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How Does a Mortgage Work?

how does a mortgage work

A mortgage is likely to be the largest, longest-term loan you’ll ever take out, to buy the biggest asset you’ll ever own — your home. The more you understand about how a mortgage works, the better decision will be to select the mortgage that’s right for you.

In this guide, we will cover:

Understanding mortgages

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 make a promise to repay the money you’ve borrowed, plus an agreed-upon interest rate.

The home is used as “collateral.” That means if you break the promise to repay at the terms established on your mortgage note, the bank has the right to foreclose on your property. Your loan does not become a mortgage until it is attached as a lien to your home, meaning your ownership of the home becomes subject to you paying your new loan on time at the terms you agreed to.

Important parts of a mortgage

You will sign a lot of documents to obtain a mortgage, including a promissory note, and in many states, a deed of trust.

Promissory note

The promissory note, or “note” as it is more commonly labeled, outlines how you will repay the loan, with details including the:

  • Interest rate
  • Loan amount
  • Term of the loan (30 years or 15 years are common examples)
  • When the loan is considered late
  • What the principal and interest payment is.

Mortgage

Though mortgage is usually used as a catchall term for home loan, it has a specific meaning.

The mortgage basically gives the lender the right to take ownership of the property and sell it if you don’t make payments at the terms you agreed to on the note.

Deed of Trust

Most mortgages are agreements between two parties — you and the lender. In some states, a third person, called a trustee, may be added to your mortgage through a document called a deed of trust.

How your mortgage gets paid off

When you make your monthly mortgage payment, it actually gets split into several different buckets. 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.

In the early years of your mortgage, interest makes up a greater part of your overall payment, but as time goes on, you start paying more principal than interest until the loan is paid off.

Your lender will provide an amortization schedule (a table showing the breakdown of each payment). This schedule will show you how your loan balance drops over time, as well as how much principal you’re paying versus interest.

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. This refers to whether the interest rate you pay will change over time.

Fixed-rate mortgage

In a fixed-rate mortgage, the interest rate is set when you take out the loan and will not change over the life of the mortgage. Fixed-rate mortgages offer stability in your mortgage payments.

Adjustable-rate mortgage (ARM)

In an adjustable-rate mortgage, the interest rate you pay is tied to an index and a margin. When this index increases or decreases, your payment may go up or down.

The index is a measure of international interest rates. The most commonly used are the one-year-constant-maturity Treasury securities, the Cost of Funds Index (COFI), and the London Interbank Offer Rate (LIBOR).

These indexes make up the variable component of your ARM, and can increase or decrease depending on factors such as how the economy is doing, and whether the Federal Reserve is increasing or decreasing rates.

The margin is a fixed number of percentage points that is added to your index, which determines your total interest rate. After your initial fixed rate period ends, the lender will take the current index and the margin to calculate your new interest rate.

The amount will change based on the adjustment period you selected with your adjustable rate. with a 5/1 ARM, for example, the 5 represents the number of years your initial rate is fixed and won’t change, while the 1 represents how often your rate can adjust after the fixed period is over — so every year after the 5th year, your rate can change based on what the index rate is plus the margin.

Many ARMs start with a lower interest rate than fixed mortgages and lock the rate in for a specific number of years. That can mean significantly lower payments in the early years of your loan.

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: Short term or long term?

The next choice you’ll want to make is the mortgage term, which is the length of time to pay the loan in full.

Long term loans

While the 30-year loan is often chosen because it provides the lowest monthly payment, there are terms ranging from 10 years to even 40 years. Rates on 30-year mortgages are higher than shorter term loans like 15-year loans.

Shorter term loans

Over the life of a shorter term loan like a 15-year or 10-year loan ,you’ll pay substantially less interest. In some cases, depending on the size of the mortgage you take out, you save several hundred thousand dollars over the life of a shorter term mortgage loan.

Option 3: Government-backed or conventional?

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

Government-backed loans

These loans are insured by the federal government.

FHA loans. FHA loans are facilitated by 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, unless you made at least a 10% down payment when you took out the original FHA mortgage.

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 may not require a down payment or mortgage insurance. However, they do require a funding fee, which can run from 1.25% to 2.4% 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 1% of the purchase price; that fee can be financed with the home loan. The USDA maintains a list of approved lenders on their website.

Conventional loans

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 Fannie Mae and Freddie Mac. For borrowers with higher credit scores and stable income, conventional loans often result in the lowest monthly payments.

