Purchasing a home requires a large amount of money. So, if you're looking to acquire one, you will most likely need a mortgage.
What is a mortgage and how does it work? In this article, we'll cover everything about mortgages, from the types to how they work and real-life samples. Whether this is your first home or your hundredth, it is crucial to know all these for informed decision-making.
Let's get right to it!
What Is a Mortgage?
Mortgages are loans taken out to buy or maintain a home, building, land, or other real estate property.
A mortgage involves a legal agreement between a borrower and a lender, where the lender gives out a lump sum to the borrower who is expected to repay it in installments with interest over a specific term. The loans usually have 15, 20, or 30-year terms, depending on the agreement.
When it comes to mortgages, the property you took out the loans to buy is your collateral. This means when you default on payments, the lender can seize and sell the property to recoup their loss.
What Parties Are Involved In A Mortgage?
A lender is a financial institution that loans you money to buy a home. Common types of lenders include banks, credit unions, and mortgage companies. The lender will review your financial history and credit score to determine if you are eligible for a mortgage and what interest rate you qualify for.
The borrower is the individual seeking the loan to buy a home. As the borrower, you are responsible for making regular mortgage payments and maintaining the property.
A cosigner may be required if you don't need the requirements of a lender. This may be due to poor or zero credit history. In cases like that, your lender may allow you to bring in a third party as a co-signer so you can qualify. Such a person must have stellar credit history and meet other requirements of the lender.
If the primary borrower defaults on the mortgage payments, the co-signer is legally responsible for making the payments on their behalf. Also, If the property is foreclosed upon, the co-signer may be held liable for any remaining debt that the sale of the property does not cover.
It is important for co-signer to understand their responsibilities and obligations before agreeing to co-sign a mortgage. It is also advisable for the co-signer to consult with a financial advisor or attorney to fully understand the legal and financial implications of co-signing a mortgage.
What's In A Mortgage Payment?
A mortgage payment typically includes several components:
Your loan principal is the amount of money you have left to pay on the loan. For example, if you borrow $500,000 to buy a home and have already paid back $100,000, your loan principal is $400,000.
The interest you pay each month is based on your interest rate and loan principal. It is calculated as a percentage of your outstanding loan balance.
Property tax is a tax an individual or corporate body pays on their property. When taking a mortgage, property tax is usually included in the payments, alongside other costs. It will be calculated with your total debt, meaning as you make monthly payments, you are paying your property tax too.
Homeowner's insurance offers protection to both you and the lender if your property is affected by disasters, fires, or other accidents.
Typically, the lender collects the insurance premiums along with your monthly mortgage payments, holds the money in an escrow account, and pays the premiums to the insurance provider on your behalf when they're due.
If you're unable to make a down payment of at least 20%, you'll likely have to pay mortgage insurance in some form.
Conventional loans usually require private mortgage insurance (PMI), which can be paid on a monthly basis or upfront at closing. Once you've built up 20% home equity, you may be able to request to stop paying PMI.
FHA loans, on the other hand, charge an upfront and monthly mortgage insurance premium (MIP) regardless of the size of your down payment.
Similarly, VA loans require a funding fee that can be added to the loan amount, and USDA loans charge an upfront and monthly guarantee fee. These fees are typically rolled into the loan as part of the mortgage.
How Does A Mortgage Work?
When you are looking to buy a home, a mortgage loan helps you to finance its purchase. Instead of fronting all the costs yourself, you will only pay the downpayment as an upfront investment and then take out the loan to pay the home cost.
For lending you the cash, the home deed stays in the possession of the lender until you fully repay your mortgage loan. This means, when you default, the lender can collect the property through foreclosure.
However, if you remain consistent with your payment and repay in full, the lender will give you the deeds, confirming your home ownership. This means the property belongs to you and can no longer be claimed by any lender.
Your monthly mortgage payment will typically consist of three components: principal, interest, and an escrow account.
- The principal is the amount of money that you still owe on the loan, not including interest.
- The interest is the finance charge based on the loan's annual percentage rate (APR).
- An escrow account is used to pay for homeowner's insurance and property taxes. You'll pay into the account with your monthly mortgage payment, and the lender will use the money to pay your bills when they come due. Escrow accounts may or may not be required depending on the type of loan or down payment amount.
