Home Buying in the US
Buying a home is typically the largest single purchase an American makes. The median US home price in 2024 is roughly $420,000, financed mostly with borrowed money over 15 to 30 years. Getting the mortgage type, down payment, and closing costs wrong doesn't just cost a little extra — it can cost tens of thousands of dollars over the life of the loan.
Learning Objectives
By the end of this topic, you should be able to:
- Compare a fixed-rate mortgage and an adjustable-rate mortgage (ARM) and identify which buyer each suits
- Explain what PMI is, when it's required, and how to remove it
- Describe what happens during mortgage pre-approval and why it matters before house-hunting
- List the major categories of closing costs and estimate them as a percentage of the loan
- Calculate the true monthly cost of homeownership beyond principal and interest
- Apply the 5–7 year rule to decide whether renting or buying makes more financial sense
Quick Answer
A mortgage is a loan secured by the home itself — miss enough payments and the lender can foreclose. The two core types are fixed-rate mortgages, where the interest rate never changes (30-year and 15-year are most common), and adjustable-rate mortgages (ARMs), which offer a lower rate for an initial period before adjusting with the market. Putting down less than 20% usually triggers private mortgage insurance (PMI), an extra monthly cost that protects the lender, not you. Before house-hunting, get pre-approved so you know your budget and can make a credible offer. Beyond the down payment, budget 2–5% of the loan amount for closing costs — fees for the appraisal, title insurance, inspection, and loan origination, due in cash at signing.
How Mortgages Work
A mortgage is a loan secured by real property. If you stop paying, the lender can foreclose — take the property and sell it to recover the loan balance. Mortgages amortize: each monthly payment is split between interest and principal, with interest front-loaded early in the loan and principal front-loaded near the end.
Fixed-Rate vs. Adjustable-Rate Mortgages (ARMs)
The single biggest decision a borrower makes is choosing between a fixed rate and an adjustable rate.
Fixed-rate mortgage: The interest rate is locked for the entire loan term — 15 or 30 years. Your principal-and-interest payment never changes, no matter what happens to market rates.
- 30-year fixed: Lower monthly payment, higher total interest paid over the life of the loan. Most common choice for stability.
- 15-year fixed: Higher monthly payment, but a meaningfully lower interest rate and roughly half the total interest paid.
Example: A $350,000 loan at 7% for 30 years costs $2,329/month in principal and interest, totaling about $488,000 in interest over 30 years. The same loan at 6.3% for 15 years costs $3,014/month but totals only about $192,500 in interest - a savings of nearly $300,000, at the cost of a $685 higher monthly payment.
Adjustable-rate mortgage (ARM): The rate is fixed for an initial period (commonly 5, 7, or 10 years), then adjusts periodically based on a market index plus a margin. A "5/1 ARM" means the rate is fixed for 5 years, then adjusts once per year afterward.
- ARMs typically start with a rate 0.5–1% lower than a comparable fixed rate.
- After the fixed period, the rate can rise (or fall) based on market conditions, subject to caps that limit how much it can move per adjustment and over the life of the loan.
Why it matters: An ARM makes sense if you're confident you'll sell or refinance before the fixed period ends — you capture the lower rate without ever facing an adjustment. It's risky if you end up staying longer than planned and rates have risen, since your payment can jump significantly.
Common misunderstanding: Students often assume an ARM's rate resets to whatever the current market rate is. In reality, it resets to the index (e.g., SOFR) plus a fixed margin set at origination, and annual/lifetime caps limit the size of any single jump — but the payment can still rise by hundreds of dollars a month.
Other Loan Types
| Type | Down Payment | Best For |
|---|---|---|
| Conventional | 3–20%; PMI if under 20% | Buyers with 620+ credit and steady income |
| FHA loan | 3.5% minimum | First-time buyers with limited savings or lower credit (580+) |
| VA loan | 0% down, no PMI | Veterans and active-duty military |
| USDA loan | 0% down | Buyers in USDA-eligible rural/suburban areas |
Key Mortgage Terms in Practice
| Term | Meaning |
|---|---|
| Interest rate vs. APR | The interest rate applies only to the loan balance; APR bundles in lender fees and points, giving a truer cost for comparing offers |
| Amortization | The schedule by which each payment is split between interest and principal over the loan term |
| Points | An upfront fee to buy down the rate; 1 point = 1% of the loan amount, typically lowering the rate by about 0.25% |
| Escrow | An account the lender holds to pay property taxes and homeowner's insurance on your behalf, funded through your monthly payment |
The Down Payment and PMI
The down payment is the cash portion of the purchase price you pay upfront; the mortgage covers the rest.
| Down Payment | Effect |
|---|---|
| Under 3% | Only available through FHA/VA/USDA programs |
| 3–19% | Conventional loan available, but PMI required |
| 20% or more | No PMI; strongest offer; best rates |
Private Mortgage Insurance (PMI) protects the lender, not you, in case you default. It typically costs 0.5–1.5% of the loan amount per year, added to your monthly payment. On a $320,000 loan at 1% PMI, that's $3,200/year, or about $267/month — money that buys you no equity or benefit.
