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Video: Demystifying Mortgages

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Watch this video to learn more about how a mortgage works to feel confident next time you're financing a home purchase.

Video Transcript

HERMAN: HEY! What's the big idea?

JEN: Oh! I'm sorry, I didn't realize you lived in there.

HERMAN: I don't. Well, not yet. I'm just here for the open house.

JEN: Are you gonna get it?

HERMAN: I'm not sure. It kind of depends on the mortgage rates.

JEN: Ha! Good one! You're not joking. Sorry. I didn't realize hermit crabs need mortgages.

HERMAN: Of course we do! It's the biggest purchase of our lives. We usually need a loan to make it happen.

JEN: If I were you, I would just find the mortgage with the lowest interest rate and go with that.

HERMAN: It's not that simple. When shopping for a mortgage—or any loan—financial institutions have products with an advertised APR, which stands for Annual Percentage Rate.

JEN: That's what I mean—just go with the one that has the lowest APR.

HERMAN: But you can't compare them at face value. The APR represents a combination of things: the interest rate, yeah, but also a wide range of additional costs. And, if you're looking at an adjustable-rate mortgage, the APR doesn't even tell you what your maximum interest rate will be!

JEN: You've lost me.

HERMAN: Look, mortgages come in two basic types: fixed rate and adjustable rate (also known as variable rate). In a fixed-rate mortgage, the interest rate is set when you take out the loan and it does not change over time. The amount you pay monthly will stay the same for the entire term of your loan. In an adjustable-rate mortgage, the interest rate—and therefore your monthly payment—is based on current interest rates in the economy. If the index they're based on goes up, so does your rate, meaning you'll be paying more. If the index decreases, so do your payments. An adjustable-rate mortgage often has a lower initial interest rate, which is very appealing.

JEN: Fixed rate, adjustable rate—how do you choose the best one?

HERMAN: It's always a trade-off. Fixed-rate mortgages are more stable and easy to budget for, but have a higher interest rate overall. Adjustable mortgages have better rates, but are riskier because your rate may increase over time. You have to think about your income, your future, how long you plan to live in the home, your financial risk tolerance—and that's on top of weighing different mortgage types, interest rates and amortization schedules!

JEN: Gesundheit.

HERMAN: Huh? No, amortization. It's how your loan repayment is broken down into regular installments over a fixed period of time. An amortization schedule shows you how much of each payment is going towards interest and how much of it is going towards the principal.

Jen: Is it that hard to figure out? If your interest rate is 3%, then 3% of your payment goes towards interest. Am I right? Your face is telling me I'm not right.

HERMAN: That 3% is the annual interest rate. If you take the total amount owing on your mortgage, and multiply it by 3%, the result is what you'll pay in interest in the current year, but the monthly payments work a little differently.

JEN: What?

HERMAN: Let's say you take out a 25-year mortgage for $150,000. It's fixed rate, so you're paying 711 bucks a month. In your first payment, $375 will go towards interest and only $336 will go towards your outstanding balance. So even though you've made a payment of $711, your balance has only decreased by $336. The following month, because your outstanding balance is now $149,664, the interest portion of your monthly payment will also be slightly lower and the principal portion will be slightly higher.

JEN: So looking at the entire stretch, even though a big chunk of my monthly payments are going towards interest at the start, over time, that kind of flip-flops and by the end, more of my payment is going towards principal than towards interest.

HERMAN: Now you're getting it! Using this example, after 25 years, you will have made over $213,000 in payments on your $150,000 loan.

JEN: Woah, that's serious.

HERMAN: All the more reason to know exactly what you're getting into before signing everything. People get into trouble by committing to mortgages they don't understand. It happened to a friend of mine. The bank came and took his shell away. He had to move into a half-eaten ice cream cone until he could figure things out.

JEN: That's rough.

HERMAN: Mortgages can be an empowering experience or a living shell. It all comes down to your understanding of the mortgage products available, honesty regarding your personal finances and clarity about your life situation. As for me, this is a little too much home for my budget. Time to go house hunting. Keep it real!

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