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Taking out a mortgage is the biggest financial obligation most of us will ever assume. So it’s essential to understand what you’re signing on for when you borrow money to buy a house.
What is a mortgage?
A mortgage is a loan from a bank or other financial institution that helps a borrower purchase a home. The collateral for the mortgage is the home itself. That means if the borrower doesn’t make monthly payments to the lender and defaults on the loan, the lender can sell the home and recoup its money.
A mortgage loan is typically a long-term debt taken out for 30, 20 or 15 years. Over this time (known as the loan’s “term”), you’ll repay both the amount you borrowed as well as the interest charged for the loan.
You’ll repay the mortgage at regular intervals, usually in the form of a monthly payment, which typically consists of both principal and interest charges.
“Each month, part of your monthly mortgage payment will go toward paying off that principal, or mortgage balance, and part will go toward interest on the loan,” explains Robert Kirkland, vice president, Divisional Community and affordable lending manager with JPMorgan Chase. Over time, more of your payment will go toward the principal.
If you default on your mortgage loan, the lender can reclaim your property through the process of foreclosure.
“You don’t technically own the property until your mortgage loan is fully paid,” says Bill Packer, executive vice president and COO of American Financial Resources in Parsippany, New Jersey. “Typically, you will also sign a promissory note at closing, which is your personal pledge to repay the loan.”
- A mortgage is a loan that helps borrowers purchase a home. The home itself serves as collateral for the debt.
- To qualify for a mortgage, you will need to supply proof of income, a list of your assets and debts, info for credit inquiries, and explanations of any financial gifts to purchase the home.
- There are a variety of mortgage products available on the market.
- Your monthly mortgage payment will include your loan principal and interest, plus your property taxes, homeowner’s insurance, and, if applicable, private mortgage insurance (PMI).
- Learning mortgage lingo upfront can help you to be an informed borrower and ask the right questions throughout the application and payment process.
How does a mortgage work?
A mortgage is a loan that people use to buy a home. To get a mortgage, you’ll work with a bank or other lender. Typically, to start the process, you’ll go through preapproval to get an idea of the maximum the lender is willing to lend and the interest rate you’ll pay. This helps you estimate the cost of your loan and start your search for a home.
Starting the mortgage process
Applying for a mortgage is a thorough process, involving many steps on your end. To start, you’ll need proof of income (through paystubs and previous year’s tax returns), a list of assets (including brokerage statements, if applicable), a list of debts, personal data for credit inquiries, and letters explaining any financial gifts you receive for the home purchase such as help with a down payment from family members.
Once you gather your documents, you’ll apply for the mortgage through the lender’s website. Having all the documents ready to go can expedite the process of earning a pre-approval, since they can show their underwriters you indeed have the qualifications to pay for the mortgage.
Types of mortgages
There are several types of mortgages available to borrowers, including conventional fixed-rate mortgages, which are among the most common; adjustable-rate mortgages (ARMs); FHA, VA and USDA loans; jumbo loans; and reverse mortgages.
- Conventional loans – A conventional mortgage is not backed by the government or government agency; instead, it is made and guaranteed through a private-sector lender (bank, credit union, mortgage company).
- Jumbo loans – A jumbo loan exceeds the size limits set by U.S. government agencies and has stricter underwriting guidelines. These loans are sometimes needed for high-priced properties — those well above half a million dollars.
- Government-insured loans – These include VA loans, USDA loans, and FHA loans, and have more relaxed borrower qualifications than many privately-backed mortgages.
- Fixed-rate mortgages – Fixed-rate mortgages have a set interest rate that remains the same for the life of the loan (terms are commonly 30, 20, or 15 years).
- Adjustable-rate mortgages – An adjustable-rate mortgage (ARM) has interest rates that fluctuate, following general interest-rate movements and financial market conditions. Often there’s an initial fixed-rate period for the loan’s first few years, and then the variable rate kicks in for the remainder of the loan term. For example, “in a 5/1 ARM, the ‘5’ stands for an initial five-year period during which the interest rate remains fixed while the ‘1’ indicates that the interest rate is subject to adjustment once per year” thereafter, Kirkland notes.
What is included in a mortgage payment?
- Principal – the specific amount of money you borrow from a mortgage lender to purchase a home. If you were to buy a $100,000 home, for instance, and take out a loan in the amount of $90,000, then your principal is $90,000.
