What is a home appraisal and how do they work?
Home appraisals determine the value of a property and are used in homebuying and refinancing. Learn more about what you can expect from an appraisal.
Emily Moore
Understanding home loan basics
A mortgage promissory note is an agreement between a borrower and a lender — usually a bank or other financial institution. The mortgage terms outline the amount to be borrowed, the length of the agreement, the amount of each payment and the interest to be paid.
Mortgages detail how the lender can recover the property they financed should the borrower fail to make timely payments on the loan and interest. In essence, mortgages use the value of the financed property as collateral.
A mortgage is most easily understood as a loan you take out to pay for a home. Buying property is expensive. Since most people don't have hundreds of thousands of dollars lying around, they have to borrow it.
All mortgages are considered secured loans because they’re tied to property (usually a house). Requirements vary by loan type and lender, but they all follow the same basic process:
1. You submit an application for the loan.
The borrower begins the application process by submitting various financial documents, including but not limited to tax returns and W-2s from your employer for the past two years and pay stubs, bank account statements and investment account statements from the past two months. If applicable, you will need documentation of alimony or child support and a gift letter if someone else is paying for a portion of the down payment.
2. The lender reviews your finances and creditworthiness.
Because a mortgage loan is for such a large sum, a potential lender will vet your creditworthiness and financial standing thoroughly to ensure it’s not making a risky loan. The lender will perform a credit check, and your credit score will help them determine two things:
3. If qualified, you’re preapproved for a certain amount.
If you meet the lender’s qualifications, it will preapprove you for a loan up to a certain amount of money. You can then use this letter of preapproval to start shopping for homes. Without this prior authorization, you won’t be able to make any offers on homes.
If you apply for a conforming loan, the total amount you can borrow is set by the government, with other rules established by Fannie Mae and Freddie Mac (the loan backers). With a nonconforming loan like a jumbo loan, you can get access to much higher amounts.
Underwriting generally takes 30 to 45 days.
4. You make an offer.
If the seller accepts your offer, your lender begins the underwriting process. Underwriting generally takes 30 to 45 days as your loan package is reviewed and double-checked for accuracy while the lender ensures your financial situation hasn’t changed since the initial review.
5. You sign a contract at closing.
At the end of the underwriting process, you will sign a contract with your lender, agreeing to pay back the loan amount plus interest over a set period of time (usually 15 or 30 years) at closing. With this, you also agree to maintain homeowners insurance and to pay the annual property taxes. All these costs are usually folded into your monthly payment.
6. You start making payments.
For the life of the loan, you are obligated to make monthly payments to your lender. Your lending institution has a claim on the property until the loan is fully paid off. If you default, the lender can take the home as collateral to help pay back the loan. After you pay off your mortgage, your lender will release its claim, and you will then be the official owner of your home.
Mortgages are generally sought by people who don’t have the financial resources to pay all cash for a house. The median age of a first-time homebuyer in 2018 was 32 — about the same as it was in 2002, according to the Consumer Financial Protection Bureau. Mortgage holders must meet some minimum standards set by their lender — usually a stable and steady source of income, a qualifying credit score and a debt-to-income ratio (DTI) below 45%. A down payment will likely be required, and the property must be appraised for an amount sufficient to use as collateral for the loan. For more, learn how to get a mortgage next.
You need to meet certain qualifications with a lender to receive a mortgage. When a potential borrower wishes to buy a house (or refinance), they apply for a loan through a bank or other lending institution. The basic process for obtaining a mortgage is generally the same from lender to lender, though specific requirements vary.
It’s advisable to contact two to three lenders to compare rates and find someone you feel comfortable working with. A good lender will take the time to answer all your questions, explain the process thoroughly and maintain open lines of communication.
While they’ll be constrained by the Federal Reserve's interest rates, specific requirements like DTI, credit score and income levels may vary slightly. They may also have differing fee structures for their services. If you’re rejected by one lender or feel that the costs associated with one are too high, it’s always a good idea to contact another.
You may find it helpful to contact both a lender and a broker. A lender works for only one financial institution, usually a bank. On the other hand, a mortgage broker can look at rates and packages from several financial institutions and match you with the best one. Some mortgage brokers charge an extra fee for their services that you won’t find with traditional lenders. Sometimes you can obtain more lenient terms going through a traditional lender, especially if you have a long relationship with a bank.
There are many guidelines out there to answer this question, but a good one is that you can afford a house that’s roughly 4 to 4.5 times your gross yearly income. For example, if you gross $75,000 a year, you could afford a house that costs roughly $300,000. If you are borrowing with a partner, you would add your incomes together to determine this number.
You can also use different online calculators to determine how much of a mortgage you can afford. If you use one of these, make sure to find one that includes reasonable estimates of annual property taxes and insurance in addition to the principal loan amount and interest. The amount you’ll pay each month is also dependent on your mortgage rate, which fluctuates based on federal directives and your credit score.
The credit score needed to buy a house will vary depending on your lender and mortgage type. Most conventional mortgage lenders look for a minimum credit score of 620 to 640. That said, you will get more favorable terms the higher your score is. Typically a "good" credit score is over 720 or, in some cases, 740. If your score falls significantly below this, you might consider several federally backed programs, such as FHA, USDA or VA loans, which accept applicants with scores as low as 580. Lenders will also look at your income and spending. Specifically, lenders will calculate your DTI (debt-to-income ratio). A “good” DTI is generally one under 36% (though this number can go as high as 45% for some conventional loans). This means lenders are looking to see if 36% or less of your gross monthly income goes toward certain debts. This includes housing expenses, consumer debt like credit cards and any outstanding loan payments, like car, business or student loans. Monthly expenses like utilities, groceries and entertainment are not included in this calculation.
When you apply for a mortgage loan, you’ll hear lots of terms tossed around that are specific to the industry. It’s a good idea to understand what they all mean ahead of time so you’re not confused when you encounter them in the homebuying process.
If you can’t come up with a down payment, look for federally backed mortgage programs, such as FHA loans and USDA loans, with more flexible requirements. There are also several down payment assistance programs (DPAs) that can help borrowers who are having trouble coming up with this money. These are usually regionally funded. A local mortgage lender or broker can give you more information about the programs available in your area.
Earnest money is usually less than 5% of the purchase price and will ultimately go toward your final purchase, though you are in danger of losing it if you decide to withdraw your offer. It’s worth noting there are a number of legitimate reasons you might withdraw your offer; as long as these are established in your offer, you get your earnest money back.
Escrow can also refer to the account where your earnest money is held during the period of time after your offer is accepted and you work toward closing.
The main types of mortgage rates are fixed and adjustable. With a fixed-rate mortgage, you pay the same rate for the entire term. Adjustable-rate mortgages have rates that can change over time.
There are two main types of second mortgages: a home equity line of credit (HELOC) and a home equity loan. A HELOC allows you to keep a revolving line of credit, much like a credit card. A home equity loan is a single lump-sum loan, paid back in monthly installments like your first mortgage. For more, read about home equity loans and lines of credit next.
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