How Do Mortgage Lenders Decide Their Interest Rates?
Mortgage interest rates are influenced by both personal and market factors.
Personal Factors That Influence your Interest Rate
- Your Credit Score
However, if you have a low credit score, the lenders may charge a high-interest rate.
Borrowers with a credit score of at least 620 usually have a higher approval chance and qualify for low rates. So, if your credit isn't up to that, you should try to improve it before applying for a mortgage. You can do that by paying your outstanding debt, mixing your credit, and correcting errors in your credit history.
- Your LTV Ratio
Your loan-to-value (LTV) ratio is the amount of the loan compared to the appraised value of the property. A lower LTV ratio is typically seen as less risky and may result in a lower interest rate.
For instance, if your home value is $200,000 and you make a down payment of $20,000, you will borrow $180,000. Then your LTV ratio will be $180,000 ÷ $200,000, which is 0.9 (90% when converted to a percentage). For a high approval chance, you should not have an LTV ratio of 80% upwards.
- Your Down Payment
When you pay a large down payment during your home purchase, the lender will most likely charge a lower interest rate. This is because it signifies that you pose a lower risk if they issue you the loan.
So, if you can afford a down payment of 20% of your home appraisal upward, pay it to access a lower interest rate.
Market Conditions Influencing Mortgage Interest Rates
- The Federal Reserve
The Federal Reserve plays a significant role in setting interest rates by controlling the money supply and adjusting the federal funds rate.
Usually, the Federal Reserve reduces the interest rate when the economy is struggling. That helps to reduce the cost of borrowing, allowing firms to take out loans to fund their businesses and hire labor.
Conversely, the Federal Reserve increases the interest rate when the economy is booming to reduce borrowing and cause inflation to fall.
Inflation can also impact interest rates. When inflation is high, interest rates tend to rise to keep up with the increased cost of goods and services.
Generally, during inflation, people spend more on goods and services but the Federal Reserve increases interest rates as a corrective measure to combat inflation. When that happens, demand falls and the prices go back to normal.
- Economic Conditions
Finally, overall economic conditions can also impact interest rates. Some additional factors include the rate of economic growth, the bond market, and overall housing market conditions—meaning the available supply of homes for sale and the demand to purchase those homes.
Types of Mortgages
A conventional mortgage is a mortgage that is not issued or insured by a government entity. It is offered by private lenders, including banks, credit unions, and other financial institutions. For a loan to qualify as conventional, it has to comply with the rules set by Fannie Mae and Freddie Mac.
These rules are;
- Borrowers must have a minimum credit score of 620- depending on other factors like income requirement, DTI, and loan amount.
- Minimal negative reports in credit history.
- The debt-to-income ratio must be lower than 43%.
- Minimum of 3% down payment or 20% if there's no mortgage insurance.
- The total loan amount must be lower or equal to $510,400 or $765,000 in high-value locations.
Pros Of Conventional Mortgages
- More flexibility in loan terms
- No mortgage insurance requirement if you put down 20% or more
- No upfront mortgage insurance premium
Cons Of Conventional Mortgages
- Higher credit score requirements
- Higher down payment requirements
- Potentially higher interest rates
Who is a Conventional Mortgage best for?
Conventional mortgages are a good fit for borrowers with strong credit and a sizable down payment.
Government-backed loans are insured or guaranteed by the federal government, making them less risky for lenders. They are designed to make homeownership more accessible and affordable for a broader range of borrowers.
Some of the most popular government-backed loans include:
- FHA Loans: Insured by the Federal Housing Administration, these loans typically require a lower down payment and have more lenient credit requirements.
- USDA Loans: These loans are designed for low- to moderate-income borrowers in rural areas and offer no-down-payment options.
- VA Loans: Available to active-duty military members, veterans, and their families, VA loans offer low or no-down-payment options and more flexible credit requirements.
Government-backed loans benefits
- Little or no down payment required
- Credit requirements are not as strict as other mortgage types.
- You can access lower interest rates
Government-backed loans Drawbacks
- Mortgage programs can be limited to certain locations.
