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How does a mortgage work?

Demystifying the homebuying process

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Written by Brandi Marcene
Edited by Cassidy McCants

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    learn how a mortgage works

    For most aspiring homeowners, obtaining a mortgage is an essential step in buying a house. Mortgages are typically large loans with long loan terms, so it’s essential to understand the basics of a mortgage and how it works before you make this significant commitment. You want to make sure you get the home loan that’s right for you.

    Mortgage basics

    A mortgage is a contract between a lender and a borrower for a loan used to purchase a property. The purchased property is used to secure the loan, which gives the lender the legal right to repossess the property and sell it if a borrower fails to make their mortgage payments. Most people have to take out a mortgage to buy a home or refinance.

    Mortgages, like other loans, accrue interest throughout the loan term and have other fees and costs. A mortgage consists of a few basic elements:

    Interest rate

    The mortgage rate is the interest rate you pay to borrow the money, expressed as an annual percentage of your total loan amount. Essentially, the interest is the profit your lender earns for giving you money.

    The annual percentage rate (APR) is an annual percentage of the loan amount that more broadly measures how much you’ll pay to take out a mortgage. APRs are higher than mortgage rates because they include interest plus other fees.

    • Fixed rate: A fixed interest rate remains the same for the entire length of your mortgage. If your fixed rate is 4%, you’ll pay 4% in interest until you refinance or pay off the loan. With a fixed-rate loan, you know exactly how much you’ll pay each month of the loan term, making budgeting simpler.
    • Adjustable rate: An adjustable rate is more unpredictable than a fixed rate, changing according to the terms of the contract and the market. Most adjustable-rate mortgages, or ARMs, start with a fixed-rate period that typically lasts up to 10 years. During this period, the interest rate on the mortgage doesn’t change. Once this period ends, however, the interest rate adjusts at a predetermined frequency. This means your monthly payments can change throughout the course of the loan.

    Loan term

    The loan term is the period of time you have to pay back the mortgage. If a borrower pays the loan off in full within this time frame, the loan balance moves to zero after the last month of the term.

    Common loan terms are 15 years and 30 years, though there are also other options (like 10-year and 20-year terms.)

    Loan amount

    The loan amount is the amount you borrow to cover the purchase price of the property. The loan amount is the sales price of the home minus the down payment.

    Repayment

    The repayment of a mortgage includes the principal loan amount you borrowed and the interest accrued. A mortgage is paid off in a series of payments over the agreed-upon loan term.

    Interest-only repayment is exactly what it sounds like: a payment you make that covers only the interest. Interest-only mortgages have interest-only payments for a set amount of time before you begin to pay the principal.

    Closing costs

    Closing costs are fees you pay to the lender during the home sale. These costs include discount points, the origination fee, loan processing fees, underwriting fees, loan funding fees and document preparation fees. This cost also includes title, appraisal, survey and recording fees.

    Closing costs vary depending on the mortgage type and location. However, the typical range is between 2% and 6% of the loan amount. So, if your mortgage amount is $250,000, the closing costs might be anywhere between $5,000 and $15,000.

    Mortgage insurance

    Mortgage insurance protects the lender in case the borrower defaults on the loan. The specifics of your mortgage insurance depend on the type of home loan. If your down payment on a conventional mortgage is lower than 20%, the lender may require monthly private mortgage insurance (PMI) until you have enough equity in the property. If you get an FHA loan, you pay mortgage insurance premiums to the Federal Housing Administration, including an upfront and monthly payment.

    Types of mortgage loans

    There are several mortgage types to choose from. Mortgage rates are either fixed (stable rate over the course of the loan) or adjustable (relatively lower fixed rate for a temporary period before adjusting at predetermined intervals).

    Long-term mortgages

    A popular mortgage option is the 30-year home loan. With this longer term, you pay higher more interest, but your monthly payments are lower. Some lenders and banks also offer 40-year mortgage options, but these are rare.

