Buying a home is one of many defining moments in a person’s life. It’s also a process often riddled with confusion. Seeing as there are so many stages in the homebuying process, it’s easy to get lost in the details. For this reason, one of the first things you should do is get a good understanding of mortgages and how financing your home will work.
If you don’t do your research, you could end up locked into a mortgage with unfavorable terms or in overwhelming debt. To help you avoid this, we’ve put together helpful information about mortgages.
Here is a simple breakdown of what a mortgage is, types of mortgages there are, and how to get one of your own.
What is a mortgage?
In simple terms, a mortgage is a loan used to finance various types of property. This could include a residential home or commercial property. Seeing as most people don’t have hundreds of thousands of dollars in cash to pay for a property upfront, mortgages make it possible to buy them without paying the full amount at once.
How a mortgage works
When a mortgage loan is approved, you enter into a contractual agreement with a lender. The lender gives you a loan, providing a set amount to buy a property. The property purchased is used as collateral to secure the loan. In turn, lenders expect you to uphold your side of the agreement, which they outline in the fine print of the loan agreement. Most times, it will include a monthly mortgage payment comprising principal (cost of the home), interest, property taxes, and insurance (PITI).
Here is a breakdown of each:
A mortgage principal is the balance you have left on your mortgage loan. When you first get a mortgage, the principal is the purchase price of the home, minus the down payment. This means if you buy a home at $100,000 and you paid 20% at closing, your principal would be $80,000.
When lenders offer you financing, it doesn’t come free. They charge interest—what it costs you to borrow the money. Interest, which comes as an annual percentage, can be variable (change periodically) or fixed.
Your APR or annual payment rate is the cost of a mortgage loan plus other fees such as mortgage insurance, loan origination fees, broker costs (if you use one), and closing costs if you don’t pay them upfront.
When an individual or corporation owns property, they must pay taxes on it. The tax is usually based on the value of the house and local governments determine how much you pay. Taxes are used to fund things like water, law enforcement, road construction, and anything else that benefits the community.
This is a form of property insurance that covers any damages or losses that happen to your residence. You’ll also receive liability coverage in case of accidents.
Private mortgage insurance (PMI) is an insurance policy that covers lenders when borrowers default on loans. It’s usually required on government-backed loans and conventional loans where the borrower gives a down payment of less than 20%.
With FHA loans, you can borrow up to 97% of the property amount, so you’ll have to make a down payment of 3% or more. Some lending programs, such as VA loans for Veterans and military Service Members allow you to borrow up to 100%, but you’re likely to pay relatively high interest and it could take you longer to build equity.
If you put down less than 20%, PMI will be added to your payments until you pay off 20% of the home’s value. So, while a lower down payment may allow you to purchase a home faster, be aware that it will increase your monthly payments for a time.
Mortgage repayment periods, known as “terms,” can range from 10 to 30 years. The most common are 15, 25, and 30-year loan terms. Although shorter loan terms mean higher payments, you’d pay the loan off quicker and potentially save in APR and interest.
Types of mortgage lenders
The lender you choose determines the terms of your mortgage and how much you end up paying. Some common types of lenders include:
- Traditional Lenders: Financial institutions like Bank of America, Chase Bank or Wells Fargo
- Online Lenders: Don’t have brick and mortar locations, thus facilitate the majority of mortgage process online
- Credit Unions: Member-owned non-profit financial institutions that offer mortgages with sometimes lower rates
- Mortgage Brokers: Intermediary between buyer and a lender who sells mortgages for lenders
- Hard Money Lenders: Private companies or individuals who lend on their own terms
Almost every lender uses the property as collateral for the loan. This means if for any reason a buyer defaults (fails to pay) on their loan, the bank can repossess and resell the property to salvage any losses. The bottom line is you don’t fully own the home until you pay all the money borrowed plus interest.
Types of mortgages
Knowing what types of mortgage loans are out there before buying is critical. Not all loans are created equal, and you’ll see that once you shop around. Terms, interest rates, and fees vary from loan to loan and lender to lender.