- Loans may not apply to all types of properties.
Who is A Government-backed loan best for?
Government-backed loans are a good fit for borrowers who may not qualify for a conventional mortgage due to lower credit scores or limited funds for a down payment.
Jumbo loans are designed for higher-priced properties that exceed the conforming loan limits set by the government. They are typically used to finance luxury properties or homes in high-cost areas.
Jumbo loan Benefits
- You can purchase high-value properties.
- The down payment percentage is usually lower than in conventional loans.
- Competitive mortgage interest rates.
Jumbo loan Drawbacks
- May come with strict requirements, like no second home loans.
- Lenders usually require higher credit scores and incomes
- Jumbo loan servicers may require you to have cash reserves.
Who Might Benefit from Jumbo Loans
Jumbo loans are a good fit for high-net-worth individuals and those looking to purchase a luxury property.
Fixed-rate mortgages have a consistent interest rate for the life of the loan. They offer predictable monthly payments and are available for both conventional and government-backed loans.
Fixed-rate Mortgage Benefits
- Predictable monthly payments
- Protection against rising interest rates
- Available for both conventional and government-backed loans
Fixed-rate Mortgage Drawbacks
- Potentially higher interest rates compared to adjustable-rate mortgages
- Less flexibility in terms of payment and repayment options
Who is the fixed-rate mortgage best for?
People who want fixed monthly payments will benefit from fixed-rate mortgages since the interest rate does not fluctuate. They can easily plan their monthly budget knowing the percentage that goes into debt payment.
Adjustable-Rate Mortgage (ARM)
Adjustable-rate mortgages have an interest rate that can fluctuate over time. They are available for both conventional and government-backed loans and typically offer lower initial interest rates.
- Initial interest rates are usually low
- If the interest rate reduces during the loan term, your monthly payment will reduce too.
- Available for conventional and government-backed loans.
- The mortgage Interest rate may increase, resulting in high monthly payments during the loan terms.
- Monthly payment is not fixed, meaning prediction may be tough.
- Since the rate fluctuates, borrowers may be taking higher risks
Who is the Adjustable-rate Mortgage best for?
Adjustable-rate mortgages are a good fit for borrowers who plan to sell or refinance their home before the interest rate adjusts and those who want lower initial payments.
How to Compare Mortgage Offers?
When seeking out a mortgage loan, you will come across multiple offers. It is crucial that you compare those offers, by checking elements like loan amount, interest rate, and total loan cost.
First, you must request loan estimates from your potential lenders. They are 3-page documents sent by a mortgage lender to a borrower within three business days of application.
With loan estimates from potential mortgage lenders, you can do a side-by-side comparison easily. If you haven't seen one before, you can check the standard sample provided by the Consumer Financial Protection Bureau to understand the sections. This will prepare you for the real documents by the time the lenders send theirs.
According to the CFPB, a loan estimate should have the following elements;
- Loan Amount
- Interest rate and APR(Annual Percentage rate)
- Total loan costs
- Prepayment penalty or fees
- Estimated monthly payment
- Total cash to close
For clarity, use the steps below to compare your mortgage offers and negotiate terms;
Step 1: Identify 5 Of Your Potential Mortgage Lenders, Including A Mortgage Broker, And Request Proposals from them
Requesting offers from multiple lenders avail a range of options to you, putting you in an advantageous position when negotiating your mortgage. The lenders, which may include national banks, community banks, mortgage banks, credit unions, mortgage banks, and online lenders will have to offer competitive offers to win you over.
Step 2: Ask For A Loan Estimate, Lender Fees Worksheet, or Written Quotes From Your Choice Lenders
You need these documents in order to compare the loan terms from the lenders and make an informed decision. You will find useful information, like the mortgage rate, repayment options, closing costs, and more in the estimate.
Step3: Compare The Proposals And Loan Estimates
After gathering the proposals, estimates, and other documents, compare their terms to decide which is best.
When comparing, you should check the loan rate (interest rate and APR) and closing cost first. This is because these elements have a major impact on your upfront and total mortgage costs.
The APR is the total percentage cost of your loan, including interest rate, closing cost, and other additional costs. With it, you can get a wholesome view of the total cost expected by a lender.
