3 Essential Mortgage Terms You Need to Know When Shopping for a Home Loan

When buying a house, you will want to make sure you get the right home loan if you must borrow to help you with your purchase. There are a few key mortgage terms you need to know in order to get the best financing for your situation.

Here's what they are.

1. Fixed vs. adjustable-rate mortgage

First and foremost, you must understand the terms fixed-rate mortgage and adjustable-rate mortgage (ARM). And you must know the difference between them so you can decide which type of mortgage loan is right for you.

A fixed-rate mortgage is a home loan that has a set interest rate, so the rate you pay to borrow won't change the entire time. An adjustable-rate mortgage has a rate tied to a financial index that can adjust or change on a set schedule. Usually, an ARM will have a starting rate fixed for a few years, such as three, five, or seven years. After that time, rates could adjust periodically, often once per year.

While an ARM may seem attractive if it has a lower starting interest rate than a fixed-rate loan, you could risk your payments increasing and could risk your total loan costs going up by tens of thousands of dollars if your rate adjusts upward. So, be sure you understand what type of loan you're being offered and whether you face a risk of costs going up or not.

2. Private mortgage insurance

Private mortgage insurance is another important mortgage term to know. It's also known as PMI, and it's a type of insurance lenders mandate home buyers purchase if those buyers make less than a 20% down payment.

PMI usually costs anywhere between 0.1% to 2.00% of your loan amount per year, depending on the specifics of your loan. If you are mandated to buy it, you typically have to pay the costs as part of your monthly payment. So, if you borrowed $300,000 and your PMI costs were 2.00%, you'd owe $6,000 annually for private mortgage insurance and your monthly mortgage payment would be about $500 higher.

PMI doesn't protect you even though you pay for it. The insurance makes sure your lender doesn't experience uncompensated losses if they have to foreclose on a home you bought with a low down payment.

3. Points

You should also absolutely make sure you know and understand the term "mortgage points," when you borrow to buy a home, as you may need to make a decision about whether to buy points.

Mortgage points -- or discount points as they are also called -- give you a chance to essentially prepay interest and buy down your interest rate. Typically, a point costs 1.00% of your mortgage and it reduces your interest rate by 0.25%.

So if your interest rate was going to be 4.50% and you bought 1 point, your rate would come down to 4.25%. If you were taking out a $200,000 loan, you'd pay $2,000 to buy down your rate and your monthly payment would go from about $1,013 per month to about $984.00. You'd also save around $10,616 in interest over the life of the loan due to your lower rate.

Buying points makes sense if you plan to remain in your home for a long period of time. You'll need to stay there for a while for the reduced monthly payments to make up for the initial money spent to buy down your rate. If you're saving about $29 a month, it would take you 69 months or 5.75 years to make up for the initial $2,000 you spent to buy down your loan rate ($2,000 divided by $29).

By making sure you understand these essential mortgage terms, you can help guarantee you get the best home loan to meet your needs. You can make an informed choice about what kind of interest rate to choose, whether to buy with a low down payment even though that means paying PMI, and whether paying points is right for you.