For most people who buy a home, applying for a mortgage is part of the process. Besides investors and the very wealthy, very few people pay cash for a house.
A mortgage is a loan product that allows you to purchase a piece of property, even though you only have a portion of the purchase price. The portion that you have to apply to the purchase is the down payment.
The rest is the mortgage, loaned to you for a specific time, at a fixed or adjustable interest rate, with the property serving as the collateral on the loan. There are many different kinds of mortgages, so finding the one that best suits your needs will lead to a more satisfactory experience.
If you decide to buy a home and take out a mortgage, first you must make sure you qualify. In other words, a lender considers whether or not you are credit-worthy and whether you can afford the loan. To do that a lender looks at a borrower’s income and how much they already owe.
Benjamin Albies, a sales development manager at Nationstar Mortgage, says the borrower's debt-to-income ratio (DTI), a measure of debts and obligations compared to income, is a critical piece of information – especially these days.
“In the wake of the financial crisis new rules have been enacted that prevent lenders from writing loans that borrowers can’t afford,” Albies told ConsumerAffairs. “Recently the Consumer Finance Protection Bureau (CFPB) has passed a rule called the Ability to Repay Rule (ATR) which requires lenders to verify a borrower’s ability to repay the loan with income documentation. Depending on the loan product, there is typically a maximum DTI that is allowable.”
A lender also examines a borrower’s credit history and score in making a decision to lend money. A lender doesn’t just need to know a borrower’s ability to repay the loan, but how he or she has managed their current and past debts.
Once pre-qualified for a mortgage amount, the would-be home buyer must decide how much money he or she can pay as a down payment. A large down payment, of 20% or more of the purchase price, can save money since mortgage insurance will not be required.
Down payments of less than 20% will require mortgage insurance, which protects the lender in case of default. The insurance premium is a small percentage of the loan balance and is paid as part of the monthly payment.
Fixed rate or adjustable
A home buyer will usually have the option to choose a fixed interest rate or one that adjusts from time to time call an adjustable rate mortgage (ARM). As a rule, fixed rate loans are more secure for the home owner but adjustable rates tend to be slightly lower. However, they can also rise if mortgage rates go up. Each homebuyer's particular situation, goals and long-term plans should be considered to determine whether a fixed rate or ARM would be more advantageous.
“Most ARM’s are fixed for the first 3,5,7,or 10 years of the loan and then adjust annually for the duration of the loan based on an index,” Albies said. “ARM’s can be a smart move for the right type of borrower given that the interest rate on ARM’s is always lower than prevailing fixed rates.”
For example, Albies says a borrower who expects to be in a home for a shorter period of time can save considerably on their payments by taking an ARM loan versus a fixed rate loan. Borrowers who don't plan to move and are on a fixed income are generally advised to consider fixed rate loans because the interest rate and payments on ARM’s can increase after the initial fixed period if rates go up.
A fixed rate mortgage is usually repaid over 30 years. However, there are 15-year loans and even 10-year loans. Adjustable rate mortgages may be repaid over similar time periods but the rates adjust at specified times. When the rate goes up, so does the monthly payment.
Components of the monthly payment
The interest rate isn’t the only thing that influences your monthly mortgage payment. The payment is made up of principal and interest. If an escrow account is established, the monthly payment also incudes taxes and insurance.
Even if an escrow account is not set up, taxes and insurance remain the homeowner's responsibility and must be considered as part of the overall monthly mortgage obligation. An escrow account is required the majority of the time.
You arrive at the principal and interest by amortizing the loan over the specified term. Using a formula, a portion of each payment is dedicated to paying the interest and a portion to the principal. Over the term of the loan, the portion going to principal gets larger while the portion going to interest gets smaller.
The local jurisdiction where the property is located imposes a property tax. To make sure it is paid on time, the loan servicer collects it from the borrower and pays it from the escrow account, if one has been established. The same house in a high-tax jurisdiction will cost more each month than in a low-tax jurisdiction. That’s something to keep in mind when house-hunting.
To make sure the property carries adequate insurance coverage, the loan servicer will also collect money each month for the insurance policy, if an escrow account has been set up.
Taken together, these 4 elements make up the monthly payments, with the additional element of mortgage insurance if the down payment is less than 20%.
For most consumers, a mortgage is the largest debt they will ever have and it might seem a bit overwhelming. But consider this: everyone incurs some kind of cost in order to have a home to live in. Some pay rent, others pay a mortgage. Either way you will face a cost to having a roof over your head.
In years past house payments were usually higher than a consumer would pay for rent. Today, that is not always the case because interest rates have remained low while rents in many markets have rapidly increased.