- Interest – interest, expressed as a percentage rate, is what the lender charges you to borrow that money. In other words, the interest is the annual cost you pay on the loan principal.
- Property taxes – your lender typically collects the property taxes associated with the home as part of your monthly mortgage payment. The money is usually held in an escrow account, which the lender will use to pay your property tax bill when the taxes are due.
- Homeowners insurance – homeowner’s insurance provides you and your lender a level of protection in the event of a disaster, fire or other accident that impacts your property. Often, your lender collects the insurance premiums as part of your monthly mortgage bill, places the money in escrow, and makes the payments to the insurance provider for you when the premiums are due.
- Mortgage insurance – your monthly payment might also include a fee for private mortgage insurance (PMI). For a conventional loan, this type of insurance is required when a buyer makes a down payment of less than 20 percent of the home’s purchase price.
How to find the best mortgage rate
To identify the mortgage that’s best for your situation, assess your financial health, including your income, credit history and score, and assets and savings. Spend some time shopping around with different mortgage lenders, as well.
“Some have more stringent guidelines than others,” Kirkland says. “Some lenders might require a 20 percent down payment, while others require as little as 3 percent of the home’s purchase price.”
“Even if you have a preferred lender in mind, go to two or three lenders — or even more — and make sure you’re fully surveying your options,” Pataky says. “A tenth of a percent on interest rates may not seem like a lot, but it can translate to thousands of dollars over the life of the loan.”
Sign up for a Bankrate account to determine the right time to strike on your mortgage with our daily rate trends. Bankrate makes mortgage loan comparison simple, so that you can weigh the various options and decide what loan product best fits your situation.
Important mortgage terminology to know
Amortization describes the process of paying off a loan, such as a mortgage, in installment payments over a period of time. Part of each payment goes toward the principal, or the amount borrowed, while the other portion goes toward interest.
An APR or annual percentage rate reflects the yearly cost of borrowing the money for a mortgage. A broader measure than the interest rate alone, the APR includes the interest rate, discount points and other fees that come with the loan.
“Conforming” refers to a conforming loan, a mortgage eligible to be purchased by Fannie Mae or Freddie Mac, the government-sponsored enterprises (GSEs) integral to the mortgage market in the U.S. These standards include a minimum credit score and maximum debt-to-income (DTI) ratio, loan limit and other requirements. Fannie Mae and Freddie Mac buy loans from mortgage lenders to create mortgage-backed securities (MBS) for the secondary mortgage market.
A “non-conforming” loan or mortgage doesn’t meet (or “conform to”) the requirements that allow it to be purchased by Fannie Mae or Freddie Mac. One example of a non-conforming loan is a jumbo loan.
The down payment is the amount of a home’s purchase price a homebuyer pays upfront. Buyers typically put down a percentage of the home’s value as the down payment, then borrow the rest in the form of a mortgage. A larger down payment can help improve a borrower’s chances of getting a lower interest rate. Different kinds of mortgages have varying minimum down payments.
An escrow account holds the portion of a borrower’s monthly mortgage payment that covers homeowners insurance premiums and property taxes. Escrow accounts also hold the earnest money the buyer deposits between the time their offer has been accepted and the closing.
A mortgage servicer is the company that handles your mortgage statements and all day-to-day tasks related to managing your loan after it closes. For example, the servicer collects your payments and, if you have an escrow account, ensures that your taxes and insurance are paid on time.
Private mortgage insurance (PMI) is a form of insurance taken out by the lender but typically paid for by you, the borrower, when your loan-to-value (LTV) ratio is greater than 80 percent (meaning you put down less than 20 percent as a down payment). If you default and the lender has to foreclose, PMI covers some of the shortfall between what they can sell your property for and what you still owe on the mortgage.
The promissory note is a legal document that obligates a borrower to repay a specified sum of money over a specified period under particular terms. These details are outlined in the note.
Mortgage underwriting is the process by which a bank or mortgage lender assesses the risk of lending to a particular individual. The underwriting process requires an application and takes into account factors like the prospective borrower’s credit report and score, income, debt and the value of the property they intend to buy. Many lenders follow standard underwriting guidelines from Fannie Mae and Freddie Mac when determining whether to approve a loan.
Additional reporting by Meaghan Hunt