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Taking out a mortgage is the biggest financial obligation most of us will ever assume. So it’s essential to understand what you’re signing on for when you borrow money to buy or build a house.
- A mortgage is a loan — typically a long-term one — that can be used to purchase a new-build home or buy an existing property from the current owner.
What is a mortgage?
A mortgage is a loan from a bank or other financial institution that helps a borrower purchase a home. The collateral for the mortgage is the home itself. That means if the borrower doesn’t make monthly payments to the lender and defaults on the loan, the lender can sell the home and recoup its money.
A mortgage loan is usually long-term debt taken out for 30, 20 or 15 years. Over this time (known as the loan’s “term”), you’ll repay both the amount you borrowed as well as the interest charged for the loan.
You’ll repay the mortgage at regular intervals, usually in the form of a monthly payment, which typically consists of both principal and interest charges.
“Each month, part of your monthly mortgage payment will go toward paying off that principal, or mortgage balance, and part will go toward interest on the loan,” explains Robert Kirkland, a mortgage industry pro-turned-financial advisor with Preal Haley & Associates in Greenbelt, Maryland. Over time, more of your monthly payment will go toward the loan principal, and less toward the interest.
Mortgage payments may also, at the lender’s insistence, incorporate some other things — namely, your property taxes and homeowners insurance premiums, along with private mortgage insurance (if you make a less-than-standard down payment) and any closing costs you roll into your mortgage instead of paying upfront. (See “What is included in a mortgage payment?” below.)
While you may feel a home is yours, “you don’t technically own the property until your mortgage loan is fully paid,” says Bill Packer, COO of Longbridge Financial in Parsippany, New Jersey. “Typically, you will also sign a promissory note at closing, which is your personal pledge to repay the loan.” The owner is your lender, and if you default on your mortgage loan, the lender can reclaim your property through foreclosure.
How does a mortgage work?
To get a mortgage, you’ll work with a bank, mortgage company or some other sort of home-loan lender. Typically, the procedure begins with you going through a preapproval process to get an idea of how much the lender is willing to give you and the interest rate you’ll pay. This helps you estimate the cost of your loan and a sense of how much home you can afford.
Applying for a mortgage is a thorough process, involving many steps on your end. To start, you’ll need proof of income (through paystubs and previous year’s tax returns), a list of assets (including brokerage statements, if applicable), a list of debts, personal data for credit inquiries, and letters explaining any financial gifts (non-repayable) you receive for the home purchase, such as help with a down payment from family members.
Once you gather your documents, you’ll apply for the mortgage — or technically, for the preapproval for the loan — through the lender’s website or in person with a loan officer. You can also work through a mortgage broker, an independent “matchmaker” that puts lenders and borrowers together. (You don’t formally apply for the mortgage until you actually have an accepted offer on a specific property.)
Types of mortgages
There are several types of mortgages available to borrowers, including conventional fixed-rate mortgages, which are among the most common; adjustable-rate mortgages (ARMs); FHA, VA and USDA loans; jumbo loans; and reverse mortgages.
- Conventional loans – A conventional mortgage is not backed by the government or government agency; instead, it is made and guaranteed through a private-sector lender (bank, credit union, mortgage company).
- Jumbo loans – A jumbo loan exceeds the size limits set by U.S. government agencies and has stricter underwriting guidelines. These loans are sometimes needed for high-priced properties — those well above half a million dollars.
- Government-insured loans – These include VA loans, USDA loans, and FHA loans, and have more relaxed borrower qualifications than many privately-backed mortgages.
- Fixed-rate mortgages – Fixed-rate mortgages have a set interest rate that remains the same for the life of the loan (terms are commonly 30, 20, or 15 years).
- Adjustable-rate mortgages – An adjustable-rate mortgage (ARM) has interest rates that fluctuate, following general interest-rate movements and financial market conditions. Often there’s an initial fixed-rate period for the loan’s first few years, and then the variable rate kicks in for the remainder of the loan term. For example, “in a 5/1 ARM, the ‘5’ stands for an initial five-year period during which the interest rate remains fixed while the ‘1’ indicates that the interest rate is subject to adjustment once per year” thereafter,” Kirkland notes.
What is included in a mortgage payment?
- Principal – the specific amount of money you borrow from a mortgage lender to purchase a home. If you were to buy a $200,000 home, for instance, and take out a loan in the amount of $190,000, then your loan principal is $190,000.
- Interest – interest is what the lender charges you to borrow that money; it’s the “cost” of the loan. Expressed as a percentage, the interest is based on the loan principal.
- Property taxes – your lender typically collects the property taxes associated with the home as part of your monthly mortgage payment. The money is usually held in an escrow account, which the lender will use to pay your property tax bill when the taxes are due.
- Homeowners insurance – homeowners insurance provides you and your lender a level of protection in the event of a disaster, fire or other accident that impacts your property. Often, your lender collects the insurance premiums as part of your monthly mortgage bill, places the money in escrow, and makes the payments to the insurance provider for you when the premiums are due.
- Mortgage insurance – your monthly payment might also include a fee for private mortgage insurance (PMI). For a conventional loan, this type of insurance is required when a buyer makes a down payment of less than 20 percent of the home’s purchase price.
