Mortgage 101 - Learn about mortgages
Getting a mortgage doesn’t have to be intimidating – especially when you understand the basic parts of the process like figuring out options, features, and costs of a home loan.
What is a mortgage?
A mortgage loan is used to finance the purchase of a home property. When you take out a mortgage, the lender provides the funds to buy the property, and you agree to repay the loan with interest over a specified period. The property serves as collateral for the loan, meaning there is a risk of foreclosure if you fail to make the mortgage payments.
Mortgages typically have repayment terms of up to 30 years, depending on what a lender offers and the type of mortgage you choose. The loan is repaid through monthly payments, which include both principal and interest.
How does a mortgage work?
Through application to closing, the mortgage process generally involves the following steps:
- Pre-approval: Before starting your search for a new home, it’s a good idea to get pre-approved for a mortgage. This involves providing a lender with information about your income, assets, and debts, and the lender will determine how much you can borrow. Pre-approval may help you understand your budget and be prepared to make a strong offer when you find the home you want to buy.
- Find a home and make an offer: When you find a property you want to buy, you’ll make an offer, which may include contingencies such as obtaining financing or passing a home inspection.
- Formal mortgage application: After your offer is accepted, you’ll submit a formal mortgage application with your lender of choice. This will include providing additional documentation such as pay stubs, tax returns, and bank statements to verify your income and assets.
- Loan processing and underwriting: The lender will review your application and documentation, verify your information, and assess your creditworthiness. The underwriting process may also include obtaining an appraisal report to determine the property’s appraised value.
- Loan approval and closing: If your loan is approved, you’ll receive a loan commitment letter outlining the terms of the mortgage. You’ll then attend a closing appointment to sign mortgage documents, pay any required closing costs, and finalize the purchase of the property.
There are various types of mortgages available, each with its own unique features and benefits. Understanding the basics of mortgages and the mortgage application process can help you make informed decisions when buying a home and finding the right financing for your needs.
Types of mortgage loans
Every home loan has two parts: principal and interest. The principal is the amount you borrow, and the interest is what you pay to borrow the money. Different types of home loans give you choices on how to structure your interest payments to meet your specific financial needs.
When shopping for a home loan, there are two major types of loans that you can choose from: a fixed-rate mortgage or an adjustable-rate mortgage (ARM).
The main features of a fixed-rate mortgage are:
- The interest rate doesn’t change on your loan.
- Your monthly mortgage payment (principal and interest) will always be the same amount.
- As a tradeoff for the security of knowing your monthly payment will never increase, the interest rate might be higher than the rate on an adjustable-rate mortgage.
The main features of an adjustable-rate mortgage (ARM) are:
- The initial interest rate might be lower than the rate on a fixed-rate loan.
- The interest rate adjusts periodically after the initial term expires (typically anywhere from 1 to 10 years), depending on movements in market interest rates.
- Your monthly mortgage payment could increase or decrease in the future, based on the adjustment period of the interest rate on the loan
- If you are considering an ARM, it is a good idea to ask your mortgage banker what your monthly payment would be if interest rates rise 1, 3 or 5 percentage points in the future, so you can get a sense for how much more you may be required to pay in the future.
Other types of mortgages include:
- Government loan programs such as those offered by the Federal Housing Authority (FHA) are also popular and are available in both fixed-rate and adjustable-rate structures. In general, government loan programs are easier to qualify for and have lower down payment requirements as well as more flexible credit requirements. FHA loans may have specific fees and payments associated with each of them. Other examples of government-backed mortgages include VA loans guaranteed by the Department of Veterans Affairs and USDA loans guaranteed by the U.S. Department of Agriculture.
- Jumbo mortgages are loans that exceed the conforming loan limits set by Fannie Mae, Freddie Mac, and their regulator – the Federal Housing Finance Agency (FHFA). According to the Consumer Financial Protection Bureau (CPFB), these loans may come with higher costs.
While you may encounter many home financing terms throughout the mortgage process, there are several key terms that may be helpful to know more about when you’re planning on purchasing a home.