    Short-term mortgages

    The 10-year mortgage is often the shortest-term home loan available to borrowers. A 10- or 15-year mortgage comes with a lower interest rate — and you’ll pay less interest overall — than a long-term loan, but you'll pay more each month because of the shorter term.

    Conventional mortgages

    A conventional loan is a privately backed loan (meaning it’s not backed by the government, which makes it riskier for lenders). Conventional loan programs typically require a credit score of at least 620 and a down payment of at least 3%. However, if you put down 20% or more, you can avoid paying PMI.

    Conventional loans can be conforming or nonconforming. A conforming loan adheres to rules from Fannie Mae, Freddie Mac and the Federal Housing Finance Agency, while a nonconforming loan does not meet these requirements. Jumbo loans are generally nonconforming loans that have higher borrowing amounts and require good credit and a large down payment.

    Government-backed mortgages

    Government-backed loans are loans insured by the government in case the borrower defaults. This makes it easier for the private lender to approve applicants. Government-backed loan options include FHA, VA and USDA loans.

    FHA loans

    FHA loans are backed by the Federal Housing Administration. You can obtain an FHA loan with a credit score as low as 500 and a minimum 3.5% down payment for those with good credit. They do require FHA mortgage insurance, regardless of how much you put down. FHA loans are popular among first-time homebuyers and those with less-than-ideal credit.

    VA loans

    VA loans, which are guaranteed by the U.S. Department of Veterans Affairs, are meant for eligible retired and active-duty military personnel and surviving spouses. In most cases, they don’t require a down payment or mortgage insurance. Often, a borrower needs to pay the VA funding fee, though there are exemptions.

    USDA loans

    Loans backed by the U.S. Department of Agriculture (USDA) are designed for low- to moderate-earning borrowers. These loans finance home purchases in designated rural locations. USDA loans don’t require a down payment and aren’t limited to first-time homebuyers.

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      The mortgage process

      The mortgage loan process can be challenging to navigate, especially if you’re a first–time home buyer. It’s helpful to learn about the process before getting into it so you know what to expect.

      Determining your budget is the ideal first step in homebuying. Calculating how much property you can afford helps to set realistic expectations when you’re property-hunting and can ensure you choose the right mortgage for your situation.

      Instead of determining the maximum purchase price possible, it’s better to estimate what monthly payments you can manage reasonably. Once you know this figure, check out the current mortgage rates to start determining your homebuying power.

      Preapproval from a lender tells you how much you’re approved to borrow based on your income, credit and savings. A preapproval letter gives you firmer standing as a borrower, showing you’re qualified and ready for a home loan.
      After getting preapproval for your mortgage, it’s time to go house-hunting. It’s smart to find an experienced real estate agent who can help you find a home that meets your needs. Once you’ve done so, you can make an offer, pledging earnest money to show the buyer you’re serious.
      When shopping for a mortgage lender, you’ll want to compare a few different lenders to find out which can offer you the right type of loan at the lowest rate with the best customer service. Remember: You don’t have to go with the lender who gave you preapproval.
      The most crucial step in the mortgage process is completing the mortgage application. Most of this process is completed in the preapproval stage, but you’ll need additional documents to get your loan underwritten. The lender will provide you with a list of everything needed so you can close on schedule.
      The mortgage lender arranges for an appraiser to conduct an independent value estimate of the home you buy. Many lenders hire a third-party company to conduct an appraisal. This step helps the lender determine whether it’s lending a fair amount for the property.
      After you submit a full loan application, the mortgage processing begins. This typically includes a waiting period for the buyer. There are a number of steps:
      1. The processor creates a mortgage file for underwriting.
      2. The processor orders necessary credit reports, along with tax transcripts and title searches.
      3. The processor verifies your mortgage application details, such as payment histories and bank deposits.
      4. Processors ask for a written explanation of any late payments, judgments and collections.
      5. After collecting a complete package with documentation and verification, the mortgage processor sends the file to the underwriter.
      6. The underwriter reviews the information in the file to evaluate red flags and missing items.

