Home loans are a kind of debt you take on as a trade-off for becoming a homeowner. They are generally considered good debt — you use them to buy a home, which typically retains value. But, home loans are still debt. To be a savvy borrower, it’s important to know loan types and terms and avoid some of the traps that can quickly turn homeownership from a dream to a nightmare.

What is home loan?

A home loan is a loan you use to purchase real estate. It is commonly called a mortgage. A home loan is generally considered good debt, because it has a low interest rate and is used to buy property that increases in value over time. Of course, there have been economic downturns (like the most recent one), where property values have dropped — but those are special cases. In general, the value of property tends to grow slowly, over time.

When you sign a mortgage, you agree to pay the lender back both the principal of the loan — the amount you borrowed — plus interest. Interest rates vary based on the type of loan, your credit history, your down payment, the economic situation and other factors. The loan you take out has a fixed term — usually 15 or 30 years — which is the period of time over which your loan payments will be spread.

When you purchase real estate with a home loan, that property functions as collateral for the bank. If you do not keep up with the monthly payments, the bank or lender can repossess and sell the property, and use the proceeds to pay off your remaining balance, through a process called foreclosure.

In addition to the loans you use to purchase a home, you also can borrow money for renovations or even uses unrelated to your home, with the loan secured by the equity you own in the home. These are called home equity loans or, if you can borrow money on demand rather than a fixed amount at once, home equity lines of credit.

How much of a home loan should I take out?

Your home loan should cost no more than 3 to 3.5 times your gross income (your income before taxes are taken out). That means if you make $45,000 per year, your home loan should be no more than $145,000-$157,000. This is not an exact figure, but it works pretty well for a lot of people.

Don't spend more than 30% of your gross income (your pay before taxes and other things are taken out) on your mortgage, property tax and homeowner's insurance combined. That means if you make $6,000 per month before taxes, your total home payments should be less than $1,800.

If you have other debt — for example, credit cards, car loans and student loans — don’t let those plus your home-related expenses add up to more than 36% of your income. In many cases, lenders have specific percentages of your income that they will let you borrow, but your target should be no more than 36%. If your income is $6,000 per month before taxes, that means you can’t spend more than $2,160 on your home payments (mortgage, insurance, maintenance), credit card payments, car payments, student loan payments and other debt combined.

Keep your combined home and debt payments to less than 36% of your gross income

During the early 2000's, many people were buying homes and taking on other kinds of debt that together amounted to 5-7 times their gross income. That's what led to the housing bubble and the economic downturn. Your goal should be to avoid owing so much to debt that you have no flexibility — that’s the quickest way to end up in a financial disaster.

What are the parts of a home loan

Here are common elements of a home loan that you’ll need to understand before you purchase a home:

Loan principal

The loan principal is the amount of money you borrow from the lender and which you are required to pay back. It does not include your interest payments.

Interest

Interest is what a lender charges a borrower for borrowing money. Interest is paid for as long as there is a remaining balance on the loan. Interest on mortgages is expressed in percentage terms, at an annual rate. For example 6% means each year that if $10,000 remains borrowed, the borrower must pay $600 in interest.

Loan term

The loan term is length of the repayment period for the loan. The most common mortgage terms are 15 and 30 years. With some loans, the payment is the same for the entire term, but with others it can vary.If you finance a home for 15 years, you have a higher monthly payment that you would with a 30-year term, but you’ll pay less interest over the life of the loan — because you borrow money (and are charged interest on that money) for a shorter period of time.

Parts of a home sale

When you buy a home, there are aspects of the home sale that may affect the home loan you take out.

Down payment

When you buy a home, it is typical to make a 20% down payment, paying for some of the home in cash. The reason is that most mortgages are obtained through two lenders that require a 20% down payment to obtain the best interest rates.

Then, you take out a home loan to cover the remaining 80% of the home’s sale price. That means immediately after the purchase, you own 20% of your home and the bank owns 80%. The more money you put down, the more of your house you own. Having a 20% down payment helps keep your interest rate down. While you’re not always obligated to put 20% down on your home, many lenders now require it.

There are a few home loan programs — for example, those set up for first-time homebuyers — that do not require a 20% down payment. However, taking out a loan of more than 80% often means you have to pay added fees when you close the loan and pay some type of mortgage insurance every month, such as Private Mortgage Insurance (PMI), which can cost you extra in the long run. PMI allows you to borrow more than 80% of the value of the home while protecting the lender in case of default. You’ll have to continue paying PMI monthly until you’ve accumulated enough equity in your home to make up for not having a down payment.

Pre-approval letter

When you’re planning to buy a home, we recommend that you apply for your home loan before your start the home-buying process. Research different lenders and see which will give you the best options and rate. A good place to start is your bank. Because you are a customer already, you may have access to better deals if you obtain a home loan through them. Credit unions also offer competitive rates on home loans.

