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How Does a Mortgage Work?

how does a mortgage work

When you consider that a mortgage is likely to be the largest, longest-term loan you’ll ever take out, you can see why getting an understanding of how it works is a good idea. After all, the more you understand, the better able you’ll be to make a good decision and select the mortgage that’s right for you.

How does a mortgage work?

A mortgage is a loan from a bank or lender to help you finance the purchase of a home. When you take out a mortgage, you agree that the lender has the right to take your property if you fail to repay the money you’ve borrowed plus an agreed-upon interest rate. In other words, the home is used as “collateral.”

There are several crucial aspects of a loan that you should know.

  • Closing costs. Closing costs are expenses over and above the sales price of a home. They may include origination fees, points, appraisal and title fees, title insurance, surveys, recording fees and more. While fees vary widely by the type of mortgage you get and by location, Realtor.com estimates that they typically total 2 to 7 percent of the home’s purchase price. So on a $250,000 home, your closing costs would amount to anywhere from $5,000 to $17,500 (a wide range indeed, Realtor.com acknowledges).
  • Points. Money paid to your lender in exchange for a lower interest rate.
  • Amortization. Each mortgage payment is split so that part goes to paying the principal and the rest goes to interest. In the early years of your mortgage, interest makes up a greater part of your overall payment, but as time goes on, the principal becomes a larger portion because you have a smaller amount of principal to charge interest against. Your lender will provide an amortization schedule (a table showing the breakdown of each payment).
  • Annual percentage rate (APR). The cost of borrowing money, based on the interest, fees and loan term, expressed as a yearly rate. APR was created to make it easier for consumers to compare loans with different interest rates and costs. By law, the APR must be disclosed in all advertising.
  • Interest rates. The amount charged by a lender to borrow money. The interest rate is expressed as a percentage of the principal loan amount.
  • PITI. PITI is an acronym lenders use to describe the different components that make up your monthly mortgage payment. It stands for Principal, Interest, Taxes and Insurance.
  • Down payment. The down payment is the amount of money you spend upfront to purchase a home. The higher your down payment, the lower your monthly mortgage payment will be.
  • Mortgage term. A mortgage term is the length of time used to calculate your payments. If you take out a 30-year mortgage, your monthly payments are calculated by amortizing the loan over 30 years, aka 360 months. At the end of the mortgage term, your home will be paid off unless you have a balloon mortgage. For a balloon mortgage, payments are generally calculated over a 30-year term, but have a maturity date of three to 10 years. On the maturity date, the balloon payment (remaining principal balance on the loan) is due. In most cases, homeowners refinance or sell the home to make the balloon payment.

Qualifying for a mortgage

When you buy a mortgage, there are several types of loans to choose from, each with its own set of requirements.

A conventional mortgage is a home loan that isn’t guaranteed or insured by the federal government and conforms to the loan limits set forth by Freddie Mac and Fannie Mac.

Loans that are backed by the federal government (i.e., the Federal Housing Administration (FHA), Veterans Affairs (VA) and the United States Department of Agriculture (USDA) are designed to make buying homes more affordable and typically offer low down payments. Because conventional loans are not guaranteed by the federal government if the buyer defaults, they’re a higher risk for the banks, credit unions and other lenders that offer them. Conventional loans require larger down payments than most federally backed loans, but may offer lower interest rates and the flexibility to negotiate fees – usually resulting in a lower monthly payment.

To qualify for a conventional loan, a borrower must meet a few basic requirements:

Credit score

Your credit score plays an integral role in qualifying for a conventional loan. Most lenders require a minimum FICO score of 620 for a fixed-rate mortgage or 640 for an adjustable-rate mortgage.

Debt-to-income ratio

Your debt-to-income ratio (DTI) is the total of your monthly debt payments divided by your gross monthly income. DTI helps lenders assess your ability to manage your monthly payments and repay the money you’ve borrowed.

To qualify for a conventional loan, lenders typically require DTI of 36 percent or lower. However, with a high credit score, and at least two months of reserves, the lender may allow a DTI of up to 45 percent.

