June 21, 2024
Loans

What is a mortgage? | CNN Underscored Money


The median sales price of U.S. homes in the third quarter of 2023 was about $431,000, according to FRED data. Most people can’t afford a purchase that large in cash — that’s where a mortgage comes in. A mortgage is a type of loan designed explicitly for homebuying. It comes with unique features and eligibility requirements.

For most people, a mortgage is a necessary part of the homebuying process and the largest financial obligation they’ll ever take on. For that reason, it’s critical that you understand how mortgages work and how to get one before you start the process.

How does a mortgage work?

A mortgage is a legal agreement between a homebuyer and a lender. The lender agrees to give the homebuyer the money needed to buy a home. In return, the homebuyer promises to make monthly payments on the borrowed amount (the principal), plus interest, until the loan is repaid. Mortgages typically require that you pay a percentage of the home’s value upfront as a down payment, which may be as much as 20%.

Mortgages differ based on factors like:

  • Loan amount
  • Interest rate
  • Rate structure (fixed versus adjustable)
  • Closing costs
  • Down payment requirements
  • Insurance requirements

Because this type of loan is larger than many other loans, they have significantly longer repayment terms. Mortgages usually range from 10 to 30 years, but the most popular repayment term is 30 years. This helps homebuyers spread their repayment over a long period to make payments more manageable.

“During this time, the lender holds a lien on the property, which is a legal claim that ensures they can take possession of the home if you fail to make payments,” said Carl Holman, communications manager for A&D Mortgage.

The lien on the home, as agreed upon in the mortgage contract, gives the lender the right to foreclose on (or seize) the home if the homebuyer doesn’t repay the debt as agreed.

Key mortgage terms to know

A mortgage is a complex loan agreement, and many first-time homebuyers feel intimidated by the industry jargon and complicated loan contract. Let’s explore some key terms to demystify the mortgage process.

  • APR: Short for annual percentage rate, it’s the total yearly cost of your loan, including interest and other costs, like broker fees and points.
  • Amortization: The process of paying off your loan. Your mortgage’s amortization schedule lays out how much you’ll pay each month toward principal and interest.
  • Appraisal: An official valuation of your home. Lenders require an appraisal to ensure the home is worth the sale price.
  • Closing: The final step in buying your home is signing your mortgage documents and taking ownership.
  • Closing costs: The lender fees and other costs — including origination, appraisal and credit report fees — that are associated with your mortgage, which you’ll pay at the closing.
  • Down payment: The portion of the home’s purchase price that you pay upfront, while the lender pays the remaining balance.
  • Escrow: An account set up during the homebuying process to hold a percentage of each mortgage payment to cover certain expenses, such as homeowners insurance premiums and property taxes.
  • Mortgage broker: A third party that shops around for a lender on your behalf, helping you find the best loan for your situation. Hiring a mortgage broker is optional.
  • Mortgage originator: The lender that helps you choose a mortgage type and complete your home loan application. The originator works with you from application to closing.
  • Mortgage servicer: The company that manages your mortgage, sends your statements, and accepts your payment. It may or may not be the same as your mortgage originator.
  • Points: An upfront fee that allows you to reduce your mortgage rate for your entire loan term. You’ll pay more at closing, but may save money in the long run.
  • Private mortgage insurance (PMI): Required by many lenders for conventional mortgage borrowers who pay less than 20% as a down payment when buying a home. FHA mortgage insurance premiums (MIPs) are similar, but if you only make the minimum 3.5% down payment, you’ll have to pay MIPs for the entire loan term.
  • Second mortgage: A loan that uses your home as collateral but isn’t your primary mortgage. Examples include home equity loans and home equity lines of credit.
  • Title: Legal ownership and rights to a home, different from the deed, which is the legal document representing that ownership.
  • Underwriting: The process through which a lender approves or denies a loan application based on your creditworthiness and financial situation. Underwriting guidelines vary by lender but often include factors like your credit history, income and debt, plus information about the property being financed.

What does your mortgage payment include?

When you make your monthly mortgage payment, you aren’t just repaying the original amount you borrowed. Your mortgage payment typically comprises principal, interest, taxes, and insurance, also known as PITI.

Principal

What it is: The amount of money you initially borrowed

At the beginning of your loan term (or amortization), the principal balance makes up a smaller portion of your monthly payment. For example, suppose you have a $300,000 mortgage principal, an interest rate of 7.50%, and a monthly payment of $2,098. Only $223 of your first payment would go toward the principal.

However, as you repay the loan, the portion of your monthly payment that goes toward the principal will increase over time. Toward the end of your mortgage term, the principal will make up the greatest portion.