      The primary focus of the processor involves the “three C’s” of underwriting:

      • Credit: Your credit history, which shows if you’ve paid debts on time
      • Capacity: Your ability to pay for the loan
      • Collateral: The property value itself as collateral for the mortgage loan

      During processing, the mortgage lender may come back with some more questions for you. Do your best to respond to provide answers quickly to keep closing on track.

      The lender sends the closing documents with instructions for the title company and closing attorney. At this point, you’ll sign a big stack of documents, including the closing disclosure (which looks similar to the Loan Estimate you got when completing the loan application).

      Mortgage requirements

      With any type of loan, there are specific requirements for qualification. These will depend on the lender, the type of loan and your personal financial profile, including your credit score, debt-to-income ratio, monthly income and down payment amount.

      Credit score

      A credit score is critical in taking out a mortgage. It reflects how you’ve managed various credit accounts throughout your financial history. Having a higher credit score can help you qualify for a lower interest rate.

      FICO Score minimums for most lenders:

      • 620 for a conventional mortgage
      • 500 to 640 for a government-backed loan
      • 680 to 700 for a jumbo loan

      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 evaluate your ability to make your loan payment each month.

      Monthly income

      It’s important to be able to show your mortgage lender you have a sufficient and stable income. Lenders review your pay stubs, income tax returns, W-2s and other documents showing your earnings. They might also consider how often you’ve switched jobs and how long you’ve worked in a particular field.

      Down payment

      A down payment is the amount of money you pay out of pocket upfront to purchase a home. Not all loan programs require borrowers to make a down payment. Making a bigger down payment means you borrow less money and make smaller monthly mortgage payments; you may qualify for a lower interest rate and avoid paying private mortgage insurance.

      Pros and cons of a mortgage

      Most people don’t have the option of buying a home without the help of a mortgage. If you’re trying to decide whether getting a mortgage is right for you, here are some benefits and drawbacks to consider.

      Pros

      • Achieve homeownership and make payments over time
      • Save cash for use toward other purposes (e.g., education, other investments)
      • Variety of loan types and borrowing options
      • Improve your credit history/score
      • Deduct mortgage interest on taxes

      Cons

      • Large source of debt
      • Lender fees and charges for the loan
      • Total repayment amount is a lot more than principal
      • Possible foreclosure if you don’t make payments on time

      Mortgage FAQ

      Can you buy a house without a mortgage?
      Yes, you can buy a house with cash and avoid the process and fees that accompany a mortgage. Being a cash buyer may make you more attractive to the seller because they don’t have to worry about financing breaking down at the last second. A seller might even be more willing to negotiate with a cash buyer. However, there are some drawbacks to paying with cash, such as having more of your money tied up in the property.
      What are the current mortgage rates?
      Mortgage rates change frequently, but we collect the most recent interest rates for popular loans each day.
      How much of a down payment should I make on a home?
      It depends on factors such as how much you have in savings, your monthly budget, the type of mortgage loan you get and current market conditions. By putting down a larger down payment, you’ll end up borrowing less and might qualify for lower rates. But, you also end up having less money available for other purposes or an emergency. The median down payment on a home from mid-2019 to mid-2020 was 12%, according to the National Association of Realtors.
      How much house can I afford?
      To estimate how much house you can afford, it can be helpful to use the 28/36 rule. The rule states that your housing expenses shouldn’t exceed 28% of your gross income, and your total monthly debt payments shouldn’t exceed 36% of your gross monthly income.

      Bottom line

      A mortgage is the only path to homeownership for most of us. Applying for a mortgage is a good idea if you can afford the down payment, monthly payments, closing costs and the overall cost of homeownership.

      However, keep in mind that a mortgage loan is a significant debt that uses your property as collateral. Before you take out a mortgage, examine your personal finances closely and educate yourself as much as possible about home loans. Once you’re ready to apply, compare offers from a variety of lenders to get the best deal possible.

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