How do you know what is best for you? Assess your financial situation and decide which you can commit to long term. Although you can’t predict what your future circumstances will be, ask yourself if you’d still be able to manage payments if unforeseen circumstances arise.
Conventional Vs. Government-Backed
There are two primary types of mortgage loans: conventional and government-insured. The former isn’t insured by the Federal Housing Association (FHA) or Veteran Affairs (VA), while the latter is. The primary differences between the two are in benefits, repayment options, and interest rates.
The government doesn’t back conventional loans, meaning they won’t repay the lender if a borrower defaults on their loan. Therefore, you’re required to pay private mortgage insurance when you put down a deposit of less than 20%. The insurance covers the lender if you can no longer afford the loan for any reason.
Common characteristics of conventional loans are that they require higher credit scores (620+) for good interest rates and have less paperwork.
Types of conventional loans include:
- Fixed-rate Mortgage: Fixed-rate mortgages are ideal for people who want predictability and plan to stay in their property over an extended period. Base monthly mortgage payments and interest rates stay the same throughout your loan term, be it 15, 20, or 30 years. This means when interest rates rise and fall, your payment amounts aren’t affected. Keep in mind that payments may increase or decrease annually based on property tax changes.
- Adjustable-Rate Mortgage (ARM): An adjustable-rate mortgage has an interest rate that adjusts at set intervals. The interest rate changes based on current economic conditions. When rates are low, an ARM can be beneficial, but when rates increase, so do the payments.
- Hybrid ARM: These loans start with a low fixed interest rate, but after a period interest rates change at annual or sometimes monthly intervals. This is favorable to homebuyers when interest rates go down but could mean higher payments when they go up.
- Two-step Mortgage: This loan type is like an ARM, except the interest rate only adjusts once. After that, you pay the same rate for the life of the loan.
- Balloon Mortgage: The loan starts out with low or no interest rates, however, towards the end of the loan term you pay one large payment.
- Bridge Loan: Some people need the funding to buy a new property before selling their old one. Bridge loans help them do this by consolidating the debt from their old and new mortgages. Once you sell the old property, you would pay off your first mortgage and then refinance.
Second mortgage products allow a homeowner to borrow against the equity built up in their home. Equity is the value of a home minus the remaining balance on the mortgage. Second mortgage products allow you to access that equity.
- Piggyback/Combination: This is essentially a second mortgage loan secured with the same collateral. It’s ideal for people who don’t have a deposit, want to avoid mortgage insurance, or want to finance the construction of a home, then get a mortgage. Piggyback loans are usually a home equity loan or an equity line of credit.
- Home Equity: With this loan type, lenders use the equity on your home as collateral. There are two common types of home equity loans: fixed-term loans (interest rate doesn’t change) and revolving home equity loans also known as a prime Equity Loan. Revolving home equity loans allow homebuyers to withdraw money and repay as needed. These loans are also tied to prime interest rates meaning they use a variable rate used by banks. Homeowners can use funds from equity loans to meet any financial obligations, be it paying off a credit card, buying a second home, or renovating.
Government-Backed (Unconventional Loans)
Some people are unlikely to get approved for conventional loans because of low credit scores or their inability to gather a down payment. This is where government-insured loans come in and save the day. Applicants can get approved for relatively low-interest loans with credit scores as low as the 500s in some cases. Also, note that the loan doesn’t come directly from the FHA. It comes from an FHA-approved lender like a bank or any other financial institution.
What about the risk this poses to lenders? Mortgage loans backed by the government cover lenders when borrowers default on their loans. Because of this, individuals who don’t meet conventional loan guidelines can qualify. Unlike conventional loans, they’re required to pay mortgage insurance irrespective of their down payment size.
Examples of government-insured loans include:
- FHA Loan: Also known as a Federal Housing Administration loan, it’s attractive because people with credit scores as low as 500 can qualify. However, higher credit scores enjoy lower down payments. Homebuyers can also use down payment assistance programs and grants to help with the initial deposit.