Interest

What it is: The price you pay to borrow money, typically expressed as a percentage of your loan amount

Due to interest charges, you’ll end up paying the lender more than you originally borrowed — this process makes lending money profitable for a financial institution. Because the loan is secured by your home, mortgage rates are typically lower than rates on many other consumer loans.

Your mortgage interest rate is based on market factors, such as the current federal funds rate, the bond market, the housing market and more. It also depends on personal financial factors, including your credit scores and debt-to-income ratio. Generally, the higher your credit scores, the lower your interest rate.

Your interest payment decreases as your principal payment increases. It’ll make up the majority of your monthly payments in the early years of your mortgage, but over time, the amount you’ll pay in interest will decline.

Property taxes

What it is: Required taxes paid to your local government, which uses the funds to provide local services, including schools, police departments, roads and more

The amount you’ll pay in property taxes depends on the state and county where you live. Although property taxes are typically levied once per year, you’ll usually pay them in installments as part of your monthly mortgage payment. The funds go into an escrow account, and at the end of the year, your lender will use the money to pay your annual property tax bill on your behalf. (You may be able to opt out of escrow and pay your taxes independently.)

Homeowners insurance

What it is: An insurance policy that pays to repair or rebuild your home after a covered incident

While homeowners insurance isn’t legally required like car insurance, most lenders require it as part of a mortgage agreement. And even if your lender doesn’t require it, carrying insurance coverage on your property is always a good idea.

Like property tax payments, your lender will collect your insurance bill in monthly installments with your mortgage payment and then, once per year, will use that money to pay your annual homeowners insurance bill. (Again, you could opt out of this payment arrangement if you wish, and pay your insurance provider directly.)

Mortgage insurance

What it is: Insurance that protects the lender against borrower default

When you borrow a conventional mortgage, you can sometimes make a down payment of as little as 3%. However, if you put less than 20% down, your lender will likely require private mortgage insurance (PMI). FHA and USDA loans also require mortgage insurance, though the process differs.

PMI is included in your mortgage payment, like your taxes and homeowners insurance. But don’t worry — it doesn’t last forever. Your PMI will be automatically canceled when your principal mortgage balance reaches 78% of your home’s purchase price or you’re halfway through your loan term.

You can also request to terminate your PMI when your principal mortgage balance reaches 80% of the purchase price. Your lender is legally required to approve the request if you can provide evidence of your home’s value, usually in the form of an appraisal.

Types of mortgages

There are several different types of mortgages, each best suited to a certain situation or designed for certain borrowers. Before applying for a loan, consider which loan best fits your unique needs and financial situation.

Conventional loans

A conventional loan isn’t backed by a government agency. These loans must fall within the loan limits set by the Federal Housing Finance Agency (FHFA). For 2024, the limit for a conforming, conventional loan on a single-family home is $766,550 in most geographical areas.

Conventional loans can have either fixed or adjustable interest rates. A fixed-rate loan has the same interest rate for the entire loan term. You lock in your rate when you get your mortgage and it won’t change unless you refinance the loan. On the other hand, an adjustable-rate mortgage (ARM) has a rate that fluctuates throughout the term, after an introductory period. Your rate will rise and fall with the market.

There are various loan repayment terms to choose from, but the most common are 15- and 30-year mortgages. A 30-year term will result in lower monthly payments but higher total interest charges, while a 15-year term will cost more each month but save the most overall.

Conventional loans have plenty of benefits, including low costs, but they also have strict eligibility requirements. Many lenders require a minimum credit score of at least 620, a maximum debt-to-income ratio of 36% and a down payment of at least 3%.

Jumbo loans

A jumbo loan exceeds the conforming loan limits set by the FHFA and, therefore, isn’t eligible to be purchased by Fannie Mae or Freddie Mac. In 2024, a jumbo loan is used to buy a property that costs more than $766,550 in most locations and $1,149,835 in designated high-cost areas.

Jumbo loans allow borrowers to purchase more expensive homes than they could with a conventional loan. The average home price in some areas exceeds the FHFA limit, making jumbo loans essential to borrowers in those areas. Jumbo loan rates tend to be similar or slightly higher than conventional loan rates.

However, jumbo loans have some downsides. They’re riskier for the lender since they can’t be sold to Fannie Mae or Freddie Mac. As a result, they typically require high credit scores and larger down payments.

Government-backed loans

Several government-backed mortgage programs make homebuying more accessible for certain borrowers. These loans are generally offered by private lenders but are backed by government agencies.

Since the government guarantees repayment in the case of borrower default, lenders can offer more affordable rates and favorable terms to a wider variety of borrowers.