Traditionally, conventional loans have required larger down payments than most federally backed loans, but the Fannie Mae HomeReady® and Freddie Mac HomePossible® loan programs now offer borrowers a 3% down option — which is lower than the 3.5% minimum required by FHA loans.

Conforming and jumbo loans

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

Conforming loan. Fannie Mae and Freddie Mac are government sponsored enterprises (GSEs) that purchase and sell mortgage-backed securities. Conforming loans meet GSE underwriting guidelines and fall within their maximum loan limits. For a single-family home, the loan limit is currently $484,350 for most homes in the contiguous states, the District of Columbia and Puerto Rico, and $726,525 for homes in higher cost areas, like Alaska, Hawaii and several U.S. territories.

You can look up your county’s limits here.

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.

How to qualify for a mortgage

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.

For government-backed loans, the requirements are a little lower — generally 580, but as low as 500 in some cases.

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 45%. However, with a high credit score, and at least two months of reserves, the lender may allow a DTI of up to 50%.

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

  • Money 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 from a 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%. However, you should remember that conventional loans require you to pay for private mortgage insurance (PMI) if you put down less than 20%.

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 as a combination of the two.

Government-backed loans have different down payment requirements. FHA loans require 3.5%, while VA and USDA loans may offer no-down-payment mortgages in some cases.

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. Equity in your home — the difference between the market value of your home and the amount you owe on the mortgage — can give you access to money when you need it. Many homeowners take out home equity loans or lines of credit to pay for home improvements, medical bills or 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. This is called being “underwater,” and it can put you in a situation where you have to pay down the loan balance to sell your home, since the loan balance is higher than your home is worth. The good news is the number of homeowners having this problem has fallen dramatically, as house prices have continued to recover and headed back to their earlier highs.

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.

Know 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.

Find out 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.

Shop around for 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, 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

Myth: 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.

Myth: You must have a 20% down payment to buy a home

You may have heard that you should put 20% 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. Conventional lenders now offer 3% down programs, FHA loans offer down payments as low as 3.5%, and VA and USDA loans may require no down payment at all.

Myth: If you prequalify, you’ll get the loan.

The mortgage prequalification 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.

If you have concerns that it might be hard for you to get approved, you might ask your loan officer whether you can get a full credit approval before you start looking at houses. This allows you to be fully approved for a mortgage based on an underwriter review of all of your income, credit and asset documentation before you have found a house.

Other common mortgage terms

There are several crucial aspects of a loan that you should know before you get started shopping.

  • 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, they typically total 2% to 5% of the home’s purchase price. So on a $250,000 home, your closing costs would amount to anywhere from $5,000 to $12,500.
  • Points. Money paid to your lender in exchange for a lower interest rate.
  • 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 and federal law requires it be disclosed in all advertising.

What happens if you don’t pay your mortgage?

There are two ways a lender can collect if you fall behind on payments — through the courts in a process called judicial foreclosure, or with a trustee in a process called non-judicial foreclosure. If you fall on hard times, it’s essential you know the timeline and processes for how long a foreclosure will take.

What you need to know about judicial foreclosure

The most important thing to understand about judicial foreclosure is that it’s a process that will go through the courts, and generally takes much longer with more costs involved. What that means to you in the event of a foreclosure is that you’ll have more time to either find a way to bring the mortgage current, or make plans to move your family into a rental or make other housing arrangements.

What you need to know about non-judicial foreclosure

If you signed a note and a deed of trust at your closing, then you are probably in a state that allows a non-judicial foreclosure process. The courts are not involved in this process, and the foreclosure process can be much faster, leaving you with less time to make alternative housing arrangements if you are unable to bring the payments current.

The bottom line

Getting a mortgage can be a stressful experience, and many people spend a lot of time and energy on all the paperwork needed to get approved. But not many people spend as much time understanding how a mortgage actually works. Besides telling you the terms of your loan, the mortgage and deed of trust (if applicable) describe the rights your lender has to take ownership of your home if you are unable to pay.

If you fall on hard times, your first phone call should be to the company you are making payments to, called a mortgage loan servicer. They can tell you your rights under the terms of your mortgage and deed of trust. There are very strict laws that were passed in recent years that require lenders do their due diligence to give you all the options possible to bring your mortgage current or exit homeownership gracefully.

By understanding how your mortgage works, you can protect your investment in your home, and will know what actions to take if you ever have challenges making the payments.

 

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