Removing PMI: Once your loan balance drops to 80% of the home's original value (through payments or appreciation), you can request PMI removal. It's automatically canceled at 78% loan-to-value under federal law (the Homeowners Protection Act).
Example: On a $400,000 home, a 20% down payment is $80,000 — often the single biggest barrier to buying. Down payment assistance programs exist to help:
- State Housing Finance Agency programs: Grants or low-interest second loans for down payment assistance
- FHA loans: 3.5% down with a 580+ credit score ($14,000 on a $400,000 home)
- Fannie Mae HomeReady / Freddie Mac Home Possible: 3% down for buyers under local income limits
Getting Pre-Approved
Pre-approval is a lender's conditional commitment to lend you a specific amount, based on a review of your income, debts, assets, and credit. It is different from pre-qualification, which is a rough, unverified estimate.
Why it matters: Sellers and agents treat offers without a pre-approval letter as far less credible — in a competitive market, an offer without one may not even be considered. Pre-approval also tells you your real budget before you fall in love with a house you can't finance.
What lenders check:
- Credit score: 740+ typically gets the best rates; many conventional loans require 620+
- Debt-to-income (DTI) ratio: Total monthly debt payments (including the new mortgage) divided by gross monthly income; most lenders cap this around 43%, though some allow more for strong borrowers
- Income and employment history: Usually 2 years of tax returns and pay stubs
- Assets: Bank statements proving you have the down payment and closing costs available
Example: A borrower earning $8,000/month gross with $600/month in existing debt (car loan, student loans) and a target DTI cap of 43% can afford a total debt payment up to $3,440/month. Subtracting the existing $600 leaves $2,840/month available for a mortgage payment (principal, interest, taxes, insurance).
Pre-approval letters are typically valid for 60–90 days, so timing your pre-approval close to when you start house-hunting matters.
Closing Costs
Closing costs are one-time fees paid at closing, separate from the down payment. They typically run 2–5% of the loan amount.
| Cost | Who Pays | Typical Amount |
|---|---|---|
| Loan origination fee | Buyer | 0.5–1% of loan |
| Appraisal | Buyer | $300-$600 |
| Title insurance | Buyer (lender's policy) + Seller (owner's policy) | $700-$2,000 |
| Home inspection | Buyer | $300-$500 |
| Attorney fee (where required) | Buyer or Seller | $500-$1,500 |
| Property taxes (prepaid to escrow) | Buyer | 2–6 months |
| Homeowner's insurance (first year + escrow) | Buyer | $1,000-$2,500 |
| Recording fees | Buyer | $25-$250 |
Example: On a $400,000 home with 20% down ($80,000), closing costs of 2–4% of the $320,000 loan add $6,400–$12,800. Total cash needed to close: roughly $86,400–$92,800.
Seller concessions: In a buyer's market, you can negotiate for the seller to cover some closing costs — often capped by the loan program at 3–6% of the purchase price.
The True Cost of Homeownership
The mortgage payment is only one line item. Budget for:
| Ongoing Cost | Typical Amount |
|---|---|
| Property taxes | 0.5–2.5% of assessed value/year; varies heavily by state |
| Homeowner's insurance | $1,000-$3,000/year |
| HOA fees (if applicable) | $100-$500+/month |
| Maintenance and repairs | 1–2% of home value/year (~$4,000-$8,000 on a $400k home) |
Example: A $320,000 mortgage at 7% for 30 years costs $2,129/month in principal and interest. Add $500 property tax, $150 insurance, and $250 maintenance, and the real monthly cost is closer to $3,029 — 42% more than the P&I payment alone.
Tax Benefits of Homeownership
- Mortgage interest deduction: Deductible on up to $750,000 of mortgage debt, if you itemize
- Property tax deduction: Capped at $10,000 combined with state and local income taxes (the SALT cap)
- Capital gains exclusion: Exclude up to $250,000 (single) / $500,000 (married) of gain when selling a primary residence you've lived in for 2 of the past 5 years
Since the 2017 Tax Cuts and Jobs Act nearly doubled the standard deduction, most homeowners no longer itemize, so these deductions matter less than commonly assumed — run the numbers before assuming a big tax break.
