As a parent, you’re proud of your financially-savvy kid. You’ve already taught them all about saving and loans. Now they’re ready to learn one of the milestones of building wealth: buying a house. In other words, it’s time to dive into the world of mortgages.
Of course, just because your child’s ready for their next financial lesson doesn’t mean you are. Wondering where to start? Don’t worry; we’re here to help! In this post, we’ll cover all the basics you and your kiddo need to master to understand how home loans work. Very well then, let’s get started!
How to Explain What a Mortgage Is to Your Kids
When talking to kids, the best thing to do is to keep things simple. And the best way to do this is by using examples. This allows you to set the foundation with simple concepts and then add more details as needed.
To get the ball rolling, you could tell your inquisitive kid that a mortgage is simply a kind of loan that adults use to buy a house. That’s it.
Easy peasy? Then, you can add in the details as needed. For instance, you can share that the bank gives the loan. And that this loan includes some interest – as is expected of any loan. You can also let them know that the duration of your typical mortgage is 15 or 30 years.
Is your kid ready for more info? You may want to mention that there’s a downpayment to initiate the process and that there are closing costs as well. Then you can continue by describing the different kinds of loans.
Sure, you get the idea, but you’re no real estate mogul yourself. Fear not! If you need to brush up on your mortgage knowledge, just keep reading, and we’ll tell you all you need to know.
How to Explain How a Mortgage Works to Your Kids
Following our own advice, we’ll start slow and then add the necessary details.
Here’s the simple definition: A mortgage is a loan the bank gives to an individual to buy a home.
For example, John wants to buy a house that costs $250,000. He approaches a bank, and because he has good credit, he qualifies for a mortgage.
Since the bank is taking a risk by financing John’s house, he is asked to give a downpayment of 20%. So the mortgage is the money the bank lends John to pay for the remaining 80% of the total cost of the house. In this case, that amount is $200,000.
When negotiating the details of the loan, the bank and John agreed to a 30-year fixed-rate mortgage. This means that John will pay the same amount every month over thirty years.
Now, as we said, that’s not the only deal that John could get from the bank. Let’s explore different types of mortgages and what kind of customer John would have to be to qualify for those options.
Types of Mortgages
Mortgages depend on three main factors:
- The type of property that you’re buying (location and price)
- Who is backing the loan (for example, some government agency)
- The borrower’s credit history (credit score, income, and assets)
Here are five examples of different types of loans with some of their characteristics:
Conventional Loan
This is the easiest to explain and most common type of home loan. Here are the main points to explain:
- There is a downpayment, typically of 20% of the value of the home
- The duration of the loan is usually 30 years
- The rate is fixed, and it will depend on the borrower’s credit score
Jumbo Loan
Next in our list is the Jumbo loan. Here’s an easy way to remember these: when you want to buy a jumbo-sized home, you need a jumbo loan. The main concepts to cover are:
- It’s the type of mortgage you take out to buy more expensive properties
- When buying a home in an expensive market (like Los Angeles, San Francisco, and Hawai’i) you may require a jumbo loan, even when buying a regular house and not a super mansion.
- These loans are not available to everyone. They are restricted to borrowers with a very high credit score, proven high income, and assets.
Government-Insured Loan
The third kind of loan you want to cover are mortgages backed by the government. If you qualify, these are a great way to get your first home. They typically require:
- Less income
- No assets
- Smaller down payments.
Supported by three federal agencies: Federal House Administration (FHA), US Department of Agriculture (USDA), and Veteran Affairs (VA).
FHA loans can be a good option for credit scores on the lower side or those looking for a lower down payment. It’s important to point out that, despite these loans can end up being a bit more expensive because they require two mortgage insurance premiums.
USDA loans are one of the most attractive because some don’t even require a down payment! However, they are only for USDA-approved rural areas, so the location of the property is limited.
Finally, VA-backed loans are for US Veterans and active service members. They are low interest, have no minimum down payment, and no credit score requirement. This is a great option if you are a service member!
Fixed-Rate Mortgage
This kind of mortgage keeps the interest rate fixed for every payment throughout the duration of the loan. Surely, your smart kiddo will immediately see the benefit in that. Imagine paying the same interest for 30 years!
Important details to cover include:
- These mortgages are usually for 15 or 30 years.
- They let buyers know exactly how much their monthly mortgage payment will be
- These loans usually have higher interest rates than adjustable-rate mortgages
Adjustable-Rate Mortgage
The main characteristic of adjustable-rate mortgages is that the interest rate changes with market conditions. What this means is that:
- Typically, the first few years of these loans are set at a fixed interest rate
- After the initial period, your rate increases every six months or so
- Some real estate investors like these loans because they buy the home with the intention of selling it before the fixed rate period is up
The Mortgage Process
Your child’s next question might be, “So, how do you actually get a mortgage?”
