Taking out a mortgage is one of the most substantial financial decisions most of us will ever make. So, it’s essential to understand what you’re signing on for when you borrow money to buy a house.
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, meaning that 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.
How does a mortgage work?
A mortgage consists of two primary elements: principal and interest.
The principal is the specific amount of money the homebuyer borrows from a lender to purchase a home. If you buy a $100,000 home, for instance, and borrow all $100,000 from a lender, that’s the principal owed.
The interest is what the lender charges you to borrow that money, says Robert Kirkland, senior home lending adviser at JPMorgan Chase. In other words, the interest is the cost you pay for borrowing the principal.
Borrowers pay a mortgage back 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,” says Kirkland.
What is included in a mortgage payment?
Depending on your mortgage agreement, your monthly payment may also include some of the following charges:
The lender might collect the property taxes associated with the home as part of your monthly mortgage payment. In such cases, the money collected for taxes is held in an escrow account, which the lender will use to pay your property tax bill when the taxes are due.
Homeowners insurance provides you with protection in the event of a disaster, fire or other accident. In some cases, a lender will collect the premiums for your insurance as part of your monthly mortgage bill, place the money in escrow and make the payments to the insurance provider for you when policy premiums are due.
Your monthly mortgage payment may also include a fee for what’s known as private mortgage insurance (PMI). This is a type of insurance required by many conventional mortgage lenders when a buyer’s down payment is less than 20 percent of the home’s purchase price.
Types of mortgages
There are several types of mortgages available to consumers. They include conventional fixed-rate mortgages, which are among the most common, as well as adjustable-rate mortgages (ARMs) and balloon mortgages. Potential homebuyers should research the right option for their needs.
The name of a mortgage typically indicates the way interest accrues. In the case of a fixed-rate mortgage, for instance, the interest rate is agreed upon at the time you close on the purchase and stays the same for the entire term of the loan.
Fixed-rate mortgages are available in terms ranging up to 30 years, with the 30-year option being the most popular, says Kirkland. Paying the loan off over a longer period of time makes the monthly payment more affordable.
No matter which term you prefer, the interest rate will not change for the life of the mortgage. For this reason, fixed-rate mortgages are good choices for those who prefer a stable monthly payment.
Adjustable-rate mortgage (ARM)
Under the terms of an adjustable-rate mortgage (ARM), the interest rate you’re paying may be raised or lowered periodically as rates change. ARMs may a good idea when their interest rates are particularly low compared with the 30-year fixed, especially if the ARM has a long fixed-rate period before it starts to adjust.
“Some examples of an adjustable-rate mortgage would be a 5/1 ARM and or a 7/1 ARM,” says Kirkland. “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.”
During the adjustable-rate portion of an ARM, the interest rate charged is typically based on a standard financial index, such as the key index rate established by the Federal Reserve or the Secured Overnight Financing Rate (SOFR).
“Adjustable-rate mortgages (ARMs) track a selected benchmark index and adjust the loan’s payments based on changing interest rates,” says John Pataky, executive vice president at TIAA Bank and head of the bank’s consumer lending and mortgage division.
Under the terms of a balloon mortgage, payments will start low and then grow or “balloon” to a much larger lump-sum amount before the loan ends.
This type of mortgage is generally aimed at buyers who will have a higher income toward the end of the loan or borrowing period than at the outset.
It also may be a good approach for those who plan to sell the property prior to the end of the loan period. For those who don’t intend to sell, a balloon mortgage may require refinancing in order to stay in the property.
“Buyers who choose a balloon mortgage may do so with the intention of refinancing the mortgage when the balloon mortgage’s term runs out,” says Pataky. “Overall, balloon mortgages are one of the riskier types of mortgages.”
An FHA loan is a government-backed mortgage insured by the Federal Housing Administration.
“This loan program is popular with many first-time homebuyers,” says Kirkland. “FHA home loans require lower minimum credit scores and in some cases lower down payments, with the average down payment being 3.5 percent.”
Although the government insures the loans, these loans are offered by FHA-approved mortgage lenders.
The VA loan is a loan guaranteed by the U.S. Department of Veterans Affairs that requires little or no money down. It is available to veterans, servicemembers and eligible military spouses.
The loan itself isn’t actually made by the government, but it is backed by a government agency, which is designed to make lenders feel more comfortable in offering the loan. As a result of the government backing, lenders often offer these loans without requiring a down payment and with looser credit parameters.
How to find the best mortgage
It’s important to understand as you shop for a mortgage that not all mortgage products are created equal, so doing your research is essential, says Kirkland.
“Some have more stringent guidelines than others. Some lenders might require a 20 percent down payment, while others require as little as 3 percent of the home’s purchase price,” Kirkland says.
Identifying the mortgage that’s best for your situation involves assessing your financial health, including such factors as your income, credit history and score, employment, and financial goals.
In addition to understanding the various mortgage products, spend some time shopping around with different lenders.
“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,” says Pataky of TIAA Bank. “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.”
Important mortgage terminology to know
As you weigh your mortgage options, here are some basic terms you may encounter (and here are other key 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. A typical home loan might amortize over a 15-, 20- or 30-year term, with the amount allocated to interest and principal decreasing and increasing, respectively, over the term. When a loan fully amortizes, that means it’s been paid off entirely by the end of the amortization schedule.
APR, or annual percentage rate, reflects the 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. The APR is higher than the interest rate and is a better gauge of the true cost of the 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. An escrow account for insurance and taxes is usually set up by the mortgage lender, who makes the insurance and tax payments on the borrower’s behalf. This system assures the lender that those bills are paid, and gives the borrower the convenience of paying for these expenses in small installments each month, instead of being hit with a large bill once or twice a year.
Mortgage underwriting is the process by which a bank or mortgage lender assesses the risk they would be taking by lending to a given borrower. The underwriting process requires an application and takes into account factors like the 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.