Key Terms
| Term | Definition | Related Concept |
|---|---|---|
| Mortgage | A loan secured by real property; the lender can foreclose on default | Amortization, foreclosure |
| Fixed-Rate Mortgage | A mortgage where the interest rate never changes over the loan term | 30-year fixed, 15-year fixed |
| Adjustable-Rate Mortgage (ARM) | A mortgage with a fixed initial rate that adjusts periodically afterward | 5/1 ARM, rate caps |
| PMI (Private Mortgage Insurance) | Insurance required on down payments under 20%, protecting the lender | Loan-to-value ratio |
| Pre-Approval | A lender's verified, conditional commitment to lend a specific amount | Debt-to-income ratio |
| Debt-to-Income (DTI) Ratio | Total monthly debt payments divided by gross monthly income | Pre-approval, loan qualification |
| Closing Costs | One-time fees paid at closing, separate from the down payment | Title insurance, origination fee |
| Escrow | An account the lender uses to pay property taxes and insurance on the borrower's behalf | Property taxes, homeowner's insurance |
| Amortization | The process of paying down a loan through scheduled payments split between interest and principal | Fixed-rate mortgage |
| Loan-to-Value (LTV) Ratio | The loan amount divided by the home's value; determines PMI requirement | PMI, down payment |
Common Mistakes
Misconception: An ARM is always riskier and worse than a fixed-rate mortgage. Why it's wrong: This ignores the borrower's actual time horizon. If you plan to sell or refinance before the fixed period ends, an ARM's lower initial rate can save real money with no exposure to a future adjustment. Correct understanding: Choose based on how long you expect to keep the loan. ARMs suit buyers who expect to move or refinance within the fixed period; fixed-rate mortgages suit buyers planning to stay long-term or who want payment certainty.
Misconception: A 20% down payment is required to buy a home. Why it's wrong: Conventional loans allow down payments as low as 3%, and FHA loans allow 3.5%. VA and USDA loans allow 0% down for eligible buyers. 20% is a target that avoids PMI, not a legal minimum. Correct understanding: You can buy with far less than 20% down, but expect to pay PMI (0.5–1.5% of the loan per year) until you reach 20% equity, which raises your effective monthly cost.
Misconception: Closing costs are the only cash you need beyond the down payment, so budgeting stops there. Why it's wrong: Buyers who budget only for the down payment and closing costs are often blindsided by move-in costs, immediate repairs, and the jump in monthly expenses from HOA fees, higher insurance, or property taxes not fully escrowed yet. Correct understanding: Budget for the down payment, closing costs (2–5% of the loan), and a cash cushion of a few thousand dollars for move-in expenses and the first months of ongoing ownership costs.
Comparison and Connections
| Feature | 30-Year Fixed | 15-Year Fixed | 5/1 ARM |
|---|---|---|---|
| Rate | Higher than 15-year fixed | Lowest fixed rate available | Lowest rate for first 5 years |
| Monthly payment | Lowest | Highest | Low initially, may rise after year 5 |
| Total interest paid | Highest | Roughly half of the 30-year total | Depends on rates after adjustment |
| Payment certainty | Full — never changes | Full — never changes | Only for the initial fixed period |
| Best for | Buyers prioritizing cash flow and long-term stability | Buyers who can afford higher payments and want to build equity fast | Buyers planning to sell or refinance within 5–7 years |
Practice Questions
Recall
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What is PMI, and at what loan-to-value ratio can it typically be removed? Answer guidance: PMI is private mortgage insurance, required when the down payment is under 20%; it can be requested for removal at 80% LTV and is automatically canceled at 78% LTV.
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What is the difference between pre-qualification and pre-approval? Answer guidance: Pre-qualification is a rough, unverified estimate; pre-approval is a lender's conditional commitment based on verified income, debt, assets, and credit.
Understanding
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Why does an interest rate alone understate the true cost of a mortgage, and what should you compare instead? Answer guidance: The interest rate excludes lender fees and points. APR bundles these costs into a single annualized rate, giving a more accurate comparison between loan offers.
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Why might a 5/1 ARM be a reasonable choice for some buyers despite the risk of a rate increase? Answer guidance: If the buyer expects to sell or refinance before the fixed period ends, they benefit from the lower initial rate and never experience an adjustment.
Application
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A borrower earns $7,200/month gross, has $400/month in existing debt, and the lender caps DTI at 43%. What is the maximum mortgage payment (including taxes and insurance) they can qualify for? Answer guidance: 43% of $7,200 = $3,096 total allowed debt; subtract $400 existing debt = $2,696/month available for the mortgage payment.