Well, the process itself might be slightly different depending on your specific needs. But these are the basic steps to getting a mortgage, explained in kid-friendly terms:
Step 1. Apply for Loan Pre-Approval
Applying for a mortgage requires a little shopping around. You need to submit applications with different banks to see what they offer and what kind of loan you qualify for.
The mortgage specialist at the bank will try to get you pre-approved. What that means is that they will ask for information about your employment, your income, your savings, if you own any other properties, your credit history, and how much down payment you can afford. That’s the basic information they will use to come up with a deal for you.
Step 2. Receive Approval Letter
If everything goes according to the plan and you are approved for a mortgage, you’ll receive a letter from the lender stating the terms of your loan. This includes the amount you can borrow, how many years you have to pay the bank back, and the interest rate.
Step 3. Make an Offer on a Property
This is the most fun part! Now that you’ve been pre-approved, you get to look at homes to find the best property you can buy with the amount the bank has agreed to lend you.
At this point, you’ll contact a real estate agent to help you find properties available in your area and within your price range. Once you find a house you like, you tell the real estate agent to make an offer on your behalf. Get ready to compete against other buyers, though. Most likely, you’re not the only person bidding for the same property! And remember that it’s OK to negotiate at this stage.
Step 4. Verify the Details
If the property owner accepts your offer, the bank will verify that all the documents you submitted for approval are still valid. They want to make sure you still have your savings and your job!
The bank will also want to confirm that the property is in the state that the seller says it is. If there is any problem with the property, this is the time for the seller to disclose it.
If everything looks OK, you’ll receive a Closing Disclosure document. This paperwork outlines all the details of the loan. Take your time to read all the details here, including:
- The amount of the loan
- The monthly payments
- The duration of the loan
- The interest rate
- The down payment
Step 5. Close on the Property
This is a meeting in which you bring the check for the down payment and the closing costs, and your ID. The purpose of the meeting is for you to sign the loan. There’s no going back after that, so be sure to ask all remaining questions at this time!
Kids’ Mortgage FAQs
Here’s a list of the most basic questions that your kid might ask you when you have that conversation about mortgages:
What is a Down Payment?
A down payment is a percentage of the home cost you pay out of pocket. It’s a requirement of most mortgages. Although the actual down payment amount depends on your type of mortgage, it’s usually around 20% of the total home value.
How Does a Down Payment Work?
Your down payment is the first payment you make when you close the transaction, and it’s not part of your loan. For instance, if you are buying a $250,000 home, a down payment of 20% (which is common) is $50,000. Your mortgage will be for 80% of the value of the home, in this case $200,000, plus interest and closing costs.
How Long is a Mortgage For?
This time period is arranged between you and the lender, which is usually a bank. The typical duration is 30 years, but it can be as short as 15 or seven years. If your loan period is shorter, you’ll pay less interest, but your monthly mortgage payments will be higher.
What Are Mortgage Payments?
These are the monthly payments you have to make until the whole debt is paid off. They include payments to the principal, interests, and sometimes the closing costs.
Important Mortgage Definitions – And How to Explain Them to Kids
As usual, when explaining new terms to kids, try to keep it simple and to the point. You can always add more nuance and detail as they show interest or gain a better grasp of the topic.
Here are the five basic terms you want to begin with:
- Mortgage: A loan that you take out to buy a home.
- Lender: The bank or financial institution that lets you borrow the money to buy the house.
- Principal: The original amount that you borrow and agree to pay back, not including interest.
- Interest: The extra amount of money that the lender charges you for letting you borrow the money to buy a home.
- Collateral: Something of great value that the bank will own if you don’t pay back your loan. In the case of a mortgage, the home itself is the collateral.
Additional Resources
Because mortgages are more of an advanced financial topic, we’ve rounded up our favorite resources to help you learn more about them and share your knowledge with your kids.
One of our favorite podcasts on real estate is Bigger Pockets. While its typical listeners are not kids, you might enjoy listening with your children. The language’s clear and to the point, so don’t hesitate to play it on your next family road trip!
A book that presents the concepts of mortgages in easy-to-understand language is Mortgages for Dummies. Here you will find definitions and applications of all the concepts we reviewed here, and then some more. A great resource to help you explain how mortgages work to your kids!
If you’ve taken your mortgage education to the next level and want to get into the mathematical side of things, give this Simple Mortgage Calculator a try. It’s a super fun way for you and your kids to learn by doing! Plus, it really helps grasp the concepts of principal, mortgage rate, and years to pay, and you can actually see how they affect one another.
Is Your Child a Future Real Estate Investor?
If they’re curious about mortgages at an early age, they might be! They could also grow up to be a mortgage specialist or a realtor. It’s probably too early to tell.
But, whether your kid becomes a banking expert or a real estate developer, the reality is that buying a home is a milestone in anyone’s financial life. And with a sound financial education, your child will feel empowered to make better financial decisions as an adult.