What to look for when comparing mortgage offers
To find the mortgage that fits you best, assess your financial health, including your income, credit history and score, and assets and savings. Spend some time shopping around with different mortgage lenders, as well.
“Some have more stringent guidelines than others,” Kirkland says. “Some lenders might require a 20 percent down payment, while others require as little as 3 percent of the home’s purchase price.”
“Even if you have a preferred lender in mind, go to two or three lenders — or even more — and make sure you’re fully surveying your options,” Packer says. “A tenth of a percent on interest rates may not seem like a lot, but it can translate to thousands of dollars over the life of the loan.”
As a potential homeowner, there are some things you want to consider as you compare loans:
- Interest rate: You may not qualify for the lowest advertised interest rate from every lender. You’ll need a pre-approval letter to get an initial realistic idea of the interest rate you’ll actually pay. You’ll get a final number when your mortgage is officially approved; see if you can lock it in until you actually close on the home. You may be able to lower your interest rate by buying discount points (aka “buying down the rate”); this requires offering more cash up front in exchange for a lower rate.
- Type of rate: Are you being offered a fixed rate or an adjustable rate? If your rate is adjustable your mortgage payment could fluctuate over the life of the loan, including going up substantially depending on the market and economic trends.
- Loan term: This is the loan’s lifespan — how long you have to repay it, basically. Most lenders commonly offer both 15 and 30-year loans; shorter and longer terms are available as well. Generally, the shorter the term, the lower the interest rate. Paying off your home faster with a shorter term saves you thousands on interest, but will require a heftier monthly payment, of course.
- Closing costs: These fees are due when you sign the final paperwork for your new home, and they can vary between lenders — a lot. You may save thousands by reading the fine print and choosing a lender with minimal closing costs or asking the seller to absorb more of the costs. Some loans let you roll closing costs into the mortgage itself, but doing so results in paying more in interest.
- Annual percentage rate (APR): The APR is the loan’s interest rate plus expenses like the closing costs and any points (annualized over the loan’s lifetime). So it gives a truer picture of what your mortgage’s cost actually is, and can be crucial when comparing lenders’ products. One might offer a nominally lower interest rate, for example, but actually have a higher APR than the other.
- Additional fees: Some mortgages may be accompanied by special, often less-than-obvious fees, including pre-payment penalties (which charge you for repaying the debt early) or balloon payments (which require a lump sum payment after a certain period of time instead of steady payments over the life of the loan). Compare your options and consider the worst-case scenario, to make sure you can afford any possible fees down the road.
Important mortgage terminology to know
Amortization describes the process of paying off a loan, such as a mortgage, in installment payments over a period of time. Part of each payment goes toward the principal, or the amount borrowed, while the other portion goes toward interest.
An APR or annual percentage rate reflects the yearly cost of borrowing the money for a mortgage. A broader measure than the interest rate alone, the APR includes the interest rate, discount points and other fees that come with the loan.
“Conforming” refers to a conforming loan, a mortgage eligible to be purchased by Fannie Mae or Freddie Mac, the government-sponsored enterprises (GSEs) integral to the mortgage market in the U.S. These standards include a minimum credit score and maximum debt-to-income (DTI) ratio, loan limit and other requirements. Fannie Mae and Freddie Mac buy loans from mortgage lenders to create mortgage-backed securities (MBS) for the secondary mortgage market.
A “non-conforming” loan or mortgage doesn’t meet (or “conform to”) the requirements that allow it to be purchased by Fannie Mae or Freddie Mac. One example of a non-conforming loan is a jumbo loan.
The down payment is the amount of a home’s purchase price a homebuyer pays upfront. Buyers typically put down a percentage of the home’s value as the down payment, then borrow the rest in the form of a mortgage. A larger down payment can help improve a borrower’s chances of getting a lower interest rate. Different kinds of mortgages have varying minimum down payments.
An escrow account holds the portion of a borrower’s monthly mortgage payment that covers homeowners insurance premiums and property taxes. Escrow accounts also hold the earnest money the buyer deposits between the time their offer has been accepted and the closing.
A mortgage servicer is the company that handles your mortgage statements and all day-to-day tasks related to managing your loan after it closes. For example, the servicer collects your payments and, if you have an escrow account, ensures that your taxes and insurance are paid on time.
Private mortgage insurance (PMI) is a form of insurance taken out by the lender but typically paid for by you, the borrower, when your loan-to-value (LTV) ratio is greater than 80 percent (meaning you put down less than 20 percent as a down payment). If you default and the lender has to foreclose, PMI covers some of the shortfall between what they can sell your property for and what you still owe on the mortgage.
The promissory note is a legal document that obligates a borrower to repay a specified sum of money over a specified period under particular terms. These details are outlined in the note.
Mortgage underwriting is the process by which a bank or mortgage lender assesses the risk of lending to a particular individual. The underwriting process requires an application and takes into account factors like the prospective borrower’s credit report and score, income, debt and the value of the property they intend to buy. Many lenders follow standard underwriting guidelines from Fannie Mae and Freddie Mac when determining whether to approve a loan.