The Federal Reserve Board has good information on how to evaluate home loans:

• Federal Reserve Board Home loans: www.federalreserve.gov/pubs/mortgage/mortb_1.htm

A few online resources for evaluating home loan options are:

• Lending Tree: www.lendingtree.com

• Bankrate:www.bankrate.com

After you’ve compared options and selected a lender, you’ll apply for a loan and wait for a pre-approval letter. When your pre-approval arrives from the lender, it is a statement of how much they will be willing to let you borrow based on factors like your income and your credit history.

Pre-approval makes the home-hunting process go more smoothly, for two reasons. First, it helps you know how much you can afford so you can narrow down your home selection. Second, it makes you a more competitive buyer, because you have an official note from your chosen lender that shows sellers you are qualified to buy their home. This is useful because purchase offers typically include a “financing contingency,” which means the buyer can back out if he’s unable to obtain a mortgage.

Also remember that a pre-approval is a maximum limit on what the bank will lend you, but you don’t have to use the full amount of the loan that you are pre-approved for and, in some cases, shouldn’t.

When considering how much of a loan to take, always return to the general rule to keep your home-related expenses — which your loan payment is just one part of — to less than 30% of your income. If you have debt, keep your total home and debt payments to less than 36% of your income.

Points

Mortgage points are pre-paid interest that you pay up-front when you purchase a home. By paying a interest up front at the time of the sale, you get a slightly lower interest rate on your mortgage. One point is equal to 1% of the loan principal — the amount you borrow from the lender. For example, if you’re buying a $200,000 home and putting 20% down, you’ll pay $40,000 and borrow $160,000. One point is equal to 1% of $160,000 — or $1,600.

Paying that point lowers your interest rate. Whether to pay points depends on how much the interest rate on the mortgage drops and how long you plan to stay in the home. To benefit, you’ll need to own the home long enough for that up-front cost to be outweighed by the reduced monthly payments. Often, this can take five years or more, but your “break-even point” depends entirely on the specific loan.

Closing costs and fees

The total cost of a home mortgage is more than just the amount borrowed to buy the home. You’ll also pay closing costs, either separately or possibly added in to the loan balance. Typical closing costs can include application fees, loan origination fees or points, appraisal fees, home inspection fees and property surveys, prepaid interest, title insurance and other costs. When you’re getting ready to buy a home, it’s a good idea to have a couple thousand of dollars saved up to cover closing costs.
You’ll also pay fees for the process of securing your loan and for services rendered to you by your lender. Be careful of “junk fees” sneaking into your documents — sometimes lenders may have other fees that you’re unaware of. Examples include high costs for postage or photocopying of documents. If there is a fee you don’t understand on your loan documents, ask your lender to explain it to you.

How do I pay my mortgage?

Once you’ve taken out the loan and closed on your new home, your mortgage payments begin.

Your mortgage payment will be in the form of monthly bill you receive from your lender — mailed or electronically — that charges you a portion of your loan principal, a portion of loan interest and other possible fees. As a borrower, you are responsible for making this payment every month. It’s a good idea to set up automatic payment through your bank so you never have to worry about missing a payment.

It’s common to pay property tax and homeowner’s insurance as part of your mortgage payment. If your loan is set up this way, you’ll pay extra each month into an escrow account held by your. Your lender then makes tax and insurance payments on your behalf by the payment deadlines.

This is a way to automate your tax and insurance payments so you don’t miss them or end up owing a big tax payment at the end of the year, and some lenders request or require an escrow. But you’ll be paying money into escrow in advance, losing the interest you would otherwise be earning if you put the money into a savings account and made these payments yourself.

Mortgages require the purchase of homeowners insurance to protect against losses from fire, storms, theft, floods and other unexpected events. You don’t have to pay homeowner’s insurance through your lender, but it is an option.

What are the types of home loan providers?

Mortgages can be divided into two categories based on the type of provider: conventional loans and government loans.

Conventional loans

Most home loans are conventional loans. These are loans that are obtained through private lenders and are not backed by the federal government (though the government agencies Fannie Mae and Freddie Mac are often the source of funds). You can get a conventional loan through a bank or a mortgage lender.

You can compare many different conventional loan types at:

• Lending Tree: www.lendingtree.com

• Bankrate: www.bankrate.com

The Federal Housing Finance Agency (FHFA) sets an annual limit each year on the maximum loan amount that the federal agencies Fannie Mae and Freddie Mac — federal agencies that work with mortgage lenders to promote homeownership among middle and low income Americans — will guarantee. If a loan stays within this limit, it is a conforming loan. Most people take out conforming loans.

If a loan goes over this limit, it is a non-conforming or “jumbo” loan. These loans have higher interest rates. Very large loans are sometimes categorized as super-jumbo.

For more information, visit:

• Federal Housing Finance Agency: www.fhfa.gov

• Freddie Mac: www.freddiemac.com

• Fannie Mae: www.fanniemae.com

Government loans

Conventional loans in general require either a 20% down payment or private mortgage insurance if it’s below 20%. For those who qualify, there are several special federal mortgage programs that help homebuyers purchase homes with much lower down payments. These are known as government loans because they are obtained through programs run by the federal government.

FHA Loans

The Federal Housing Administration (FHA), which is part of the U.S. Dept. of Housing and Urban Development (HUD), administers various mortgage loan programs. FHA loans have lower down payment requirements and are easier to qualify than conventional loans. FHA limits vary by the area you live in.

