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Woman holding a toy house and a fan of dollars bills in the palms of her hands to represent how home loans work.

How Do Home Loans Work?

A home loan, also known as a mortgage, is a long-term loan provided by a bank for the purpose of purchasing a house. Due to the expense of a house, a home loan is a large loan that matures over a very long period. Though you obtain a home loan at a local bank, your loan will be sold to a finance company or mortgage company that specializes in managing large, long-term loans. You will then make your monthly loan repayment checks to this company.

Principal and Escrow

Your home loan pays off two things: The principal, which is the value of the house and the amount of the loan, and escrow, which is property tax and home insurance. Most mortgages are set up so that your mortgage company pays these costs annually, and the expected cost of these expenses is included in your monthly payment. If your property taxes and home insurance premiums rise, the mortgage company will raise your monthly payment. Sometimes these increases are anticipated, but sometimes your property values can fluctuate rapidly. If property values in your area soar, you will likely see a substantial increase in your monthly mortgage payment.

Down Payments are Important

Mortgages typically mature in ten to thirty years and because you will be paying this interest rate for many years, it will add up. As a rule of thumb, you want to put as much money as possible down on the house to minimize the size of the home loan you will need to take. When you purchase a house, you are required to put some money down, usually a minimum percentage of the cost of the house. The home loan will be for the specific remainder of the cost. Home loans may either have a fixed or adjustable interest rate.

For the most part, a down payment is 20% of the home’s value. If a buyer puts down a smaller payment, they will have to get private mortgage insurance, which protects the lender in case of a default. Monthly PMI payments are based on the buyer’s credit score, down payment, and the duration of their loan; when the buyer has paid 20% equity, they can contact their lender to stop monthly payments.

Home Loan Interest Rates

If you want a fixed-rate home loan, which means the interest rate is permanently locked in, then this interest rate will be determined by the rate of inflation. The rate of inflation is affected by price increases and the general state of the economy. The higher the rate of inflation, the higher the interest rates on loans. Many consumers may avoid purchasing a house during periods of high inflation to avoid having a fixed-rate mortgage set at a high interest rate.

An adjustable-rate mortgage has an interest rate that can rise or fall based on inflation and the economy. Though it may offer lower initial payments than a fixed-rate home loan, payments may quickly become more costly, rendering it less predictable. Your monthly payment can also vary with fixed-rate mortgages.

Payment Term Affects Payment Amount

Payments on both types of home loans depend on the length of the mortgage, meaning a longer mortgage will have lower monthly payments. A thirty-year home loan means that you will pay off the loan balance in thirty years, necessitating a lower monthly payment. A ten-year home loan obviously means you must pay more per month to pay down the loan quickly. When paying off your home loan, keep in mind is that you must pay the remaining balance in full at the end of the mortgage time period. Therefore it’s important to stay ahead of your payments.

Last Updated: June 17, 2015