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How Does a Home Loan Work?

For most people, purchasing a home is the biggest financial decision they will ever make. And with homes often costing hundreds of thousands -- and in some cases millions -- of dollars, most people can't afford to pay cash for the entire property up front. As a result, they need to take out a home loan (i.e. borrow) from a bank, credit union, or specialized mortgage lender for borrowers with lower budgets (such as the USDA, FHA, or VA).

There are several types of home loans available on the market, but each home loan is typically defined by four main factors:

1. The Principal, or the amount of money you're borrowing. This amount is typically the purchase price minus your down payment, minus closing costs and other related fees.
2. The Term, or how long you have to repay the entire loan. The term of a home loan can range between five to 30 years.
3. The Interest Rate, or the annual amount you need to pay the lender to borrow the money, shown as a percentage of the current principal balance.
4. The Repayment Frequency, or how often you make payments. Borrowers usually pay back their mortgages on a monthly or bi-weekly basis.

Home loans are designed to suit a variety of borrower needs and budgets, and thus can come in several different forms. Here are three of the most common types of home loans.

The most common type of home loan is the fixed-rate mortgage, which requires a borrower to repay the principal over a "fixed term" (an unchanging length of time) with a "fixed rate" (an interest rate that never fluctuates over that time period). Borrowers looking for steady and predictable mortgage payments often take out 30-, 15-, or 10-year fixed-rate mortgages. Generally, the shorter the term of the fixed-rate mortgage, the lower the interest rate the borrower can get.

Unlike a fixed-rate mortgage with its static interest rates, adjustable-rate mortgages (ARMs) have variable interest rates that can move up or down over the course of the loan. To entice buyers with smaller budgets, lenders frequently offer one-year ARMs with a more affordable introductory interest rate for the first year (often with interest rates that are significantly lower than a comparable fixed-rate mortgage). The interest rate can then increase in the following years if market interest rates go up. As you might imagine, this can become costly for a borrower if the Federal Reserve raises interest rates over time, as the borrower's monthly ARM payments would also increase.

A cross between a fixed-rate mortgage and an ARM, the hybrid mortgage offers a fixed rate for a set term (usually fewer than 10 years) and then allows the interest rate to adjust up or down much like an ARM loan would. For example, a 5/1 hybrid mortgage, or 5/1 ARM, offers a borrower a fixed interest rate for 5 years before switching to an adjustable rate (with the rate adjusting once per year) for the remainder of the home loan's term. As the "goldilocks" option among home loans, hybrid mortgages typically offer interest rates that are lower than fixed-rate mortgages and higher than ARMs.

Why Does a Home Loan Matter?

Home loans make buying a home a reality for people who want to own property. Getting a home loan often takes a substantial investment (closing costs, down payment, time to apply), but these upfront costs can be recouped by a homeowner over time if their property value appreciates. Given the upside potential, it's little wonder why homeownership rates in the United States have historically averaged more than 60% since the 1950s.