What Is a Mortgage and How Does It Work?

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A mortgage is a loan from a bank, online lender or mortgage lender that allows you to purchase a home. The home you purchase with a mortgage loan serves as collateral for the money you borrow.

Whether you're a first-time homebuyer or you're buying your fifth home, understanding how a mortgage works can help you better navigate the borrowing process.

How Does a Mortgage Work?

When you purchase a home, a mortgage loan allows you to finance the price of the sale minus any cash you bring to the table in the form of a down payment.

In turn, you agree to repay the money you borrowed to the mortgage lender over 10, 15, 20 or 30 years. While you're making payments, the lender holds the deed to the home.

This means that if you stop making payments, the lender has the right to take possession of the house, otherwise known as foreclosure. But if you make all your payments on the loan, you'll receive the deed for the home when you pay the loan in full.

Your monthly mortgage payment typically has three components, including:

  • Principal: This figure represents the actual amount of money that you still owe on your loan.
  • Interest: This is the finance charge based on the loan's annual percentage rate (APR).
  • Escrow account: This involves adding your property taxes and homeowner's insurance to your monthly mortgage payment. It is usually optional, though some lenders may require it in certain situations. The extra amount is held in an escrow account until the property taxes and insurance are due, then the lender pays them out of that account.

One hard part of the mortgage process is running into several terms that you're not familiar with. Here are some of the more common ones, along with their definitions:

  • Down payment: The cash amount you contribute to the sale. Lenders often require a down payment of at least 3% to 5% of the sale price, but many buyers aim for a 20% down payment.
  • Closing costs and fees: These are paid when you finalize the sale and purchase of the home. They can vary based on location, type of loan and what type of property is involved, but typically are 2% to 5% of the purchase price. You can either pay them in cash, roll them into the loan, or ask the lender to pay them in exchange for a slightly higher interest rate.
  • Loan term: How long you have to repay your loan. Usually, the length of a mortgage loan is 10, 15 or 30 years.
  • Property taxes: This is the amount you pay to your local, county or state government each year based on the value of your home and property. Tax rates can vary depending on where you live.
  • Foreclosure: When you fail to make payments on time, your mortgage lender has the right to take ownership of the home unless you make the necessary payments.
  • Private mortgage insurance (PMI): This insurance protects the lender in case you default on your loan obligation. It's generally required by lenders if your down payment less than 20% of the total original loan amount.

Types of Mortgages

There are many different types of mortgages, and each can vary based on the length and amount of the loan, how the interest rate works, and whether the loan is backed by a government agency.

Conventional Loan

A conventional mortgage loan is a loan that's not backed by a government program or insured by a government agency. Conventional loans include mortgages originated by banks, credit unions and mortgage lenders.

In some cases, conventional loans are issued by one mortgage lender and then sold to another mortgage lender who services the bulk of the loan. Your first few payments are to the mortgage lender that you closed with, and then you will receive a letter letting you know that your mortgage loan will be serviced by another lender.

Government-Insured Loan

As the name suggests, these loans are insured by a government agency, such as the Federal Housing Administration (FHA), Veterans Administration (VA) or the U.S. Department of Agriculture (USDA).

The government does originate these loans, however. Instead, you'll get the loan through a private lender, and it will be insured by the federal agency.

The only exception is the USDA Direct Housing Program, which provides loans to very low-income families. Its Guaranteed Housing Loans program, however, acts similarly to other government-insured loans.

Here's a breakdown of some of the common government-insured loans that are available:

  • FHA loans: Available to all types of home buyers. The government insures the lender against the borrower defaulting on the loan. FHA loans allow buyers to make a down payment of as low as 3.5% on the purchase price of a home.
  • VA loans: A loan for military members and their families. Borrowers can purchase a home with $0 down and receive 100% financing.
  • USDA or RHS loans: Mainly geared to rural borrowers who meet the income requirements from the program. These loans don't require a down payment.

Fixed-Rate Mortgage

Fixed-rate mortgage loans are very popular and typically come with repayment terms of 15, 20 or 30 years. They have the same interest rate for the entire loan term, which means the principal and interest portion of the monthly payment will stay the same throughout the life of the loan.

Adjustable-Rate Mortgage

Adjustable-rate mortgage (ARM) loans have an interest rate that will change or adjust from the initial rate. For example, a 5/1 ARM loan will have a fixed interest rate for the first five years, then adjust every year based on the current market rates.

ARMs can be popular because they tend to come with a lower interest rate compared with a fixed-rate mortgage, at least initially; the risk with ARMs is that rates can rise dramatically over time.

Conforming Loan

A conforming loan is a home loan that conforms to limits set by the Federal Housing Finance Agency (FHFA) and meets the funding criteria of Fannie Mae and Freddie Mac, government-sponsored enterprises that purchase mortgages from lenders, providing stability to the housing market. The FHFA's 2019 limits for conforming loans include $484,350 or less in 48 states and $726,525 or less for Alaska and Hawaii.

Because conforming loans meet the guidelines set by Fannie Mae and Freddie Mac, they typically offer lower interest rates and better overall terms than non-conforming loans.

Non-Conforming Loan

Also called a jumbo loan, a non-conforming loan is a mortgage loan where buyers borrow an amount greater than the conforming mortgage loan limit.

