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How Does a Mortgage Work?

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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 how a mortgage works, the better equipped you should be to select the mortgage that’s right for you.

Understanding mortgages

A mortgage is a loan you get from a lender to finance a home purchase. When you take out a mortgage, you promise to repay the money you’ve borrowed at an agreed-upon interest rate.

The home is used as collateral. That means if you break the promise to repay your mortgage, the bank has the right to foreclose on your property. Your loan doesn’t become a mortgage until it’s 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.

Common mortgage terms

You will sign a lot of documents with paragraphs of legal language to obtain a mortgage, including a promissory note, and in many states, a deed of trust. Here are some common terms you’ll need to know if you’re getting a mortgage:

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

  • Your interest rate
  • Your total loan amount
  • The term of the loan (30 years or 15 years are common examples)
  • When the loan is considered late
  • Your monthly principal and interest payment

Mortgage. Though mortgage is usually used as a catchall term for a home loan, it has a specific meaning. The mortgage gives the lender the right to take ownership of your home and sell it if you don’t make payments at the terms you agreed to on the note.

Deed of Trust. A deed of trust works like a mortgage and is secured against your home. 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. A deed of trust gives the trustee the authority to take control of your home on behalf of the lender if you stop making payments.

Mortgage closing costs. These are expenses charged by a lender to make or originate your loan.  They typically include origination fees, discount points, fees related to underwriting, processing, document preparation and funding of your loan. However, your total closing costs include 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 6% of the loan amount. So on a $250,000 mortgage, your closing costs would amount to anywhere from $5,000 to $15,000.

Discount points. Also called “mortgage points,” this is money paid to your lender in exchange for a lower interest rate.

Note rate. This is the actual interest rate you pay each year based on the loan amount you borrow, expressed as a percentage rate. It doesn’t reflect any of the costs or charges for the mortgage, and should not be confused with the annual percentage rate, which we’ll explain next.

Annual percentage rate (APR). The APR is typically higher than your note rate because it reflects the cost of borrowing money, based on the interest, fees and loan term, expressed as a yearly rate. The APR was created to make it easier for consumers to compare loans with different interest rates and costs, and federal law requires it to be disclosed in all advertising. Basically, the higher the difference between your note rate and APR, the more you’re paying in closing costs.

Mortgage insurance. Mortgage insurance protects a lender against losses incurred if they have to foreclose on your home because you can’t make your payments. You’ll pay mortgage insurance on some government-backed loans regardless of down payment, but you can avoid it on conventional loans with a down payment of 20% or more.

How a mortgage works

Every month you make a mortgage payment, it gets split into at least four different buckets that make up principal, interest, taxes and insurance or PITI for short. Here is how each bucket works:

  1. Principal. This is the portion of your loan balance that’s paid down with each payment.
  2. Interest. This is the interest rate charged monthly by your lender for the mortgage you chose.
  3. Taxes. You’ll pay 1/12th of your yearly property tax bill each month based on how much is assessed each year in your neighborhood.
  4. Insurance. Lenders require homeowners insurance to cover your home against hazards like fire, theft or accidents. You may have an additional, separate monthly payment for mortgage insurance based on your down payment or loan type.

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.

THINGS YOU SHOULD KNOW

Mortgage lenders require an escrow account to collect your property taxes and homeowners insurance each month if you make less than a 20% down payment on your mortgage.  Your lender uses the funds in an escrow account to pay your property tax bills and homeowners insurance premiums.

How to qualify for a mortgage

You’ll need to meet minimum mortgage requirements to qualify for a mortgage. Lenders typically consider the following when reviewing your mortgage application:

Your credit score

Your credit score reflects how you’ve managed different credit accounts in your financial history. The higher your credit score, the lower your interest rate and mortgage payment will be. Most lenders require a minimum FICO Score of:

  • 620 for a fixed-rate or adjustable-rate conventional mortgage
  • 580 for a minimum down payment government-backed loan
  • 500 for a government-backed loan with a higher down payment (at least 10%)

Your 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. The Consumer Financial Protection Bureau (CFPB) recommends a DTI or no more than 43%. However, some loan programs (which we’ll cover later) allow DTIs above 50% in certain cases.

Your income

To qualify for a mortgage loan, your lender will ask for proof that you have stable and reliable income based on a review of your paystubs, W-2s, income tax returns or other documents that show your earnings. Lenders will also review how often you’ve changed jobs and how long you’ve been in your current field of work.

Your down payment

A down payment is how much money you pay upfront to buy a home. Not all loan programs require a down payment, but the more you put down, the lower your mortgage payment will usually be. Lenders typically ask for two months of bank statements to show where your funds are coming from. You’ll need to document down payment funds from a gift, 401(k) loan or down payment assistance program.

Your rainy-day reserves

Essentially, mortgage reserves are assets you can easily convert to cash to make your mortgage payments if you were to hit a rough financial patch. They can make the difference between mortgage approval and denial, especially if you have low credit scores or a high DTI ratio.

