Don’t take out a mortgage without understanding the costs.
- Borrowing to buy a house is very common.
- You will likely have to pay large mortgage payments each month.
- You need to make sure you understand how much your loan will cost you.
Although home loans can be a low-cost borrowing option, your mortgage will likely be your biggest debt. And you don’t want to get carried away and borrow more than you should, even if you’re tempted by the perfect home.
To make sure the mortgage you take out is financially right for you over the long term, it helps to understand the two numbers that determine the price of the loan.
1. The interest rate
Interest is what you pay for the privilege of having access to money from a lender to buy your home. If you are charged at a higher rate, you pay more to borrow than if you are charged at a lower rate.
Interest is charged as a percentage of your outstanding balance. Your rate can be fixed or adjustable. As a general rule, it’s best to choose a fixed rate loan so that your payments don’t change over time. Fixed rate loans offer predictability so you know your costs up front.
Your interest rate affects both the size of your monthly payment as well as the total costs of your loan over time. When you borrow, the goal is to repay the entire principal balance, plus interest, on a set schedule. This means that your payments are calculated based on:
- The amount of accrued interest that must be paid
- The amount of your principal needed to pay your full balance on time
If you’re stuck paying a higher rate, more of each payment has to go to cover those finance costs. But you still need to pay your balance on time, so your total monthly payment will increase.
Say, for example, you took out a $100,000 30-year fixed rate mortgage at 5% versus 3%. Your monthly principal and interest payment would be $422 at 3%, but it would be $537 at 5%.
You would repay the same $100,000 principal with both loans, but your monthly costs and total borrowing costs would be much higher with the high rate.
2. The amount borrowed
The amount you borrow also affects mortgage costs, because if you take out a larger loan, you have a higher principal balance to pay off and you will owe more interest.
To continue the example above, what if you borrowed $500,000 at 5%, rather than $100,000? You would obviously have to repay $500,000 in capital rather than just $100,000. But your monthly interest charges would also be much higher since your finance charges are a percentage of your outstanding balance.
If your loan was $500,000, your monthly payment would be $2,684 instead of $537. It’s a huge difference. You would also pay significantly more total interest over time. In fact, it would cost you $966,279 in total to pay off your mortgage, compared to $193,256 if you borrowed just $100,000.
If you want to reduce monthly payments and total borrowing costs, your best bet is to try to borrow as little as possible and aim for the lowest interest rate loan you can qualify for. You can see this by shopping around and comparing mortgage quotes from different lenders before you commit to borrowing.
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