Mortgage Basics

What Is a Mortgage and How Does It Work?

A mortgage is a loan from a bank, online lender or mortgage lender to purchase a home. The home you purchase will serve as collateral for the money you borrow. Many home buyers borrow around 80% of the home's value.

How Does a Mortgage Work?

A mortgage works when a lender pays the seller (or the seller's lender) for the home you bought and you agree to repay the money you borrowed. By accepting a mortgage, you have agreed to make payments to the lender.

If you stop making payments or don't repay the money you borrowed, the lender has the right to take the house back, otherwise known as foreclosure. The length of the mortgage loan may be 10, 15 or 30 years. Once you pay off the entire loan, you own the home. Until then, your mortgage payment goes toward a few areas of the loan that include:

  • Principal: this pays the actual amount of money that you borrowed.
  • Interest: this is the finance charge based on the Annual Percentage Rate (APR) of the loan that the lender approved for you
  • Escrow: this is an optional amount you can arrange to have added to your monthly principal and interest payment to cover your property taxes and homeowner's insurance.

Additional items in a mortgage to consider would include whether it is a interest-only loan, if there it is an adjustable-rate or fixed interest rate, a balloon payment clause, graduate payments, or any other changes that could take place during the time that you are making payments.

How Do You Get a Mortgage?

To get a mortgage you can apply at a bank, credit union, online lender, or mortgage broker. That lender will review your application, credit history, and credit scores to determine if you qualify; and, if so, how much money they are willing to let you borrow based on your creditworthiness and the money you have for a down payment.

The lender will then use your credit history to decide the mortgage terms such as the interest rate on the loan which can change depending on the amount of your down payment. To get approved for a mortgage you have to show the lender that you have the ability to pay back the amount of the loan that you borrowed.

Some common terms to understand while going through the mortgage process include:

How Much Should I Save for a Down Payment?

A down payment on a mortgage is the money you pay the home seller. Many mortgage lenders will require a downpayment of between 3%-to-5% with many buyers aiming for a 20% down payment. 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 with:

  • 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

Another reason for a 20% down payment on a mortgage is to avoid having to buy private mortgage insurance (PMI) which lenders will require with less than 20% down.

What Is Mortgage Insurance?

If you make a down payment on a mortgage that is less than 20% then you must buy mortgage insurance. There are two main types of mortgage insurance:

  • Private mortgage insurance (PMI) is paid to an insurance company on a monthly basis. Many mortgage insurers will provide the option of making a payment at the beginning of the loan which is usually a substantial amount.
  • Federal Housing Administration (FHA) insurance is paid to the federal government when you have FHA-insured mortgage and require a down payment of at least 3.5% (it can be higher depending on your credit history). Here is a good resource to find out if an FHA loan is right for you.

What Are Different Types of Mortgages?

There are many different types of mortgages that revolve around different factors such as interest rate, length of the loan, and if the loan is are backed by the government or not. First-time homebuyers can receive help through several government programs such as conventional mortgages backed by Fannie Mae and Freddie Mac that require a down payment of only 3% for qualified buyers.

What Is a Conventional Loan?

A conventional home loan or mortgage means that the mortgage is not backed by a government program or insured by a government agency. Conventional loans include mortgages backed 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.

Here is a list of conventional mortgages:

  • Conforming Loan or conventional mortgage is a home loan that is for $453,100 or less in 48 states except for Alaska and Hawaii where the home loan amount can be $679,650 or less for 2018. Conforming mortgages typically require an LTV ratio of 97% or less and a borrower credit score of at least 680. Lenders typically require the borrower to demonstrate the ability to repay the mortgage according to Qualified Mortgage guidelines.
  • Non-Conforming Loan or jumbo Loan is a mortgage loan where buyers borrow an amount greater than the conforming mortgage loan limit of $453,100 for 2018.
  • Portfolio Loan is a loan that is not sold to another lender and instead is held by the original mortgage lender who keeps the debt on their portfolio to earn interest on the loan. This type of loan has some features others don't such as using other investments, like stocks and bonds, as security for a mortgage.
  • Subprime Loan these are home loans for home buyers with low credit scores and typically come with high interest rates and fees. You can read about the pros and cons of subprime mortgages here.

What Is a Unconventional Loan?

An unconventional loan or government loan is a loan that is secured by a government agency such as the FHA, Veterans Administration (VA), or the US Department of Agriculture (USDA). Government agencies like the FHA and VA will insure mortgages from private lenders that are considered non-conforming loans as well.

The USDA will provide loans to lower-income buyers through their Direct Housing Program and also guarantees loans through its Guaranteed Housing Loans program from private lenders.

Here is a list of some non-conventional mortgages:

  • FHA loans are available to all types of home buyers and the government insures the lender against the borrower defaulting on the loan. FHA loans allow buyers to make a down payment of 3.5% on the purchase price if they want.
  • VA loan is a loan for military members and their families that is guaranteed by the federal government. Borrowers can purchase a home with $0 down and receive 100% financing which means there is no down payment.
  • USDA or RHS loans are mortgages for mainly rural borrowers who meet the income requirements from the program that is managed by the Rural Housing Service (RHS), part of the USDA.

What's the Difference Between Fixed-Rate and Adjustable-Rate Mortgages?

The difference between fixed-rate and adjustable-rate mortgages (ARMs) is that a fixed-rate mortgage will stay the same for the entire loan, while an adjustable-rate mortgages can change during the loan.

