loan or line of credit, the best use for such funds is investing it in the home.
For example, you can take out a home equity loan for $75,000 in order to construct an additional bedroom for your property.
This benefits you because you are increasing the value of your home — and thus your overall equity — when you improve your own property. You can then sell the home for a higher price than before.
Even though you borrowed money, you increased the value of the property you own, which means you can get even more for it when you sell it than before.
If you used a HELOC or a loan for something other than improving the value of your home, you must pay the loan or line of credit back without gaining any benefit to your property.
In additional to HELOCs and home loans, you also have the option of signing up for a reverse mortgage. If you or your partner is 62 years of age or older, you may be able to take a reverse mortgage on your property.
Rather than paying the bank for the home, the bank will give you monthly payments to purchase the home over time.
You can continue to live in the home for the remainder of your life as long as you keep up with property taxes and general maintenance.
This is an appealing option for elderly homeowners who want an additional source of income but are not prepared to move out of their home and sell it. Any outstanding balance must be paid when the homeowner dies, moves or sells the property.
NOTE: If you owe on the value of the home when you die, any heirs to your estate must pay off the mortgage in order to retain the property.