Basics

The loan you get from the bank is called a mortgage, also called a note. (We'll talk more about how to get a loan in a minute.)

The bank loaning the money is the lender. The amount you pay to the bank each month is your mortgage payment. The rate of interest on the loan is the mortgage rate (or the interest rate).

If you don't make your mortgage payments then the bank will repossess the house. Then they'll sell it to make sure that they can recoup the money they loaned to you, and that you didn't pay back.

The number of years it takes to pay back the loan is called the term, which in the U.S. is either 15 or 30 years. There are pros and cons of each:

15-year mortgage

• Saves a bundle on interest
• Pay off the loan in half the time

30-year mortgage

• Easier to qualify for
• Lower monthly payments
• Allows you to buy a higher-priced home
• Keeps your cash liquid

How do you choose between the two? If you want the most flexibility then take the 30-year loan. You can still save on interest and pay your loan off early by paying the bank a little extra each month (or whenever you can afford it). The difference is that with a 30-year loan you get to dictate how much extra you want to pay, and therefore how much you want to save. With a 15-year loan you have to make bigger payments every month whether you like it or not.

On the other hand, if you can definitely afford the payments on a 15-year loan, and you don't trust yourself to make extra principal payments on a 30-year loan, then take the 15-year loan and enjoy the fact that you'll save a bundle of interest and pay off the loan in half the time, without having to do anything special.

If you're satisfied with that advice then keep reading. Otherwise you can check out more about 15- vs 30-year mortgages in the appendix.

Right now you should figure out how much money you have saved up that you can use for a down payment, unless you know you can get a loan with no down payment.

Paying back a mortgage

You pay back your loan by making a payment every month. The bank doesn't send you a bill, so it's your responsibility to remember to make the payments every month. They do give you a cute little coupon book, with one slip for each month, so you can include the slip when sending in your check each month. These days most banks also let you pay online. I strongly urge you to set up an automatic monthly draw from your bank account, so you never miss a payment, and so it's one less thing you have to worry about each month.

Part of your payment goes towards the principal (the amount the bank loaned you), and part of it is interest (the bank's profit from lending you money). So when the bank loans you $100,000 you pay them back that $100,000 and then some. If you only had to pay back the same $100,000 they gave you then there wouldn't be anything in it for them. That's why they charge interest.

Even though part of your monthly payment is for principal and part is for interest, you write only a single check to the bank each month, and that payment amount stays the same for the life of the loan. You don't have to know how much of your payment is for principal and how much is for interest, but it's usually printed on the coupon, as well as in an end-of-the-year statement the bank will send you for your taxes, since you'll get to deduct the interest you paid if you itemize.

Maybe you remember percentages from high school, so you figure that if you have a $100,000 loan at 9% you'll be paying the bank back $109,000? Nice try, but that's simple interest, and banks don't work that way. If you like you can see the appendix about compound interest, but all you really need to know for now is:

1. You'll be paying the bank a lot more than just simple interest.
2. When comparing loan offers from two different banks, just a percentage point or two of difference means a big difference in how much interest is paid.
3. For the first several years most of your payment goes to interest, not principal. On a 30-year, 7% mortgage, in year #15 over 75% of your monthly payment goes to interest and not equity. After 15 years you won't own half your house, you'll own only 27% of it.

Here are some pretty pictures to demonstrate the first two points. We'll assume a $125,000 loan for 30 years at various interest rates.

Total Interest Paid Over the Life of the Loan

So even at a very low interest rate of 6%, you're paying $145,000 in interest on a $125,000 loan. So you borrow $125,000 and pay back $270,000 -- more than double what you borrowed!

It's even worse if you have a higher interest rate. Note how going from a 6% to 10% interest rate means you pay an extra $125,000 over the life of the loan. So the total you'd pay on a $125,000 loan at 10% would be $125,000 principal + $269,907 interest = $394,907! Quite a lot to pay back for a $125,000 loan, huh?

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Average Yearly Interest ($125,000 loan, 30 years)

Here again, going from 6% to 10% interest means you pay an extra $5000 on average in interest each year!

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How the interest rate affects the monthly payment

Types of loans

For the most part, you don't have to concern yourself with the difference between the three main kinds of loans (Conventional, FHA, and VA loan). It's your lender's job to try to pick the best loan for your needs and qualifications, not yours. But since you'll hear these terms bandied about frequently, you might want to know what they mean, so here ya go.

Conventional. This is a fancy word for "normal". A conventional loan is just a regular, normal loan.

FHA. The U.S. government offers the FHA loan program to make home-buying easier. The government guarantees part of the loan if you default, which means that they pay the bank if you fail to make your payments. Since the loan is partially guaranteed, it's easier to get. Don't get excited about the government making your payments for you, though -- if you fail to make your mortgage payments the bank will still take the house back from you. The government pays the bank after the bank has already repossessed your house. Note that not all sellers will agree to an FHA loan, because there's a little more red tape involved, and because the house can't be a fixer-upper -- the house has to be in excellent shape to pass an FHA inspection.

VA. VA loans are an option for veterans, and it's possible to put 0% down on one. Just like with FHA loans, the VA itself doesn't lend money, it just guarantees part of the loan so lenders feel comfortable lending the money. VA-guaranteed loans can be combined with second mortgages (which is when the bank makes the main loan covering most of the price of the house, and the seller makes a separate loan to the buyer for the rest of the price.) VA loans can be assumed by any future qualified buyer, so your hands aren't tied if you need to sell -- you can sell to anybody, not just another veteran.