What Is a Mortgage and How Do Home Loans Work?

Home mortgages (or home loans), in principle, are not that complicated.  You are borrowing money from an entity (typically a bank), which you then repay based on the interest rate of the loan.

So, in the general sense, they are pretty straightforward: you borrow a certain amount and repay the original loan amount, plus an agreed-upon interest.

Taking a deeper dive into mortgages can be more intimidating as we go through various types, interest rates, mortgage insurance, and terms.  As an investor, understanding the ins and outs can potentially save you a significant amount of money. It can also optimize your business strategy and open doors to grow your portfolio.

How Do Mortgages Work?

We know a home loan helps you buy real estate, but how does it work, and what factors are involved?

INTEREST RATE

One of the most important things to consider when looking into mortgages is the interest rate that will be applied to the loan.   The higher the interest rate, the higher your monthly payment will be and the higher the overall amount you will pay on the loan.

Here is an example:

If you have a $100,000 mortgage over a 30-year term period (most common):

• 3.125% interest ->  $428 per month, which is just principal and interest
  • Total cost of mortgage: $154,215
• 5.00% interest -> $537 per month, which is just principal and interest
  • Total cost of mortgage: $193,256

You can see here that the difference in monthly payment doesn’t seem too extravagant, but when you look at the total after 30 years (~$40,000), you can see just how much interest rate matters.

Did you know Rent to Retirement offers LOW-interest-rate loans on build-to-rent turnkey rentals?

WHAT AFFECTS INTEREST RATES?

• Influenced by the Federal Reserve
• Current economic conditions – enter inflation
• Inflation
• Your personal finances – specifically credit scores

Of the previously mentioned items that can affect interest rates, the only ones you have direct control over are your financial situation and your credit score. 

The better your credit score, the lower your mortgage interest rate can be.  Remember, lending is based on the likelihood that you will be able to repay the loan.  If you have poor or bad credit, the bank doesn’t have strong confidence in your ability to repay, and to offset that, they will charge a higher interest rate to make up for a potential default.

Wondering what's coming next for mortgage rates? Check out our full blog on mortgage rate predictions! 

TERMS

The duration or length of your loan is typically decided upon by you, the investor.  However, certain lenders may require or stipulate a length based on the loan product. 

Typically, for conventional residential mortgages, terms are generally 15, 20, or 30 years, with 30 being the predominant type.

Well, the longer the loan terms typically equate to a lower monthly payment, it frequently is associated with a higher overall payment amount.

When the interest rate is kept the same, for instance, 4.5%, we can see the significant difference in the total amount paid over the course of the loan as well as the difference in monthly payments ($200,000 mortgage):

• 30-year mortgage -> $1,013 monthly payment -> $364,813 total cost of mortgage
• 15-year mortgage -> $1,530 monthly payment -> $275,398 total cost of mortgage

Having a higher monthly payment will apply more of the payment to the principal balance of the mortgage, thereby significantly reducing how much you get charged for interest.

As real estate investors, typically, we want to maximize cash flow, so obtaining a 30-year mortgage to have the lowest monthly payment is optimal.

Looking for cash-flowing turnkey real estate investments?

Fixed vs. Adjustable

Understanding the difference between a fixed-rate and adjustable-rate mortgage is vitally important.  Each has its unique qualities, and when utilized correctly, both can offer significant benefits to you, the investor.

A fixed-rate mortgage is exactly what it sounds like – the rate is fixed over the life of the loan.  Once you “lock” the rate in, it won’t change unless you decide to refinance the loan.  It is beneficial because you can rest assured that you’ll have the same monthly payments (barring significant changes in your escrow balance) over the course of the loan.  This can help with predictability and help ease any potential stress.  Oftentimes, locking in a fixed-low-rate mortgage is highly advantageous to keep expenses low and optimize cash flow.

Adjustable-rate mortgages (ARMs) are the opposite of fixed-rate mortgages, with the exception of the “introductory period”.   Unlike fixed-rate mortgages, adjustable mortgages can have a fluctuating interest rate throughout the life of the loan.  Typically, ARMs are designed to have a fixed rate for the first 3-10 years, depending on the structure, and then will adjust on a semi-annual or annual basis. 

Fixed vs. Adjustable: How to Choose

When it comes to choosing from the various types of loan options, it often comes down to a numbers game in addition to your plans as an investor for the property.

Term Length: there are advantages and disadvantages to shorter and longer-term loans. 

Longer will cause you to pay more overall (due to interest) for the loan but give you smaller monthly payments.

Shorter will decrease how much you pay overall in interest but will lead to higher monthly payments. 

• If you are looking for cash flow, then it makes more sense to choose as long of a term as possible.  This will give you the lowest monthly payment and the biggest “delta” (difference in income and expenses) or cash flow.
  • If you are wanting to be “free and clear”, meaning have no more mortgage on the property, then a shorter-term length is ideal. 

Fixed vs Adjustable: Again, consider the advantages and disadvantages, but also consider what your plans are for the property.

Oftentimes, getting a fixed conventional loan provides an investor with the comfort of knowing their payments won’t change significantly over the life of the loan. Which can be great, especially if you get a great rate and aren’t planning on selling the property. 

Conversely, adjustable rates, while they carry potentially more risk, can be beneficial to investors as they often offer lower fixed rates for the first several years of the mortgage.  This can be advantageous as it allows you to have lower monthly payments and the opportunity to refinance at a lower rate in the future.  Additionally, if you plan to keep the property for only a short term, then the risk of fluctuating rates is of little consequence because you will be selling the property anyway. 

Adjustable rates can come with risk, especially if interest rates don’t decrease as anticipated or if you aren’t able to sell the property as intended.  You could then be stuck with fluctuating rates that are sometimes significantly higher than had you just gone with a fixed rate in the beginning.

Ready to Get a Home Loan?

Understanding mortgages doesn’t have to be complicated.  However, it is essential to understand the basics to make the right decisions about creating the best financial situation for your business. 

Remember, there are risks and benefits to both short and long-term loans as well as fixed or adjustable rates.  It’s important to understand how to use the benefits for your particular situation to help make you the best investor you can be!

Need help figuring out the best financing for your next investment property? Rent to Retirement has relationships with numerous investment property lenders who can help you on your journey to financial freedom!