Reserves are highly liquid assets that are available to you after your mortgage closes, such as:

  • funds in checking and savings accounts
  • investments in stocks, bonds, mutual funds, CDs, money market funds and trust accounts
  • Vested retirement account assets
  • The cash value of life insurance policies

 

Essentially, reserves are assets that you could tap to make your mortgage payments if you were to hit a rough financial patch.

Income

To qualify you for a conventional loan, your lender will consider whether you have stable and reliable income. It may require copies of paystubs, W-2s, income tax returns and other documentation to make an assessment. Frequently changing jobs will not necessarily disqualify you for a conventional mortgage, if you can show that you’ve earned a consistent and predictable income.

Down payment

Depending on your lender’s guidelines and other qualification factors, you may be able to qualify for a conventional loan with a down payment as low as 3 percent. However, you should remember that conventional loans require you to pay for private mortgage insurance (PMI) if you put down less than 20 percent.

PMI is an insurance policy designed to protect the lender if you stop making payments on your loan. PMI may be paid in monthly installments along with your regular mortgage payment, in an upfront premium paid at closing, or a combination of the two.

Pros and cons of a mortgage

Since mortgages are long-term commitments, it’s essential to be informed about the pros and cons of having a mortgage so you can decide whether having one is right for you.

Advantages of a mortgage

  • Achieve homeownership. A mortgage allows you to purchase a home without paying the full purchase price in cash. Without a mortgage, few people would be able to afford to buy a home.
  • Access to cash flow. Equity in your home, or the difference between the market value of your home and the amount you owe on the mortgage, can give you access to funds when you need money. Many homeowners take out home equity loans or lines of credit to pay for home improvements, medical bills and college tuition.
  • Improved credit score. Having a mortgage loan in good standing on your credit report improves your credit score. That credit score determines the interest rate you are offered on other credit products, such as car loans and credit cards.
  • Tax benefits. The tax code currently provides tax benefits for homeownership. You may be eligible for a deduction for the interest paid on your mortgage, private mortgage insurance premiums, points or loan origination fees, and real estate taxes. And when you sell your primary residence, you may be able to exclude all or part of your gain on the sale of your home from taxable income.

Disadvantages of a mortgage

  • The risk of losing your home. Because your house is collateral for the mortgage, the lender has the right to take your home if you stop making payments. If the lender takes your home in a foreclosure, you’ll also lose any money already paid up to that point.
  • Loss of value. Any property you purchase can lose value over time. If the real estate market drops and your home loses value, you could end up with a mortgage balance greater than the value of your house.

Types of mortgages

Homebuyers have several options when it comes to choosing a mortgage, but these choices tend to fall into the following three headings.

Option 1: Fixed or adjustable rate?

One of your first decisions is whether you want a fixed- or adjustable-rate loan.

  • Fixed-rate mortgage. The interest rate is set when you take out the loan and will not change over the life of the mortgage.
  • Adjustable-rate mortgage (ARM). The interest rate is tied to an index. When this index increases or decreases, your payment may go up or down. Many ARMs start with an introductory period during which the rate is fixed for a few months or years. When that initial period ends, your interest rate can be adjusted up or down depending on the index.

Fixed-rate mortgages offer stability in your mortgage payments. However, many ARMs start with a lower interest rate than fixed mortgages and lock the rate in for a few years. That can mean significantly lower payments in the early years of your loan, so some borrowers opt for an ARM with the intention of selling or refinancing their home before the rate can adjust.

However, keep in mind that your situation could change before the rate adjustment. If interest rates rise, the value of your property falls or your financial condition changes, you may not be able to sell the home, and you may have difficulty making payments based on a higher interest rate.

Option 2: Government-backed or conventional?

You’ll also need to decide whether you want a government-backed or conventional loan.

Government-backed loans. Loans insured by the federal government.

  • FHA loans. FHA loans are a program from the Department of Housing and Urban Development (HUD). They’re designed to help first-time homebuyers and people with low incomes or little savings afford a home. They typically offer lower down payments, lower closing costs and less-stringent financial requirements than conventional mortgages. The drawback of FHA loans is that they require an upfront mortgage insurance fee and monthly mortgage insurance payments for all buyers, regardless of your down payment. And, unlike conventional loans, the mortgage insurance cannot be canceled, even if you have more than 20 percent equity in your home.