• FHA Loan program: www.hud.gov/buying/loans.cfm

• State limits: www.fha.com/lending_limits_state.cfm?state

VA Loans

The U.S. Department of Veteran Affairs (VA) also has a government loan program available to qualified members of the U.S. military, called the VA Loan program.

• VA Loans: www.benefits.va.gov/homeloans

How do home loan interest rates work?

Most home loans fall under two classifications: fixed-rate loans and adjustable rate-loans.

Fixed-rate loan

Borrowers who take out a fixed-rate loan will have the same interest rate over the entire life of the loan. If you take out a fixed-rate loan, your monthly mortgage payment won’t change — though each month it covers a slightly different amount of principal and interest, as you gradually pay the loan down. Note that your monthly payment may change if you use an escrow account, due to changes in your property tax or insurance rates.

Fixed-rate mortgages commonly come in 30-year or 15-year terms. If you take out a shorter loan term, your monthly payment will be higher but you’ll pay less in interest over the life of the loan. You also will pay your property off faster. Some fixed-rate mortgages come in other terms — but 30- and 15-year terms are by far the most common.

Adjustable-rate mortgages (ARMs)

Adjustable-rate mortgages have an interest rate that can change over the life of the loan. The interest rate stays fixed for an initial period of time, such as five years, but then it can go higher or lower at set times throughout the remaining life of the loan. The loan name is shorthand for the initial period and the frequency of interest rate changes. For example, a 5/1 ARM has the same rate for the first five years, and then the interest rate changes annually based on lending rates at the time.

The rate adjustment is usually based on a published reference rate like the prime rate or LIBOR (both of which are listed in the business section of most newspapers, or online at sites such as Bankrate.com or Yahoo Finance). When the rate changes, so does your required monthly mortgage payment. Note that ARMs still have a fixed term that is used to recalculate your monthly mortgage payment — it’s the interest rate, and therefore the monthly payment, that changes.

Adjustable-rate mortgages are more risky than fixed-rate loans because there’s no way to predict whether your interest rate will go higher or lower in the long run. If your interest rate resets to a higher rate, you could end up with a higher monthly mortgage than you can't afford. An ARM is best suited to a home that you do not plan to keep much longer than the initial fixed-rate period.

In addition to these basic classifications of loans, there are other types of loans you might come across — interest-only loans and balloon loans, for example.

You can learn about these loan types at:

• Bankrate:www.bankrate.com/finance/financial-literacy/mortgage-loan-choices-abound-1.aspx

• USA.gov Common types of mortgages: www.usa.gov/topics/family/homeowners/buyingselling/mortgages/types.shtml

We recommend sticking with a fixed-rate loan and only buying if you plan to live in your home five years or more. A home should be a long-term investment that you buy using loan debt that you take out cautiously.

How to apply for a home loan

When you apply for a home loan, the bank or lender will check your income and credit histories to determine how likely you will be to pay back your loan. This is how they qualify you for a loan.

Before you apply for the loan, there are some documents you should gather so you are prepared to enter the information required on the application:

• Federal income tax returns and W-2 forms for the past two years

• Recent pay stubs showing your name and Social Security number

• Proof of other income, if you have it

• Statements from accounts showing where you down payment will come from

• A list of where you owe money, such as credit cards, student loans and auto loans.

Lenders will look closely at this information and will review your credit history to find any late payments you made during the past two years. They will pay particular attention to any rent or mortgage payments that were more than 30 days past due. They'll also look at late payments for any credit cards during the past six months.

Lenders also will look for steady employment with a single employer for the past two years. Other sources of income, such as earnings from part-time or freelance work, overtime, bonuses or self-employment may be acceptable if it has a two-year history. If you don't meet the minimum requirements, it doesn't mean you'll never quality for a mortgage — you may need to consult with more lenders, provide more supporting documents, or pay a higher interest rate.

Most lenders use a credit scoring system from Fair Issac Company, called FICO, that gives you a credit score based on your bill-paying history and your debt level. It doesn’t consider your income or assets.

• FICO: www.myfico.com

If your FICO score is between 760 and 850, then you will most likely qualify for a loan with a lower interest rate. If you’re FICO score is below 760, you may qualify for a loan with a higher interest rate. If your FICO score is between 580 and 650, you may run into problems securing a loan. These guidelines can change from time to time based on the current state of the mortgage market.

Once you are approved for a loan, you will be given a pre-approval letter (if you have not yet bought your home) or the actual loan agreement.

Words to know

Unsure about something you read? Many of the financial terms you came across in this article are defined in our financial glossary. A-Z Glossary

Links we like

Here are a couple online features you might find useful:

• Federal Reserve Board Home loans: www.federalreserve.gov/pubs/mortgage/mortb_1.htm

• Lending Tree: www.lendingtree.com

• Bankrate: www.bankrate.com

• Federal Housing Finance Agency: www.fhfa.gov

• Freddie Mac: www.freddiemac.com

• Fannie Mae: www.fanniemae.com