- VA Loan: The Department of Veterans Affairs created these government-backed loans for Service Members, Veterans and some surviving spouses. VA loans don’t require a down payment or deposit and don’t have a set minimum credit score. You must get a Certificate of Eligibility (COE) to qualify. A clause is that guidelines for what home you can buy can be strict, as homes must meet minimum property requirements.
- USDA Loan: Oftentimes, individuals who live in rural areas don’t have homeownership opportunities. USDA mortgage loans cater to them as the government finances 100% of the home, so they don’t have to make down payments. They also offer discounted interest rates, making it more affordable.
- Indian Home Loan Guarantee Program: This program provides homeownership opportunities for Native American and Alaska Native Families. To qualify, the home must be the applicant’s primary residence and they must be enrolled in a federally recognized American Indian tribe or Alaska Native Village. These loans base interest rates on the market as opposed to applicant credit scores and offer cheaper mortgage insurance.
- Reverse Mortgage: Mortgage loans designed for over 62s who want to turn their home equity into income. Homeowners can have funds released in a single payment, monthly, or as a line of credit. The equity is repaid when the homeowner passes away or sells the property.
How to apply for a mortgage
There are several stages in the mortgage process. If you’re wondering how long it takes, it could be anywhere from 3-5 months depending on how complex your application is. Here is a step-by-step explanation of how to apply for and hopefully secure a mortgage.
Step 1: Check you qualify
There’s no use looking for a home and making an offer if you don’t know whether you qualify. This means knowing you can afford the house and that lender will likely approve your loan application.
Start by checking how much you can afford to pay and what type of mortgage best suits your needs. Key things to look out for are the interest rate, APR, and if plans come with a fixed or adjustable interest rate.
Once you’ve shortlisted prospective lender and mortgage plans, you can try to get pre-approved. It’s advisable that you apply to multiple lenders at once. Note that getting pre-approved doesn’t guarantee you’ll get a mortgage loan when you get to the closing stage. However, lenders will tell you how much you can borrow, programs you qualify for, and interest rates.
And don’t worry about hurting your credit score. Any applications for pre-approval made within 14 days of each other will get grouped as one credit inquiry. This allows you to shop for a mortgage without negatively affecting your credit score with multiple inquiries.
Things lenders look at for pre-approved mortgage loans include:
- A good credit score of 620+ for conventional loans or 580 + for government-backed loans. Higher scores can increase your chances of pre-approval, but you can still get approved with lower scores. The better your score, the better APR you’ll get, and the more you can borrow. If you have bad credit, consider credit repair before starting the homebuying process.
- Good debt to income ratio (DTI) is the percentage of your monthly income that goes to paying off debt. There are two types of DTIs: front-end-ratios and back-end ratios. Front-end ratios calculate income that goes towards housing costs like mortgage, taxes and insurance. Back-end ratios refer to income that goes to all debt including housing costs, auto insurance, and anything else. Keep in mind that for conventional loans, lenders prefer a DTI of 50% or less with the new mortgage payments included. However, for FHA loans, front end debt to income ratios are capped at 46.9%, while the maximum for back end is 56.9%.
- Proof of income like tax returns, W-2s for the past two years, and asset documentation are needed for pre-approval. This will show lenders you have a stable income and can afford mortgage payments.
Getting pre-approved before shopping for a home shows sellers you’re qualified and serious about buying. It also gives you a competitive advantage if you find a house that has multiple bidders.
Step 2: Find a home
Knowing your budget and getting pre-approved for a loan can give you peace of mind when hunting for a house. It can also make the process of elimination easier. During this step, you want to find a home that meets your criteria and put an offer forward. Be sure to negotiate the best deal possible or use a real estate agent to help.
Step 3: Secure a lender
You’ve found the home of your dreams and made an offer — now it’s time to secure a mortgage lender. Once you choose one, submit a loan application so you can get a loan estimate.