FHA loans don’t come directly from the FHA but from an FHA-approved lender. HUD has a searchable database where you can find lenders in your area that offer FHA loans.

  • VA loans. The U.S. Department of Veterans Affairs offers a mortgage loan program for military service members and their families. The advantage of VA loans is that they do not require a down payment or mortgage insurance. However, they do require a funding fee, which can run from 1.25 percent to 2.4 percent of the loan amount.
  • USDA loans. The United States Department of Agriculture (USDA) provides a loan program for homebuyers in rural areas who meet certain income requirements. Their property eligibility map can give you a general idea of qualified locations.

USDA loans do not require a down payment or ongoing mortgage insurance, but borrowers must pay an upfront fee, which currently stands at one percent of the purchase price. That fee can be financed with the home loan. The USDA maintains a list of approved lenders on their website.

Option 3: Conforming or jumbo?

Depending on the amount you want to borrow, your loan may be conforming or jumbo.

  • Conforming loan. Fannie Mae and Freddie Mac are government-controlled corporations that purchase and sell mortgage-backed securities. Conforming loans meet their underwriting guidelines and fall within their maximum size limits. For a single-family home, the loan limit is currently $424,100 for homes in the contiguous states, the District of Columbia and Puerto Rico, or $636,150 for homes in Alaska, Guam, Hawaii and the U.S. Virgin Islands. However, in certain high-cost counties, loans limits can go as high as $954,225.
  • Jumbo loan. Jumbo loans may also be referred to as nonconforming loans. Simply put, jumbo loans exceed the loan limits established by Fannie Mae and Freddie Mac. Due to their size, jumbo loans represent a higher risk for the lender, so borrowers must typically have strong credit scores and make larger down payments. Interest rates may be higher as well.

Things to do before shopping for a mortgage

Buying a home may be the largest purchase of your life, so it’s a good idea to know the following factors before you start shopping.

  1. Your credit score. Your credit score is one of the most significant factors in getting approved for a mortgage, and it also influences the interest rate you’ll end up with. The better your score, the lower your rate will likely be and the less you’ll pay in interest. You’re entitled to free credit reports each year from the three major credit bureaus, so request them from annualcreditreport.com and dispute any errors that may be dragging your score down.
  2. How much you can afford. Lenders will be happy to tell you how much they’re willing to lend you, but that’s not actually a good indication of how much house you can afford. Check out our affordability calculator to get an idea of where you stand before you start looking for houses. Remember that your monthly payment will be more than just principal and interest. It will also include homeowner’s insurance, property taxes and, potentially, mortgage insurance (depending on your loan program and down payment). You’ll also need to factor in utilities and maintenance.
  3. Where to get the best deal. If you qualify for an FHA, VA or USDA loan, you may be able to get a better deal on interest rates and other costs using their programs. Familiarize yourself with their criteria. Whether you choose a government-backed or conventional loan, keep in mind that fees and interest rates can vary widely by lender, even for the same type of loan, so shop around for the best deal. You can start your search by comparing rates with LendingTree.

Common mortgage myths

You need to have perfect credit to buy a home.

Your credit score is a key factor lenders consider when you’re applying for a mortgage, but bad credit won’t necessarily prevent you from getting a mortgage. You may, however, need to have a more substantial down payment in hand and be ready to demonstrate your creditworthiness, despite your low score.

You must have a 20 percent down payment to buy a home.

You may have heard that you should put 20 percent down when you purchase a home. It’s true that having a large down payment makes it easier to get a mortgage and may even lower your interest rate. But many people have a hard time scraping together a down payment that large. Fortunately, there are many options for homebuyers with little money for a down payment. FHA loans offer down payments as low as 3.5 percent. VA and USDA loans may require no down payment at all.

If you prequalify, you’ll get the loan.

Simply put: Nope, not so. The mortgage pre qualification process can give you an idea of how much lenders may be willing to loan you, based on your credit score, debt and income. However, there’s no guarantee that you’ll actually get the loan. Once you find a home and make an offer, the lender will request additional documentation, which may include bank statements, W-2s, tax returns and more. That process will determine whether your loan gets full approval.

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