=The Mortgage Money Guide= Page 2
Updated Edition from the Federal Trade Commission Creative Financing For Home Buyers

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Federal Trade Commission

DEFINING YOUR TERMS

To buy or sell a home today it's important to know the vocabulary. Don't let terms like "amortization" or "appreciation" scare you. Understanding the concepts can save you time and money; it can also prevent you from obtaining a mortgage ill suited to your needs.

Three important words are: "interest," "principal," and "equity." When you first buy a home you're likely to make a down payment on the property. But, because you financed the purchase, you are now in debt and the lender "owns" most of the property's value. In traditional mortgages, the monthly payments on the loan are weighted. During the first years, they are largely interest; in time, more of each payment is credited to the loan itself, or the principal. Gradually as you pay off principal, you build up equity, or ownership. Your equity also increases if the value of the home increases. This process of gradually obtaining equity and reducing debt through payments of principal and interest is called amortization.

Until recently most mortgages had fixed monthly payments, a fixed interest rate, and full amortization (or transfer of equity) over a period of 20 to 30 years. These features worked in the buyer's favor. Inflation made your payments seem less and your property worth more. So, although the payments seemed hard to meet at first, over time, it became easier.

Many home financing plans are different from traditional mortgages. They may help you buy a home you otherwise couldn't, but they also may involve greater risks for buyers. For example, the interest rate and monthly payments may change during the loan to reflect what the market will bear. Or the interest rate may fluctuate while the payments stay the same, and the amount of principal paid off may vary. The latter approach allows the lender to credit a greater portion of the payment to interest when rates are high. Some plans also offer below-market interest rates, but they may not help you build up equity.

In shopping for financing sources today keep in mind the terms which are keys to the affordability of the home:

  • the sales price minus your down payment, or amount you finance;
  • the length, or maturity of the loan; the size of the monthly payments;
  • the interest rate or rates;
  • whether the payments or rates may change;
  • how often and how much the payments or rates may change; and,
  • whether there is an opportunity for refinancing the loan when it matures, if necessary
These concepts will be discussed in greater detail as we describe specific types of financing.

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