Prequalified vs Preapproved
Before you start looking for a home, you will need to know how much you can afford, and the best way to do that is to get prequalified or preapproved for your loan. Many real estate agents want you to be prequalified so they can show you homes in your price range.
- To get prequalified, you just need to provide some financial information to your mortgage banker, such as your income and the amount of savings and investments you have. Your mortgage banker will use this information to estimate how much they can lend you.
- You can also get preapproved for your mortgage, which may involve providing your financial documents (W-2 statements, paycheck stubs, bank account statements, etc.) so your lender can verify your financial status and credit. Preapproval may give you confidence that you can afford a particular home when you’re ready to make an offer, and it might help your seller consider your offer more seriously because they know you can get the money you need to purchase.
The term is the number of years that you will make payments on your home loan. The longer the term, the lower your monthly payment will be. With a longer term, you will also pay more in interest over the life of the loan.
The interest rate is used to calculate your total monthly payment. The higher the interest rate on a particular loan, the higher your monthly payment will be, and vice versa.
With a fixed-rate mortgage, the interest rate on your loan won’t change over the term of the loan. With an Adjustable Rate Mortgage (ARM), however, the interest rate is linked to an index of interest rates published by a third party. As this index changes over time, so will the interest rate used to calculate your total monthly payment.
Annual percentage rate (APR)
If you are comparing loans across lenders, you want to be sure to look at your loan estimate and the annual percentage rate (APR) for each loan. The APR tells you the estimated cost of your loan, which includes the interest rate and other upfront fees that you pay for the loan (example: discount points and origination fees). Comparing APRs will help you understand which loan is the best value for you when all costs are considered.
One popular home loan strategy is to negotiate discount points. These are fees you can choose to pay the lender to reduce your interest rate. Generally, each point you purchase will lower your rate by 0.25% (for example, a 7.50% interest rate would be lowered to 7.25%).
This, however, depends on the term of the loan. The cost of buying one point is generally equal to 1% of the loan amount. For a $300,000 loan, a point would cost you $3,000. For a $400,000 loan, a point would cost $4,000. Buying discount points may be smart for those who know they’ll be in their home for a long time, as it saves money over the life of the loan.
Interest rates can change in the time it takes to complete the home loan application process.
To protect yourself against a potential rise in interest rates, you can ask your lender to lock in the rate you have been quoted for a specific period, usually 30-60 days (some lenders may charge a fee for locking in the rate).
If you decide to lock in the rate, be sure to get the agreement in writing and make sure it covers the length of time needed to complete your home purchase (this applies the same to a mortgage refinance). Other borrowers prefer to take the chance that interest rates will decrease while the loan is processed and let the rate on their loan “float.” The rate can then be locked in at any time until the day before your loan closes.
Buying a home or refinancing a mortgage requires the help of a lot of different people (the lender for processing the loan, the title company for verifying ownership of the property, the appraiser for assessing the value of the home, etc.).
Don’t worry about finding all these resources – your mortgage banker and real estate agent can handle that for you. All the fees from these services are collectively called closing costs. Some of these costs are controlled by the lender, while the rest are controlled by other firms that are involved in your loan process.
The closing costs can either be paid up-front, or in some situations, the lender will add them to the amount you are borrowing. Your lender will outline these costs in a loan estimate, so you can get a sense of how much you will need to pay when the loan closes. Your mortgage banker will send you a loan estimate within three business days from when your application is received to help you understand what you are paying for.
Monthly mortgage payment
Generally, your monthly mortgage payment includes principal and interest.
Property taxes and homeowner’s insurance may also be collected by the lender through your monthly mortgage payment, held in an escrow account, and then paid on your behalf when the payments are due.
Home loan originator vs Home loan servicer
Don’t be surprised if you are asked to send your monthly mortgage payments to a company that is different from the one that lent you the money to buy your home.
A home loan originator works with you during the mortgage process and provides the money for your loan. Once your loan closes, a different firm called a home loan servicer might then be responsible for managing your account, collecting your monthly payments, and paying your property taxes and insurance (when applicable).