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What Is a Home Loan and How Does It Work?

In the fourth quarter of 2021, the US homeownership rate stood at 65.5%. That represents an increase of 0.1% from the previous quarter.

Then, in January 2022, sales of existing homes grew further in all regions across the country. The start of the year marked a 6.7% increase from the previous month’s sales.

All those figures indicate that homeownership is still vital to the American dream. And if that goes for you, too, then know that a home loan can turn that into a reality.

So, what is a home loan, and how can it help you become a homeowner? How does it work, and why would you want to apply for one?

If all those questions are running through your mind, worry not, as we’re here to answer them. So, keep reading, as what you learn in this guide may help during your homeownership journey.

What Is a Home Loan?

Also known as a mortgage or housing loan, a home loan is a loan used to finance the purchase of a home. It allows a home buyer to buy a residential property without paying for it in one go. Instead, a lender, usually a bank, provides the funds to pay the house seller.

How Do Home Loans Work?

When you take out a home loan, the lender “lends” or lets you borrow a specific amount of money to buy the home you want. That amount is what you refer to as the loan principal.

You, as the borrower, then agree to pay back what you borrowed with interest. In most cases, you need to make your mortgage payments every month.

How much you pay every month depends on the principal, interest rate, and loan term. The term refers to the length of the time your contract with the borrower stands. For example, it can be a 30-year term, which means that you have 30 years, or 360 months, to pay back what you owe, plus interest.

Suppose your total amount due is $350,000, including interest and other fees. The lender then spreads your payments over 360 months. In this scenario, your monthly repayments for the next 30 years should be $972.22 ($350,000 / 360 months).

While you haven’t fully paid off your home loan yet, the lender retains rights over the property. Thus, if you fail to repay your mortgage, the lender can seize the house and sell it to recoup its losses. However, that process doesn’t usually start until after 120 days of non-payment.

Once you’ve completed all your loan payments, though, the lien attached to your home goes away. At that point, you’ve already become a mortgage-free homeowner.

What Are Some Home Loan Benefits?

The median home price in January 2022 reached a staggering $350,300. That’s a 15.4% increase from the median price in January 2021.

If it weren’t for mortgage lenders, such high prices would be unaffordable to home buyers.

Thus, the number one benefit of a home loan is that it makes homeownership easier. After all, not everyone has the means to shell out hundreds of thousands of dollars in one go. So, thanks to mortgage loans, you, as a first time home buyer, can transition to homeownership.

Then, once you become a homeowner, part of your loan payments go toward building equity. That’s the value of the interest you’ve already invested in your house. It’s the difference between what your home is worth and what you still owe your mortgage lender.

For example, suppose that in a few years, your home will be worth $300,000 and that you’d only owe $100,000 on it by then. In that case, you’ll have $200,000 of equity in your home, which you can then use as a security for other loans.

What About the Drawbacks?

The primary disadvantage of taking out a home loan is paying much more than the amount you borrow. After all, you also need to pay interest aside from the principal loan amount. You can think of the interest as the lender’s service fee for lending you a sizeable amount.

Another thing is that not everyone who applies for a mortgage gets approved. A borrower’s eligibility depends on many factors, such as creditworthiness and income. For example, you might qualify if you have a high credit score, a clean credit history, and a stable job.

In addition, you could be in debt for a long time since a mortgage involves a massive amount of money. How long depends on the term you choose. One of the most common is 30 years, but you can get something as short as five years.

Lastly, there’s the risk that your home could be in jeopardy if you can’t keep up with your loan payments. In that case, you can face foreclosure.

Foreclosures don’t often happen, though; indeed, in 2021, the rate was only 0.11%. That’s an all-time record-low in the US.

Still, if you can’t pay your dues, your lender can repossess your home to clear off your debts.

Are Home Loans Worth It?

Home loans are worth it for most people who dream of becoming homeowners. That’s especially true for low- to moderate-income families with little to no savings. Even if they have savings, the amount is usually far lower than the price of most homes for sale.

If you decide to take out a home loan, it’s best to make the highest down payment you can afford. That can help you borrow much less from the mortgage lender. Taking out a smaller loan, in turn, can make it easier for you to pay it back, thus, reducing your risks of non-repayment.

If you have a less-than-stellar credit score, it’s best to improve it before applying for a home loan. Even a tiny increase in your score can help you snag a lower interest rate. The lower your interest rate, the less you then have to pay toward interest alone.

Compare Your Home Loan Options Today

And there you have it, the guide that answers your question, “what is a home loan?” Now you know that it’s a financing service that can help fund your dreams of homeownership. However, it’s expensive, so compare your options and offers before applying for one.

Don’t forget to review your finances to ensure you can afford a mortgage before you take one out.

Did you like this article? If so, we have more home and lifestyle guides to share, so check out our other blog posts now!

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