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A $350,000 loan at 7% for 30 years costs about $2,329/month in principal and interest. The same amount at 6.3% for 15 years costs about $3,014/month. If a buyer can comfortably afford $3,000/month, which loan minimizes total interest paid, and what's the trade-off? Answer guidance: The 15-year fixed loan minimizes total interest (roughly $192,500 vs. $488,000 over the loan life) but requires a materially higher monthly payment and less cash flow flexibility.
Analysis
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Compare a buyer putting 5% down with PMI versus a buyer putting 20% down with no PMI on a $350,000 home. What are the financial trade-offs beyond the down payment amount? Answer guidance: The 5%-down buyer keeps $59,500 more cash available upfront but pays PMI (roughly 0.5-1.5% of the loan annually, or about $140–$415/month) until reaching 20% equity, plus a slightly higher loan balance and interest cost. The 20%-down buyer ties up more capital immediately but has a lower monthly payment and no PMI.
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A buyer assumes closing costs and the down payment are the only cash needed to close. On a $380,000 purchase with 10% down, estimate the total cash required and identify what the buyer may be missing. Answer guidance: Down payment = $38,000; closing costs at 2-5% of the $342,000 loan = $6,840-$17,100; total cash needed = roughly $44,840-$55,100. The buyer may still be missing move-in costs, immediate repairs, and a cash cushion for the first months of higher ownership expenses.
FAQ
Should I choose a 15-year or 30-year fixed mortgage? It depends on your monthly cash flow and goals. A 15-year loan builds equity faster and saves a large amount in total interest, but the payment is significantly higher — often several hundred dollars more per month. A common middle path is taking a 30-year loan for payment flexibility, then making extra principal payments when possible to shorten the effective payoff period without being locked into the higher required payment.
Is it ever smart to take an ARM instead of a fixed rate? Yes, if you're confident you'll sell or refinance before the initial fixed period ends — typically 5, 7, or 10 years. The lower initial rate can save meaningful money with no exposure to the adjustment, since you're out of the loan before it happens. The risk is being wrong about your timeline: if you end up staying and rates have risen, your payment can increase substantially.
Can I avoid PMI without putting 20% down? A few options exist: some lenders offer "lender-paid PMI" that's baked into a slightly higher interest rate instead of a separate monthly charge, and VA loans require no PMI regardless of down payment. Piggyback loans (an 80/10/10 structure, for example) are another route, though less common today. Compare the total cost of each option — a higher rate for the life of the loan can cost more than PMI you'll eventually cancel.
How much should I save before starting to house-hunt? Beyond the down payment, plan for closing costs (2–5% of the loan) and keep your emergency fund intact — don't drain it for the down payment. Many financial planners recommend having 3–6 months of expenses saved separately from your home-buying funds, since a home purchase increases your fixed monthly costs and financial risk.
Does getting pre-approved hurt my credit score? A pre-approval typically involves a hard credit inquiry, which can lower your score by a few points temporarily. However, multiple mortgage inquiries within a short window (usually 14–45 days, depending on the scoring model) are counted as a single inquiry for scoring purposes, so shopping multiple lenders for the best rate won't multiply the damage.
Quick Revision
- A mortgage is a loan secured by the home; missed payments can lead to foreclosure
- Fixed-rate mortgages never change; ARMs have a fixed initial period, then adjust periodically
- 30-year fixed = lower payment, more total interest; 15-year fixed = higher payment, roughly half the interest
- PMI is required when the down payment is under 20%; it protects the lender, not the buyer
- PMI can be removed at 80% loan-to-value and is automatically canceled at 78%
- Pre-approval is a verified lender commitment; pre-qualification is just an estimate
- Lenders typically cap debt-to-income (DTI) around 43% for mortgage qualification
- Closing costs run 2–5% of the loan amount and are paid in cash separately from the down payment
- APR includes fees and points, making it a better comparison tool than the bare interest rate
- Budget for property taxes, insurance, HOA fees, and 1–2% of home value/year in maintenance beyond principal and interest
- The mortgage interest deduction and SALT cap ($10,000) only matter if you itemize, which most homeowners no longer do post-2017 tax law
Related Topics
Prerequisites: Budgeting and building an emergency fund, understanding credit scores and debt-to-income ratios, basic familiarity with loans and interest
Related Topics: Banking and Credit (credit scores that determine mortgage rates), Taxes (mortgage interest deduction, SALT cap, capital gains exclusion), Insurance (homeowner's insurance requirements)
Next Topics: Investing (balancing extra mortgage payments against investment returns), Retirement Accounts (how a mortgage payment fits into long-term financial planning), Estate Planning (transferring or including home equity in an estate)