  • Fixed-rate mortgage loans are very popular with repayment terms of 15, 20 or 30 years and have the same interest rate for the entire loan term. The size of the monthly payment will stay the same, month after month, and year after year. It will never change.
  • Adjustable-rate mortgage 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. That's what the 5 and the 1 mean in the name of the loan. ARMs can be popular because they tend to come with a lower interest rate compared to a fixed-rate mortgage, at least initially; the risk with ARMs is that rates can rise dramatically over time.

What Determines My Mortgage Rate?

Mortgage rates are determined by several factors from the home buyer's financial history and credit scores, as well as current market conditions and changes to interest rates. Overall, the amount of your down payment will make the biggest impact on your mortgage rate.

What Does My Credit Score Need to Be to Get Approved for a Mortgage?

What your credit score needs to be to get approved for a mortgage is hard to define because lenders will look at a lot of different credit data to make a decision.

That data can include your income, employment status and how much money is going towards your down payment. If you want to qualify for an FHA-insured mortgage, referred to as a conventional mortgage, you will typically need credit scores of about 680. The credit scores that mortgage lenders use to approve a mortgage loan have a range of 300-850 on average.

Average Mortgage Rates by FICO® Score

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% depending on your score. The interest rates change daily so make sure to research the latest interest rates.

How Do I Improve My Credit to Buy a House?

In order to improve your credit before you apply for a mortgage loan make sure your credit history is in order by addressing the following factors:

  • Credit Obligations: Make sure you're current on all of your accounts (credit cards, loans, etc.)
  • Credit Utilization Ratio: Using too much credit may negatively impact your score.
  • Credit History: A long history of on-time payments is ideal.
  • Account Types: A diverse mix of accounts (such as credit cards, student loans, an auto loan, etc.) shows that you can manage a variety of credit obligations.
  • Debt-to-Income Ratio (DTI): While your income is not part of your credit report, many lenders will ask for income information to make a more informed decision.

What Are Some Tips for Finding the Best Mortgage Lender?

Finding the best mortgage lender can pay off over the course of a home loan as the national average mortgage debt is $201,811, an increase of almost 3% from 2016, and up 9.49% from 2007.

Here are some tips to help find the best mortgage lender:

1. Know Your Credit Scores

Some lenders prefer to work with borrowers with sparkling credit scores, and others also welcome borrowers with lower credit scores. Checking your FICO® Score is a smart first step, so you can understand what a lender is going to look at.

2. Find the Right Mortgage

Lenders often specialize in certain types of loans so knowing what type of loan you need will help you focus your search.

3. Shop Different Lenders

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, how long does it take to get a pre-approval 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.

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.

What Is a Mortgage Pre-Approval?

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

What Are the Steps to Refinance a Mortgage?

Refinancing your mortgage can be a worthwhile investment of your time if you do your research, shop for a good deal, watch your credit, and be patient. Here are some seven steps you can take to refinance your mortgage:

  1. Determine Your Target Rate: Know the interest rate that makes sense to refinance, so you don't miss any great refinancing opportunities. You can estimate the number of years you plan to be in your home, then divide the closing costs by the annual savings to calculate the breakeven point for a given rate.
  2. Choose a Qualified Lender: Ask friends and family for a recommended lender because if you can't close a loan than the best refinancing interest rate won't matter. You can search the Consumer Affairs database for qualified U.S. mortgage lenders.
  3. Shop Around: Make sure to shop multiple lenders when refinancing your mortgage and don't make the mistake of refinancing with your current lender, or the first offer you receive. Interest rates, closing costs, and other fees will vary and can be negotiated using quotes from other lenders.
  4. Watch out for High Lending Fees: Some mortgage lenders will try to add fees and costs that will be refinanced into your new refinance loan. You want to calculate what you're saving monthly to see if it's worth it. For example, if you're closing costs end up being $3,000 and you're only saving $100 per month, you'd need to stay in the loan 30 months before ever seeing any kind of savings
  5. Be Patient About Signing a Mortgage: Many people get impatient and sign off on a deal too quickly without looking over the costs, fees, and contract overall.
  6. Take Advantage of Good Credit: The higher the credit score, the lower the interest rates and a chance to decrease the monthly payments.
  7. Don't Open Any Credit During the Refinancing Process: Do not apply for a new credit card or car loan while going through a new home refinance loan.

Can You Buy a House with Bad Credit?

Yes, you can buy a house with bad credit but you may not receive a very good interest rate or terms on the loan and only qualify for a subprime mortgage.

Lenders consider subprime mortgage borrowers as higher risks that may default on their loans than borrowers with better credit. As a result, lenders typically charge these borrowers higher interest rates and fees. All subprime mortgages have a couple things in common:

  • High Closing Costs: lenders offset the risk of lending to borrowers with poor credit by collecting higher up-front payment.
  • High Interest Rates: rates on subprime mortgages are usually higher than the average conventional mortgage, costing you thousands of dollars over the lifetime of the loan.

Paying your mortgage in full and on time, every time will build a positive payment history and can improve your credit scores, whereas missing a payment or not paying the full amount owed can hurt your score.

Lenders will tell you what you are qualified to borrow, or in reality, what they are willing to lend you. A new home is a major purchase that you want to be able to afford and not find yourself stretched too thin. Make sure that you take into account all your expenses and choose a mortgage that fits your budget.

Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.

This article was originally published on June 2, 2018, and has been updated.

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