Examples of accounts you can use to meet a mortgage reserve requirement include:

  • 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

Different types of mortgages and how they work

The table below highlights the basics of the different types of mortgages available.

Mortgage type  How it works
Fixed-rate mortgage
  • Offers a stable monthly payment that doesn’t change for the life of the loan
Adjustable-rate mortgage (ARM)
  • Lower teaser rate for a set time period
  • The rate changes after the low initial rate period ends and could rise or fall based on the type of ARM you choose
Long-term loans
  • 30-years is typically the longest term offered with the lowest possible payment
  • You’ll pay more interest over the life of the loan than a shorter term
  • Your interest rate is usually higher than shorter-term loans
  • Some lenders may offer 40-year fixed rates
Short-term loans
  • The 10-year fixed-rate mortgage is usually the shortest available term
  • You’ll make a much higher payment than a longer-term loan
  • You’ll pay far less than mortgage interest with a shorter-term loan
FHA loans
  • Allow scores as low as 580 with a 3.5% down payment
  • Allow scores as low as 500 with a 10% down payment
  • Requires two types of FHA mortgage insurance regardless of down payment
  • Insured by the Federal Housing Administration (FHA)
Conventional loans
  • Offer programs with a 3% down payment and 620 credit scores
  • Don’t require any mortgage insurance with a 20% down payment
  • Guidelines set by government-sponsored enterprises Fannie Mae and Freddie Mac
VA loans
  • Exclusively for eligible active-duty and retired military borrowers and surviving spouses
  • No down payment required in most cases
  • No mortgage insurance is required
  • May pay a VA funding fee unless exempt
  • Loans are guaranteed by the U.S. Department of Veterans Affairs (VA)
USDA loans
  • No down payment required
  • The program is for low- to moderate-income borrowers
  • The loan can only finance homes in USDA-designated rural areas
  • Backed by the U.S. Department of Agriculture (USDA)

Pros and cons of a mortgage

Advantages of a mortgage

  • You’ll 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.
  • You can cash in your equity. 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 home equity lines of credit (HELOCs) to pay for home improvements, medical bills or college tuition.
  • Your credit score may improve. 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.
  • You may have extra tax benefits. The tax code currently provides tax benefits of 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

  • Your risk 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.
  • Your home’s value could drop. 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.

3 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. Know your credit score and take steps to boost it

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. You can check your credit score and improve it by:

  • Requesting a free credit report from annualcreditreport.com
  • Disputing any errors that may be dragging your score down
  • Keeping your credit card balances low, or better yet pay them off
  • Paying all your monthly bills on time

2. Find out how much 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 homeowners insurance, property taxes and, potentially, mortgage insurance (depending on your loan program and down payment). Also, be sure you budget for:

  • Utilities (including water, electric, cable)
  • Maintenance costs
  • Homeowners association dues
  • Furniture and appliances
  • Extra mortgage reserves in case of a financial emergency

3. Shop around for your best deal

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 your best deal. Collecting loan estimates from at least three different mortgage lenders can save you thousands over the life of your mortgage. You can start your search by comparing rates with LendingTree.

What happens if you can’t pay your mortgage?

If you fall on hard financial hard times, there are several steps you can take that will help you avoid foreclosure while you’re working things out. Be prepared to provide documentation and letters detailing your situation.

Request a forbearance. Contact your loan servicer and request a mortgage forbearance. This option allows you to stop making payments for a set time period that will vary based on your loan servicers policies. Make sure you understand the repayment options after the forbearance period ends. They typically include an option to repay the entire past due balance, to make extra payments for a set time or defer the missed payment balance payoff until you sell or refinance your home.

Request a loan modification. If you’re not eligible for a forbearance, discuss mortgage modification options with your loan servicer. You may be able to negotiate a reduced interest rate, a longer term or a combination of both. Make sure you keep track of all written correspondence from your lender and respond quickly to requests for additional documentation.

What happens if your mortgage is foreclosed?

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 can’t make your payments, it’s essential you know the timeline and processes for how long a foreclosure will take.

Judicial foreclosure. A judicial foreclosure is a court process and generally takes much longer than a non-judicial foreclosure. It gives you more time to either find a way to bring the mortgage current or make plans for other housing arrangements.

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 timeline may be much faster, leaving you with less time if you are unable to bring the payments current.

Common mortgage myths

You need perfect credit to get a mortgage. With government-backed loan programs like the FHA, you may be approved for a loan with a credit score as low as 500, if you can make a 10% down payment. However, lenders will need to demonstrate your creditworthiness based on other factors such as your DTI ratio and cash reserves for you to get a mortgage with bad credit.

You need a 20% down payment to get a mortgage. There are many low-down-payment mortgage programs to choose from that require less than a 20% down payment. In addition, you may be eligible for down payment assistance programs offered in your area.

If you’re prequalified, you’ll get a mortgage. Getting prequalified for a mortgage only gives you an idea of how much a lender might loan you based on your credit score, debt and income. However, the lender still has to review supporting documents that could reveal roadblocks to your final approval. You may want to consider getting a full credit approval before you look at houses if you know you have issues with your income or credit.

 

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