You can compare the APR to the interest rate. If the APR is much higher than the interest, you may conclude that the additional fees are relatively high. In cases like that, you should negotiate with the lender for a lower cost or choose an offer with a lower rate.
Step 4: Negotiate The Best Terms For Your Mortgage
After checking the terms and estimates of the lenders, use the information to negotiate for the lowest rate and loan closing costs. Try to negotiate the terms of even the least costly of them all to get the best rates.
10 Steps to Getting a Mortgage
Step 1: Check Your Finances
Before applying for a mortgage, it's essential to understand your current financial situation. Start by requesting a credit report with scores from all three major credit reporting bureaus: Equifax, Experian, and TransUnion.
Step 2: Select The Suitable Mortgage Type
There are different types of mortgages available in the market and some may offer bigger advantages to you than others. Therefore, you have to identify the best one for your financial status and capability.
Step 3: Decide on Your Mortgage Term
Choose the length of your mortgage term. A 30-year, fixed-rate loan is the most popular choice for the lowest monthly payment. However, a shorter, 15-year fixed loan may save you thousands of dollars in interest charges, as long as your budget can handle the higher monthly payments.
Step 4: Save, Save, Save
Mortgages come with some expenses, meaning you have to save for them. So, always prepare for mortgage costs, like the down payment which may be up to 20% of your mortgage, depending on your capability. Also, save for the closing cost too, which can be 2% to 6%, depending on the loan amount and lender.
Step 5: Research The Best Mortgage Lender For Your Situation
Compare mortgage rates and terms from multiple lenders to find the best deal. Be sure to consider both online and brick-and-mortar lenders.
Step 6: Get a Mortgage Preapproval Before You House Hunt
A mortgage pre-approval letter confirms you can get a mortgage loan to shop for homes within a set price range.
Step 7: Make an Offer on Your Dream Home
Once you've found the perfect place, submit your best offer along with a copy of your pre-approval letter. If your offer is accepted, you'll also pay the required earnest money deposit to show your commitment to the transaction.
Step 8: Get A Home Inspection
Evaluating the property before closing benefits both you and your servicer. This helps you know if the home is worth the cost. It enables the lender to know if lending you cash for the loan is too risky.
In fact, most lenders ask for a home inspection report before processing your loan. If there are areas that need major repair, ask the seller to rectify the situation or adjust the asking price.
Step 9: Cooperate With The Underwriting team
During your mortgage application processing, an underwriter from the lender's end will reach out to you for some information. They may request verification documents to back the claims on your application to measure the risk of lending you cash. You are expected to cooperate with such people to speed up your loan processing.
Step 10: Evaluate and Inspect The Property Again To Ensure Everything is Set And Close The Home
Before you head to the mortgage closing, walk through the property to double-check that all necessary repairs were completed, and the home is ready for you.
How Many Mortgages Can I Have on My Home?
Previously, the Federal National Mortgage Association (FNMA), allowed 4 mortgages. Now, the number of conventionally financed properties has been increased to 10.
Note, however, that accessing multiple mortgages comes with its own difficulties. When you have a mortgage or more already, some lenders may see you as having a higher lending risk. As a result, your application for another mortgage can be rejected.
In addition, the requirements for mortgages may become stricter. You may have to pay a higher down payment and interest rates, have a high credit score, and provide proof of cash reserves.
What's the Difference Between a Loan and a Mortgage?
A loan is a general term that can refer to any type of borrowing, such as a personal loan or business loan. It entails a relationship between a borrower and a lender whereby the borrower receives an amount and pays it back with interest. A loan can be secured or unsecured and can be used by individuals, businesses, and the government.
Mortgage loans are a type of secured loan because they require collateral. It is a type of loan specifically used to purchase or maintain a home or other types of real estate. The property in question is the collateral in this case. It is seizable by the lender if the buyer fails to pay their loans.
A mortgage loan lets you finance the purchase of a property, minus any down payment you make. The lender holds the deed to the property while you make mortgage payments. If you miss payments, the lender can take possession of the property through foreclosure.
However, if you make all payments on time, you'll eventually receive the deed for the property when the loan is paid in full.
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