Your prospective mortgage lender will require you get the home you want to buy appraised. This tells lenders the value of the home, based on factors like location, structural construction, square footage, and more. If the appraisal shows the value of the home is below the selling price, the lender could deny your application.
Before closing, it’s a good idea to get a home inspection, although it isn’t mandatory. It will reveal significant damages or things in need of repair. If after an inspection you find damages that aren’t worth fixing, you could potentially walk away from the property, ask the seller to repair them, or ask them for money to do the repairs yourself. Your contractual agreement will determine your options at this point.
Last, you’ll need a title search to ensure there aren’t legal actions or liens on the property.
Step 4: Underwriting and closing
Once your prospective lender approves the appraisal, they should start the underwriting process. This is where the lender officially approves you for the exact loan and sets the final terms.
The underwriter assesses the risk of lending to you by verifying your income, debt, and other financial information. In some cases, they may request further documentation. If you’re given the green light, expect a closing disclosure—a summary of the loan and closing costs.
Once everything is final, a closing agent facilitates the closing. At this point, you sign the final sale contract and celebrate purchasing a new home!
Cost of buying a home
Now that you know the buying process your next question may be ‘how much mortgage can I afford’?
To save yourself financial stress, figure out how much you can afford before beginning the homebuying process. You don’t want to shop for houses outside of your budget or end up locked into a mortgage you can’t afford long-term.
|Down payment||The percentage you have to put down before lenders borrow you money||As low as 3% of the home value|
|Escrow||Neutral third party (person or entity) who holds money and key documents until all parties uphold their end of the agreement||Between 1-2% of the sale price of the home|
|Appraisal||Report that tells you the value of your property||$300-$500|
|Title||Checks whether the property you want to buy has existing liens or ongoing legal issues||$150+|
|Title Insurance||Lenders title insurance (mandatory) and personal title insurance (optional) cover financial losses and title issues that could arise after closing. You can bundle two policies together or get them separately||One time upfront cost from $1,000-$4,000 depending on loan amount and state. Alternatively, negotiate to have the seller pay for both|
|Application fee||The cost of initiating and processing your application||$0-500|
|Underwriting||Steps taken to assess the risk of loaning you money. An underwriter assesses your credit score, credit report, and appraisal||$400-$900|
|Lender-Based origination Fee||Cost of completing loan transaction||0.5-1% of total loan cost|
|State Recording Fees||Charges for legally recording your deed and mortgage||Anywhere from $125+ depending on the state|
|Prepaid property tax, insurance, and interest fees||Advanced payment of property insurance, tax, and interest||about 12 months of insurance and 6 months of taxes upfront|
|Home inspection||Optional, but recommended to check the condition of the home||$250-500|
|Flood Insurance||Insurance for individuals approved for mortgage in a flood zone||$400-700|
|Transfer Tax||City, county, or state charge when a change of ownership occurs||1% of sale price or property value or a set rate for every $500 depending on the state|
Once you’ve paid the many fees required to close on a home, you still have other ongoing costs. They may include:
- Property taxes
- Homeowner’s insurance
- Flood or fire insurance
- Private mortgage insurance
- Homeowner’s association fees
Principal, interest, tax, and insurance (PITI) are ongoing costs you’ll have as a homeowner. Most of these expenses are paid annually by the lender or the buyer. If your lender requires you open an escrow account at closing, your PITI fees go in there monthly. Why do some lenders require an escrow? To ensure borrowers don’t fall behind on payments.
If you have an escrow, the mortgage servicer (company handling your loan) is responsible for paying your PITI at the end of the year. They should send money to your lender for principal and interest payments, give your property taxes to local taxing authorities, and pay your insurance company. Note that sometimes, the mortgage servicers changes. However, when this happens, you should receive a notice from your current and new servicer (at least 15 days before the effective date of transfer), notifying you of the change. It is crucial you make note of these transfer dates and register at your new mortgage servicer’s portal if you make online payments.
