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. 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.
How does a mortgage work in simple terms?
A mortgage loan is typically a 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 pay the 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,” explains Robert Kirkland, vice president, Divisional Community and affordable lending manager with JPMorgan Chase. Over time, more of your payment will go toward the principal.
If you default on your mortgage loan, the lender can reclaim your property through the process of foreclosure.
“You don’t technically own the property until your mortgage loan is fully paid,” says Bill Packer, executive vice president and COO of American Financial Resources in Parsippany, New Jersey. “Typically, you will also sign a promissory note at closing, which is your personal pledge to repay the loan.”
What is included in a mortgage payment?
There are four core components of a mortgage payment: the principal, interest, taxes and insurance, referred to as “PITI.” There can be other costs included in the payment, as well.
The principal is the specific amount of money you borrowed from a mortgage lender to purchase a home. If you were to buy a $100,000 home, for instance, and borrow $90,000 from a lender to help pay for it, that’d be the principal you owe.
The interest, expressed as a percentage rate, is what the lender charges you to borrow that money. In other words, the interest is the annual cost you pay for borrowing the principal. There are other fees involved in getting a mortgage besides interest, including points and other closing costs.
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 provides you and your lender a level of protection in the event of a disaster, fire or other accident that impacts your property. 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.
Your monthly mortgage payment might also include a fee for private mortgage insurance (PMI). For a conventional loan, this is a type of insurance is required when a buyer puts down less than 20 percent of the home’s purchase price as a down payment.
Difference between a mortgage and a loan
A mortgage is essentially a lien, or claim, on the title to your home, explains David Carey, vice president and residential lending manager at Tompkins Mahopac Bank in Brewster, New York.
“This allows the lender to foreclose if you default on your obligation,” Carey says, adding that the mortgage serves as the instrument of security that pledges the home as collateral for the loan. (In some states, a deed of trust represents that security instrument, instead of the mortgage.) The mortgage’s promissory note is what actually represents the loan.
Another key point: While a mortgage is secured by real property (in other words, your home), other types of loans, such as credit cards, are unsecured, says Jodi Hall, president of Nationwide Mortgage Bankers, Inc., in Melville, New York.
Types of mortgages
There are several types of mortgages available to borrowers, including conforming and non-conforming loans; conventional fixed-rate mortgages, which are among the most common; adjustable-rate mortgages (ARMs); balloon mortgages; FHA, VA and USDA loans; jumbo loans; and reverse mortgages.
With a fixed-rate mortgage, the interest rate is agreed upon before you close the loan, and stays the same for the entire term, which generally ranges up to 30 years. Paying the loan off over a longer period 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 can be raised or lowered periodically as rates change. An ARM might be a good idea when the introductory interest rate is particularly low compared with a 30-year fixed loan, especially if the ARM has a long fixed-rate period before it starts to adjust. An ARM can also be an option if you don’t plan to stay in the home for longer than that introductory period.
“Some examples of an adjustable-rate mortgage would be a 5/1 ARM and or a 7/1 ARM,” explains 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). Most ARMs come with a cap (for each adjustment and/or for the life of the loan), so your rate can only increase up to a certain amount.
“Adjustable-rate mortgages 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.
With a balloon mortgage, payments start low and then grow or “balloon” to a much larger lump-sum amount before the loan matures.
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 might be a good approach for those who plan to sell the property before the end of the loan period. For those who don’t intend to sell, a balloon mortgage might require refinancing 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,” Kirkland says. “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, service members and eligible military spouses.
The loan itself isn’t actually made by the government, but it is backed by a government agency (the VA), which is designed to give lenders some protection when funding the loan. As a result of the government backing, lenders often offer these loans without requiring a down payment and with looser credit parameters.
The benefits of a USDA loan include no down payment requirement, no set maximum purchase price and low interest rates with fixed-rate terms, says Lamar Brabham, CEO and founder of Noel Taylor Agency, a financial services firm in North Myrtle Beach, South Carolina. On the downside, only qualified homes in approved rural/suburban locations are eligible for a USDA loan. These loans also usually take longer to close than some other types of loans.
Jumbo loans are loans for more expensive properties priced above the conforming loan limits set by the Federal Housing Finance Agency (FHFA) each year. These loans can have higher interest rates than conforming loans, as well as a requirement for a bigger down payment.
A reverse mortgage provides homeowners aged 62 or older monthly income based on their home’s value.
“It allows them to tap into the equity of their home and defer monthly payments until they leave the home, which works well for those needing relief from house payments and who require access to cash,” Brabham explains.
Unlike a forward mortgage, where over time the borrower is repaying the loan and the balance goes down, “with a reverse mortgage, the lender gives you money over time and the balance you owe grows the longer you live,” adds Packer.
First mortgage vs. second mortgage
A first mortgage is in the first or senior lien position on a property, which means that it typically takes priority over all other claims or liens in the event of default and foreclosure.
“Some very specific claims, such as failure to pay property taxes, can take priority over the first lien holder,” Packer says.
If the home were to be foreclosed and the lender sells the property, the proceeds of the sale would first go toward repaying the first mortgage, because it’s in the senior lien position.
A second mortgage refers to a lien in a junior position, such as a home equity line of credit (HELOC) or home equity loan. In the event of foreclosure sale, this second mortgage would be repaid after the first mortgage, and only up to the amount the proceeds of the sale allow for.
How to find the best mortgage
To identify the mortgage that’s best for your situation, assess your financial health, including your income, credit history and score, employment and financial goals. 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,” Pataky 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.”
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How to qualify for a mortgage
Here are a few tips to improve your chances of qualifying and being approved for a mortgage:
- Educate yourself. “Make sure you know what you’re getting into before applying for a loan,” Carey says. “Research how much property taxes are, what type of mortgage product best fits your needs and what kinds of first-time homebuyer assistant grants may be available.”
- Establish a credit history and work to maintain or improve your score. “Lenders put a lot of weight on past credit performance as a good indicator of future performance,” Carey says. Strive to make all of your credit card, loan or other debt payments on time, and check your credit reports for any errors before applying for a mortgage. If you spot incorrect information (like incorrect contact info), dispute it with the credit reporting bureau as soon as possible to get it corrected. Likewise, avoid making larger purchases (like a car) and applying for new credit cards.
- Build up savings for a sufficient down payment. “Limiting the percentage of the purchase price financed helps improve your ability to qualify for a mortgage,” Carey says. “Responsible saving practices demonstrate your ability to manage finances and reduce the overall risk involved in lending you money.”
- Avoid changes to your employment status. “Quitting your job, losing your employment or switching companies might affect your qualification,” Hall says.
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 more of the monthly paying going toward the principal over time. 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.
“Conforming” refers to a conforming loan, a mortgage eligible to be purchased by Fannie Mae and 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. The lenders, in turn, use the proceeds from those sales to continue to make mortgages for borrowers.
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.
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. The servicer also steps in with relief options if you’re having trouble making payments. A servicer differs from a mortgage lender, which is the financial institution that loaned you the money for your home.
Unlike a conforming loan, a “non-conforming” mortgage doesn’t meet the requirements that allow it to be purchased by Fannie Mae and Freddie Mac. One example of a non-conforming loan is a jumbo loan.
Private mortgage insurance
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 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.
With additional reporting by Erik J. Martin