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3 Things Every Homebuyer Should Understand

By Jeremy Bowman - May 21, 2016 at 7:20AM

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If you're considering buying a home, it will help to familiarize yourself with these concepts.

If you're like most Americans, then taking on a mortgage is the biggest financial decision you'll make in your life. Taking out a six-figure (or more) loan to be repaid over as many 30 years is a huge commitment that should be seriously considered and understood beforehand. Yet the benefits of homeownership -- such as the possibility of capital gains on the sale of your property, the prospect of eventually living rent- and mortgage-free, and having full control of your home -- mean that most Americans prefer to own rather than rent.

More than 60% of Americans own their homes today, and, according to estimates, as many 90% will own one at some point in their lives.

Let's take a look at three concepts that homebuyers, especially first-timers, should know about mortgages and owning a home.

1. Adjustable-rate vs. fixed-rate mortgages

Homebuyers have two primary options when choosing a mortgage. They can get a fixed-rate or an adjustable-rate loan, also called an ARM (adjustable-rate mortgage). As the names imply, the interest rate on a fixed-rate mortgage will remain the same for the duration of the payback period, while an adjustable-rate mortgage is generally fixed for a certain period like five or seven years and then floats according to a benchmark index rate.

The initial rate on an ARM is generally lower than that of a fixed-rate mortgage. While the lower interest rate on an ARM may make it a tempting option, it's important for homebuyers to understand how the rate will change once the fixed term ends. The most popular adjustable-rate mortgage is the 5/1 ARM -- the "5" representing the number of years the rate is fixed and the "1" meaning the rate changes every year subsequently. The adjustable rates on most ARMs are tied to one of three indexes -- the maturity yield on a one-year treasury bill, the 11th District Cost of Funds Index (COFI), or the London Interbank Offered Rate (LIBOR). The floating rate is then determined by adding an agreed-upon number of percentage points, or margin, to the index.

The adjustable rate can fall below the fixed rate, but with mortgage rates at historic lows, a fixed-rate loan may be a better bet, since index rates are likely to rise over the next few years. Still, for those expecting to sell their homes sooner rather than later, an ARM may be the better choice.

2. The amortization schedule

The best way to understand your mortgage payments is through the amortization schedule. Each monthly payment you make will go partly to paying off principal and partly to interest. While your monthly payment is generally fixed, the amount devoted to each portion constantly changes. As you pay off your mortgage, more of your payment will go to the principal rather than interest. Online calculators are available to make amortization schedules according to potential loan terms, or if you prefer to be hands-on, you can design your own in Excel. The amortization schedule will show you the full amount you can expect to pay over the life of the loan, and allows you to compare a fixed-rate mortgage against different outcomes of an adjustable-rate one, or to see how increased payments in the beginning of the loan period will have an outsize benefit in lowering the total payment. Many borrowers are surprised to learn that most of their initial payments go to paying off interest rather than the principal. Accelerating payments early on can significantly reduce the payback period.

3. The mortgage interest tax deduction

The mortgage interest tax deduction can be the biggest benefit to owning a home for some Americans. According to the IRS, home mortgage interest can be deducted from federal income tax on an individual's main home or second home, for a mortgage worth up to $1 million.

As of 2013, the average mortgage deduction claimed was $10,640, but results vary widely depending on the state. In California, it was $15,755, compared to just $7,177 in Iowa. The actual savings from the deduction is estimated to be much less, under $1,000, because Americans must forego the standard deduction in order to claim mortgage interest, and because the country's median home value is only around $200,000. For wealthier Americans, however, the mortgage interest deduction is much more beneficial. For example, a person paying $40,000 in annual mortgage interest with a marginal tax rate of 35% would save $14,000 with the deduction. Additionally, some states allow you to deduct mortgage interest from state income taxes, furthering benefits for those who claim.

While the mortgage interest deduction may not be worth it for all homebuyers, its benefits should be taken into consideration as you consider your purchase.

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