First-time Homebuyer Series: Understanding Mortgages

Buying a house in the U.S. usually requires a mortgage. It will be the biggest loan you’ll ever take out in terms of total cost and time you’ll take paying it off. As a tech worker, you’ll usually be able to qualify with your base income, equity (e.g., RSUs), and bonus with some caveats. Here we give you considerations when getting a mortgage and the basic components of a mortgage payment.

What is a mortgage? A mortgage is a type of loan specifically used to purchase real estate. In a mortgage agreement, the borrower agrees to pay back the loan, plus interest, over a set period of time to the lender, which is usually a bank or a mortgage lender. The property itself serves as collateral for the loan, which means if the borrower fails to make the agreed-upon payments, the lender has the right to take possession of the property, typically through a legal process known as foreclosure. Mortgages are a common way for individuals and businesses to finance the purchase of a property without paying the full purchase price upfront.

Choose the right lender. The steps to getting a loan can be long and convoluted, but luckily loan officers/agents are trained to guide you and answer your questions through the process. Keep in mind a mortgage lender typically does NOT have fiduciary duties, while a mortgage broker does (i.e., they are obligated to try to get you the best loan terms). If you are unsure, ask (preferably in writing) if they are an individual lender (for a bank/institution) or a broker (who will shop around and find the best mortgage product for you). You are not obligated to stick to a single lender when you are under contract for a house. It is wise to consider multiple lenders due to a multitude of issues that may crop up that are not the buyer's fault; for example, the loan officer may be new and did not pre-qualify you correctly. You may feel they are piling on unnecessary fees and a higher rate than originally advertised (i.e., a bait-and-switch). Having multiple options lets you choose the best terms.

Downsides of a mortgage. Society usually touts owning is better than renting because you aren’t “throwing away” money. However, that doesn’t mean a mortgage doesn’t have any downsides. A 30-year amortized mortgage is usually front loaded with interest in the first few years (i.e., very little of the principal is paid down). It isn’t until around the halfway mark where you’ll start making a dent towards the principal and start gaining substantial equity. This is money that is thrown away like when you rent. Does that mean you pay in cash? Not exactly. Tying up your cash in an illiquid asset means that you incur the opportunity cost of not using the money towards other activities. A mortgage when used the right way can be an excellent way to leverage your good credit and down payment to purchase an appreciating asset and build wealth.

Know your numbers. Ideally you’ll come up with a 20% down payment, with the remainder 80% financed by a lender over a typical 15- or 30-year term. You can put less than 20% but you’ll have higher monthly payments due to a higher principal and the addition of private mortgage insurance (PMI). The basic components of the monthly payment towards the lender are principal, insurance, taxes, and insurance (PITI).

1. Principal: This is the portion of your payment that goes toward paying down the original amount borrowed.
2. Interest: This part of the payment covers the cost of borrowing money and is determined by your loan's interest rate.
3. Taxes: Property taxes charged by your local government are often included in your mortgage payment and are held in an escrow account by your lender, who then pays the taxes on your behalf when they're due.
4. Insurance: This includes homeowners insurance, which covers damage to your property from things like fire or theft, and possibly mortgage insurance, which protects the lender if you're unable to pay your mortgage. Mortgage insurance is typically required if your down payment is less than 20%.

In addition to these four components, some mortgage payments also include homeowners association (HOA) or condominium fees, if applicable. These fees cover the costs of maintaining common areas and other community facilities. Things to note are that taxes and insurance will most likely go up in the future. You also need to budget for potential major repairs like replacing the roof and HVAC (hence the need for an emergency fund). 

This concludes a basic primer on mortgages for purchasing your first home. There are many topics not covered here such as refinancing, fixed-rate vs. variable-rate loans, government vs. conventional loans, etc. We will cover them in other articles and in our FAQs. Feel free to submit your questions to Debug Finance!