4 Banking Terms Every First-Time Homebuyer Should Know

Before applying for your first mortgage loan, make sure you understand these four terms.

Aug 31, 2014 at 2:35PM

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Image source: Images Money.

Before you walk into your local bank and apply for a mortgage loan, get a head start by learning these four banking terms.

As a first-time homebuyer, these concepts form the real foundation of your mortgage loan and can make a huge difference in your monthly payment and how much your mortgage costs over the long term.

1. Interest rate
The interest rate is the percentage the bank will charge you for borrowing the money. It's the cost of your loan (there may also be some recurring fees, but the bank must disclose those to you in the form of an APR -- the annual percentage rate).

The calculations for how much principal and interest you are paying over time can be pretty confusing. Thankfully, the Internet has mortgage calculators for that. I like this one, because it gives you a clear picture of your total interest paid over time as well as a helpful table to see how much of your cash goes to principal and how much to interest on a yearly or even monthly basis.

As an example, if you borrowed $100,000 at a 5% interest rate, and then paid it backed monthly over a 30-year term, you would pay the bank a total of $93,256 in interest over that 30-year period.

At the beginning of your loan, you pay more interest than later in your loan. The reason is that your loan balance is going down over time with each payment. In the preceding example, you will pay $4,966 in interest in the first year of your loan, compared with just $171 in the final, 30th year of your loan. 

Interest is the bank's incentive for doing business with you -- it's how the bank makes a profit. Therefore, just like you would shop around to get the best deal on your new TV, you should also shop around to get the best interest rate possible. Changing our example slightly from an interest rate of 5% to 4% would save you more than $20,000 over the course of your loan.

Put another way, negotiating a lower rate from 5% to 4% in our example makes your loan 22.9% cheaper over the full life of the loan. That's huge!

2. Discount points
Most banks offer you the opportunity to purchase "discount points." Discount points are a bit complicated at first, leading many first-time homebuyers to avoid them and miss out on big potential savings.

Money Roll Flickr Images Money
Image source: Images Money.

Discount points are, in essence, prepaid interest on your loan. You pay a certain amount upfront in exchange for a lower interest rate on your loan over time. Generally speaking, one point costs 1% of your total loan amount and will lower your interest rate somewhere between 0.125% and 0.25%.

It's important to remember here that the discount point system varies from borrower to borrower. The specific numbers used here work fine in general terms, but your bank may offer you slight variations depending on your specific situation.

In the example from earlier, one point would cost $1,000 (1% of $100,000) and would lower your rate from 5% to 4.875%. Buying two points could reduce your rate to 4.75%.

Banks like selling discount points because it increases their income today. The benefit to the borrower is long term -- the breakeven point for purchasing points is usually several years into the future. Therefore, if you plan to own the home for only a few years, buying points may not make sense. The key is to take the time to do the math.

In our example, buying two points for $2,000 wouldn't benefit the borrower until year nine! So in that case, if you plan to live the home for nine years or longer, buying those two points make sense. Otherwise, it would be in your benefit to pay the slightly higher interest rate.

3. Origination fees
The bank incurs costs when it approves and books your loan. Unfortunately for the borrower, the bank passes on those charges in the form of fees.

The bank will charge a percentage fee of your loan amount that goes directly to the bank -- typically this fee is between 0.125% and 1%, but it can run higher in certain situations. Origination fees additionally include charges for an appraisal, documentation fees, filing fees, lawyer fees, and other miscellaneous expenses. 

The bank is required to give you a "good faith" estimate of those charges early in the application process so you will know what to expect. The exact figures may change slightly, but in general these estimates are typically accurate.

Depending on your loan amount, expect to pay anywhere from a couple of thousand to several thousand dollars.

4. Loan term
The loan term is the length of time it will take you, through your regular monthly payments, to pay back the loan.

In the U.S., the standard loan term is 30 years, or 360 monthly payments. A shorter loan term will increase your monthly payment, but it will allow you to pay off your loan more quickly. By paying off your loan more quickly, you'll also pay less total interest than you would over a longer time period.

Piggy Bank Dollar Images Money Flickr

Image source: Images Money

Further, because shorter-termed loans are paid off more quickly, they're less risky for banks. Therefore, you can oftentimes negotiate a lower interest rate with a 15- or 20-year term than you could with a 30-year term. So the benefits are really twofold: lower costs because the loan is paid off more quickly, and a lower interest rate that further saves you money.

That said, make sure you can comfortably pay the monthly payments at the shorter term; they will be considerably higher.

In the $100,000 loan example we've been using at a 5% interest rate, changing the loan term from 30 years to 15 years increases the monthly payment from $537 to $791. That's a 47% increase.

The benefit is that the total interest paid on the loan decreases the total interest cost 54% to just over $42,000.

Foolish conclusion
Now that you're armed with a rock-solid understanding of these four critical banking terms for first-time homebuyers, you can go forth into your local bank or credit union and get your loan.

Remember to shop around, though, to get the best interest rate and lowest origination fees you can find. Then you can do your own homework to determine whether discount points or shortening your loan term make sense to save you thousands on your mortgage!

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