How to Qualify for a Mortgage

To get a mortgage, you can apply with a bank, credit union, online lender or mortgage broker. A mortgage preapproval is determined by a lender to indicate the amount you can borrow, the type of loan, and the interest rate that you would likely qualify for.

A mortgage preapproval is not actual approval; it's just a document that says the lender believes that it would likely approve a mortgage application based on the income and credit information submitted. The information needed for a home mortgage preapproval typically includes personal information such as your credit history, credit score, income, assets, debts, tax returns and employment history.

Here are some factors lenders will evaluate when considering a mortgage application.

Credit Scores

Most lenders use FICO® Scores to determine mortgage creditworthiness. There's no hard-and-fast rule for what your credit scores need to be to get approved for a mortgage. Some mortgage types, however, may have minimums.

For example, if you want to qualify for an FHA-insured mortgage, you will typically need a FICO® Score of 580 or higher. Conventional loans typically require a score of 620 or higher, but some lenders may set a higher bar.

Also, lenders that offer VA and USDA loans may have a set minimum, even though those agencies don't have a minimum score.

Again, the higher your credit scores, the better your chances of getting a mortgage with a low interest rate.

At this writing, the average mortgage interest rates by FICO® Score for a $216,000 home with a 30-year fixed-rate mortgage can vary in range from 4.13% to 5.71%. These interest rates change daily, so make sure to research the latest interest rates.

If your FICO® Score is...Your interest rate is...And your monthly payment will be...

Debt-to-Income Ratio

Mortgage lenders' primary concern is that you pay back what you owe, which can be tough if you're overburdened with debt. Your debt-to-income ratio shows how much of your gross monthly income goes toward debt payments.

Lenders typically like to see no more than 28% of your gross monthly income go toward a housing payment and no more than 36% toward all of your monthly debt payments combined.

Down Payment

The more money you put down, the less money you need to borrow, which reduces the risk the lender takes on. What's more, a higher down payment typically means that you have more skin in the game, so to speak, and you're less likely to default.

If you make a down payment on a mortgage that is less than 20%, you typically need to buy mortgage insurance to protect the lender against default. There are two main types of mortgage insurance:

  • Private mortgage insurance (PMI): Paid to an insurance company on a monthly basis, PMI is common with conventional and jumbo loans. You're only required to pay PMI until your loan-to-value ratio is lower than 80%.
  • Mortgage insurance premium (MIP): If you have an FHA-insured mortgage, you're typically required to pay MIP, both upfront and ongoing. In some cases, you'll need to pay MIP for the life of the loan.

Past Payment History

If you have a history of making payments late or allowing accounts to become delinquent, you may have a tough time getting approved for a mortgage loan.

How Much Should I Save for a Down Payment?

Your down payment directly reduces the amount you owe on your mortgage loan. Many mortgage lenders will require a down payment of between 3% to 5%, but 20% or more is ideal.
The more money you put down for a mortgage down payment, the lower the loan amount you'll need and the less interest you'll pay over the life of the loan.

For example, if you buy a house for $200,000 on a 30-year loan with a 5% interest:

  • A down payment of 3% means that you pay $6,000 and then borrow $194,000.
    • Monthly Payments = $1,041.43
    • Total Principal Paid = $194,000
    • Total Interest Paid = $180,916.22
    • Total Cost of Loan = $374,916.22
  • A down payment of 20% means that you pay the bank $40,000 and borrow $160,000.
    • Monthly Payments = $858.91
    • Total Principal Paid = $160,000
    • Total Interest Paid = $149,209.25
    • Total Cost of Loan = $309,209.25
    • Savings = $66,706

Finding the Right Mortgage Lender

The right mortgage lender will not only give you the best terms available for your situation, but it may give you a specific loan feature that would make for a better experience. Here are some tips to help find the best mortgage lender for your situation.

1. Know Your Credit Scores

Some lenders prefer to work with borrowers with near-perfect credit scores, while others are willing to work with borrowers who have lower credit scores. Checking your FICO® Score is a smart first step, so you can understand which lenders to focus on.

2. Find the Right Mortgage

Some lenders specialize in certain types of loans, and some even offer specialty loans that you can't get anywhere else. Knowing what type of loan you need will help you focus your search.

3. Shop Different Lenders

Take some time to shop around to get an idea of what's out there. Asking family, friends and colleagues for recommendations is a good first step. You may also want to check your bank or credit union to see what deals they might be offering. And make sure to ask questions such as what is their loan specialty, as well as how long it takes to get a preapproval or close a loan.

4. Get a Few Loan Estimates

Compare offers by applying to at least three different lenders to help you find the best deal. The more lenders you get rates from, the likelier you are to get the lowest rate available for your financial and credit profiles.

5. Consider a Digital Mortgage

A digital mortgage can make getting a home loan fast and easy, as most of the interaction takes place over the phone, a self-service portal and via email.

Take Your Time to Do Things Right

A mortgage loan is an incredible commitment, so it's important to take your time during the process. It can be easy to get caught up in the emotions of homeownership and getting your dream home. But understanding how the mortgage process works and what's best for your situation can potentially save you thousands of dollars over the years.

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