Here are the three federal government-backed loan programs:

  • FHA loans: These are backed by the Federal Housing Administration (FHA), a part of the Department of Housing and Urban Development. FHA loans are available to borrowers with credit scores as low as 500, making homeownership and affordable interest rates accessible to those with poor and fair credit.
  • VA loans: Backed by the Department of Veterans Affairs, VA loans are available to military service members, veterans and some surviving spouses. They have competitive interest rates and no down payment or private mortgage insurance requirement, but they require an upfront fee known as a VA funding fee.
  • USDA loans: These loans are backed by the Department of Agriculture and help people in rural areas buy, build or repair their homes. USDA loans have no down payment requirement but are limited to low-income borrowers in certain rural areas.

Balloon loans

This type of mortgage requires a large “balloon” payment at the end of the loan term — usually at least twice the normal monthly payment, but often far larger.

A balloon mortgage is amortized differently than other mortgages. Your normal monthly payments are lower and aren’t sufficient to pay off the entire loan balance. You’ll save money each month, but at the end of the loan term, you’ll owe one balloon payment that could be tens of thousands of dollars.

Since the large, end-of-term balloon payment presents a high degree of risk, many lenders have stopped offering this loan type. Rates tend to be higher than a conventional loan, and the small monthly payments mean it’ll take much longer to build equity. Many borrowers resort to mortgage refinancing to avoid making the balloon payment.

7 steps for getting a mortgage

Getting a mortgage seems daunting, but you can simplify the process by taking it step by step. Here’s how to get started:

  1. Check your credit. Because most mortgages and lenders have minimum credit requirements, checking your credit ahead of time is critical to understanding whether you’ll likely qualify. You can review your free credit reports at AnnualCreditReport.com, and your financial institution or credit card issuer may give you access to your credit scores. If your scores aren’t up to par, work to increase your credit scores before applying.
  2. Save for a down payment. A down payment is a substantial sum — usually thousands or tens of thousands of dollars. The homebuying process will go more smoothly if you’ve already saved your down payment when you start shopping for a mortgage. Prioritizing savings can be challenging, but there are strategies to save money you can try, including budgeting, paying off credit card debt and meal planning.
  3. Choose the right type of mortgage. Decide which type of mortgage makes the most sense for your financial situation and the type of home you want to buy. Also, consider what loan term and interest rate structure you want. A mortgage loan officer can help you with these choices and point you toward first-time homebuyer programs.
  4. Apply for preapproval. This gives you an idea of whether your application will be approved and how much you’ll be allowed to borrow. Having a mortgage preapproval also shows sellers you’re a serious buyer, so they may be more likely to accept your offer.
  5. Make an offer on a home. Once you’ve been preapproved, you can start shopping for a home. When you find the right home and make an offer, include a copy of your preapproval letter with your offer.
  6. Complete your mortgage application. Once you’ve found a home and the seller has accepted your offer, you can submit a formal application. During the approval process, known as underwriting, you’ll provide documentation about your employment, income, assets, debts and overall financial situation. The property must be appraised and inspected, and your lender may contact you periodically requesting additional information.
  7. Close on your loan. On the closing day, you’ll bring a check for your down payment and closing costs, sign a hefty stack of mortgage documents and leave the closing with the keys to your new home.

Frequently asked questions (FAQs)

The terms mortgage and home loan are often used interchangeably. When people talk about mortgages, they’re typically referring to the loan you get to buy a home. However, the term mortgage technically refers to the legal agreement between you and the lender that gives you a home loan.

If you fail to make your mortgage payments, you risk foreclosure, which is when your lender seizes your home to recover its financial losses. Mortgage laws vary by state, but a lender can usually start the foreclosure process within a few months of your first missed payment.

If you can’t make your mortgage payment or worry you may not be able to, contact your lender as quickly as possible. It may be able to put your mortgage into forbearance or modify your loan agreement to help make your payments more manageable.

Yes, you can pay off your mortgage early by paying more than your minimum payment each month, making extra payments or making one large lump-sum payment. Nothing in a mortgage agreement prevents you from paying off your loan early, but some lenders may charge a prepayment penalty if you do. The good news is it’s relatively easy to find a lender that doesn’t charge prepayment penalties.

To avoid paying private mortgage insurance (PMI) on a conventional loan, you must have a down payment of at least 20% of the home’s value. Some lenders also allow you to pay your PMI upfront to avoid the additional monthly cost.

The credit score you’ll need to qualify for a mortgage depends on the loan type and lender. For a conventional conforming loan, you must have a credit score of at least 620. For an FHA loan, you’ll need a score of either 500 or 580, depending on the size of your down payment. Other government-backed loans, such as VA and USDA loans, don’t have minimum credit scores. However, each lender can set its own minimum score for all mortgage types.



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