How Do You Finance a Home?

Presuming you do not have a very large supply of cash on hand, you will have to finance your home with a mortgage. A mortgage loan is essentially a secured loan that uses the home as collateral. Mortgages are typically paid in monthly installments over several years—usually 15 or 30 (40-year mortgages do exist, but they are not offered by every lender).

Mortgages contain two distinct parts:

Principal. The amount you need to borrow to pay for your home and closing costs.
Interest. What you pay the financial institution for the use of its money.

Your monthly payments will be based on an amortization schedule in which the percentage of each payment that goes to interest gradually decreases as your equity in the property increases.

You can also select between a fixed-rate mortgage—locking in your interest rate for the life of the loan—and an adjustable-rate loan, one in which the interest rate may fluctuate from year to year. There are advantages and disadvantages to each. You need to compare the rates and make a guess of how future rates will move, as well as how long you plan to stay in that same home.

The percentage of each payment that goes to interest gradually decreases as your equity in the property increases.

Lower loan rates often require that points be paid up front. A point equals 1% of the loan's principal and represents pre-paid interest.

Balloon financing is another way to decrease your monthly payment. Basically, this type of financing offers a below-market interest rate for a predetermined amount of time, with a balloon payment (the balance of the loan) paid at the end of the term.

Interest-only loans have become popular in recent years. They are a variation on balloon financing and resemble how a bond works. With an interest-only loan, the borrower pays only the interest on the loan each month. At the end of the loan term, the borrower repays all the principal. The advantage of an interest-only loan is that the payments are lower than those of a regular amortized loan. Because no principal is paid each month, buildup in equity is slower, and if the property value declines, the borrower may be faced with insufficient equity to repay the principal. Interest-only loans may be fixed, but are usually offered as variable-rate loans.

In order to know how much home you can afford, you will want to be pre-approved by your lender. In the pre-approval process, your lender will examine your gross monthly income and your long-term debt, using a set of loan ratios.

For instance, to figure your total loan amount, a lender will calculate 33% of your monthly income and subtract your monthly long-term debt (loans, credit cards, car payments, etc.). That number will be compared to 25% of your gross monthly income. The lower of the two numbers will be considered the maximum monthly mortgage payment you can afford. The total amount you can borrow will be calculated from that figure.