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- A mortgage is a long-term loan from a financial institution that helps you purchase a home, with the home itself serving as collateral.
- Mortgage payments typically consist of principal (the amount borrowed), interest, property taxes and homeowners insurance. They can also include mortgage insurance or a guarantee fee.
- There are several types of mortgages, including conforming conventional loans, jumbo loans, FHA and VA loans.
- When comparing mortgage offers, it’s important to consider the loan type, loan term, interest rate and the total associated fees.
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.
What is a mortgage?
A mortgage is a long-term loan used to buy a house. Mortgages are offered with a variety of loan terms — the length of time to repay the loan — usually between eight and 30 years. Mortgage payments typically include both interest and principal payments (although there are interest-only mortgages), as well as escrow payments to cover property taxes and homeowners insurance.
How does a mortgage work?
When you get a mortgage, you have a set loan term to repay the debt as well as a total loan amount to repay. The majority of your monthly payment will be comprised of interest and principal, also known as your loan balance.
“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. As the loan is paid off, a larger portion of the payment will go towards principal.
Most mortgages are fully amortized, meaning they’re repaid in installments — regular, equal (usually) payments on a set schedule, with the last payment paying off the loan at the end of the term. The exception to this is the uncommon balloon mortgage, where you pay a lump-sum at the end of the loan term.
Mortgages are also secured loans, meaning that they are backed by collateral — in this case, your home. This means that, if you fail to pay your mortgage, your home can enter into foreclosure and your lender can reclaim it.
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.”
Types of mortgages
There are several types of mortgages available to borrowers.
- 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.
Conventional fixed-rate mortgages are by far the most common type of home loan.
What is included in a mortgage payment?
There are four core components of a mortgage payment: the principal, interest, taxes, and insurance, collectively referred to as “PITI.” There can be other costs included in the payment, as well.
- Principal – The specific amount of money you borrow from a mortgage lender to purchase a home. If you were to buy a $400,000 home, for instance, and take out a loan in the amount of $350,000 then your loan principal is $350,000.
- 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.
You don’t technically own the property until your mortgage loan is fully paid.— Bill Packer, COO, Longbridge Financial
How to compare 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 you compare offers, consider the full scope of its features. Here are the main parts of offers you should weigh:
- The interest rate and APR: The interest rate is your charge for borrowing, a percentage of the loan principal. The annual percentage rate (APR) includes the mortgage interest rate plus additional loan fees, representing the total cost of your loan.
- Type of rate: Are you looking at a variable rate that will adjust after a certain period, or will it stay fixed over the life of the loan?
- Loan term: How long it will take to repay the loan. Note: longer-term loans allow for lower monthly payments, but you’ll pay more in interest over the course of the loan.
- Fees: Some lenders charge fees that other lenders don’t, such as origination fees, application fees and prepayment penalties. Always understand the scope and cost of these fees when comparing offers.
Mortgage terms 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.