Those who don’t have escrow are solely responsible for paying fees on time. An advantage of not having an escrow is lower monthly payments. Also, you can save your PITI fees in an interest-bearing account and earn more money. That said, you usually need a down payment over 20% to opt-out of escrow and some lenders charge a fee. You will also need to pay property taxes and insurance separately.
Homeowner’s Association fees are sometimes required to maintain and improve certain residential properties. Said fees can cost anywhere from $100-$700 monthly. Finally, don’t forget to budget for upkeep, maintenance, and renovations.
Calculating your monthly mortgage payments
A common question among prospective buyers is “how much mortgage can I afford?” The answer is different for each person. Your financial circumstances and budget mostly determine what you can afford spend on a home.
To give you an idea, use our mortgage calculator. It will give you an estimate of your monthly mortgage payments so you can look for homes within your budget.
Some lenders advise against buying a house that exceeds 2.5 times your annual salary. That means if your annual salary is $70,000, you should avoid buying a house over $175,000. Another thing to consider is your debt to income ratio. If you have piling debt, keeping up with mortgage payments could become challenging.
Managing an existing mortgage
Life is full of changes and some of them can impact your mortgage. For instance, falling interest rates could mean you want to refinance. On the other hand, you may decide you want to increase mortgage payments if your income increases.
Homeowners are always looking for ways to save on their mortgage and reduce the overall amount they pay. While there are many ways of doing this, an effective method is making extra payments to pay off your mortgage quicker.
You could make bi-weekly payments to increase your yearly payment amount. This would look like 26 half-payments a year instead of 12 full ones. If you had a $300,000 loan and your monthly payments were $800, 12 payments would total $9,600 at the end of the year. However, by making 26 bi-weekly payments of $400, you would pay $10,400 towards your mortgage at the end of the year.
Alternatively, you can make a bulk payment at the end of each year if that’s easier. Doing this consistently could lead to you paying your mortgage in half the time and paying less in interest. You’d also be building your home equity much faster.
Note that with some mortgage plans, making extra or early payments can result in penalties. The reason being, when you repay the loan early, lenders don’t make as much interest. How are pre-payment penalty fees charged? Some lenders base them on the remaining principal while others may require 6 months’ worth of interest fees. To avoid this, read your contract or ask your lender beforehand.
Refinancing your home
Refinancing a home is when you use a new lender to pay off your existing mortgage. The process is like that of getting a mortgage. So, you have to go through the motions of shopping for a mortgage, income verification, credit checks, and closing again.
People refinance their homes for various reasons. The most common reason is to lower the interest rate to get lower monthly payments. Other common reasons include to reduce overall costs, reduce risk, tap into home equity, or get rid of private mortgage insurance.
As with paying your mortgage off early, refinancing can come with fees too. You should know refinancing has recently become more expensive as Fannie Mae and Freddie Mac announced they are adding a 0.5 percent fee on all refinancing’s that close after Dec 1 , 2020.
To minimize total interest, consider going for a shorter loan term the second time around. Ultimately, make sure it’s a smart financial decision before refinancing. A refinance calculator can help you with that decision by showing you how much you’ll save over the loan term and whether refinancing is worthwhile.
Looking to refinance your property? Compare rates to find your best option.
Home equity refers to the amount of home you actually own. It’s attractive to homeowners as they can use their equity to do things like finance a project, fund their child’s education, or pay credit card debt. Most home equity loans allow you to borrow between 80%-85% of your home’s value plus interest. To avoid ending up in a cycle of debt and a higher risk of foreclosure, only use the equity on your home when it makes financial sense.
If you’re over 62, you can tap into equity through a reverse mortgage. You can choose to take out the equity on your home in a bulk payment, receive a set amount every month, or set up a credit line that you can draw from as needed. Reverse mortgages offer a lower risk of foreclosure because there are no monthly payments to worry about. The loan is paid back when the last living homeowner dies or leaves the home.
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Article last modified on October 7, 2020. Published by Debt.com, LLC