Buying a home is a significant investment, and many aspiring homeowners cannot afford the upfront cost of a down payment. A mortgage is a type of loan you can use to finance the purchase of real estate with your monthly payments.
This guide will explain the different types of mortgages, how the mortgage application process works, and will provide examples of how mortgages function in practice.
What Is a Mortgage?
A mortgage is a legal agreement that allows you to borrow funds to buy or refinance a property, with the condition that the bank owns the home until the debt is fully paid off. There are several significant features of a mortgage loan, including the principal amount being the body of the loan, the interest for the borrowing service, and the term.
Furthermore, many mortgages also require bi-annual payments for property taxes, and insurance, and – subject to circumstances – monthly mortgage insurance premiums.
How Does it Work – The Mortgage Process
The mortgage application process usually begins with the “preapproval” stage. A bank or a mortgage lender reviews your income, credit score, debt-to-income ratio, assets, and employment status to provide a mortgage preapproval. Although not definitive, this allows you to understand how much you can spend on a house purchase. Following “preapproval,” the next stage typically includes finding a property and making an offer. During the mortgage application review process, you work with the lender to review your options: your financial and personal history, and the characteristics of the home – including an appraisal of the property you wish to purchase. Finally, if approved, you sign a mortgage closing contract and the actual closing of the loan takes place.
Your monthly mortgage payment depends on how much equity you owe on your home and the interest rate you choose. Mortgages typically use fully amortized payments with the majority of the early monthly installments going to interest, with only a small amount applying to the body of the loan. The opposite is true for later years: as the principal decreases over time, the amount of interest owed decreases, and the portion of principal in the monthly mortgage payment increases.
For example, if you take out a mortgage loan with a monthly payment of $300,000 with a 30-year fixed mortgage at a 6.5% interest rate. The principal-and-interest payment would be approximately $1,896, this would not include property taxes, insurance, or home owners’ association (HOA) fees or mortgage insurance.
Common Types of Mortgages
Fixed-rate mortgages – these are the most prevalent type of mortgages.
The most common is a 30-year fixed-rate mortgage, but the 15-year fixed-rate mortgages are also common: their interest rates are generally lower, but the payments are higher. With a fixed-rate mortgage, you repay the loan with consistent monthly payments throughout the loan term. The appeal, however, is the stability of payments: many homeowners prefer knowing they won’t have to increase their monthly budget for a mortgage.
For adjustable-rate mortgages, these are typically broken down by the range of interest rates for the life of the loan: For example, a “5/1 ARM” has a fixed rate on the interest for every year for the first 5 years, but can adjust every year in the following years.
These types of adjustable interest-rate mortgages usually start out with a lower rates than do fixed-rate loans, and they are often preferable to fixed interest rates because the borrower knows that future payments will most likely not change, but for variable interest-rate loans future payments might fluctuate.
Many government entities offer government-backed mortgages to assist homebuyers and make purchasing a home more accessible. Federally-insured loans, such as FHA loans or VA loans , can be lower down payment and more flexible in their approval process for people with poor credit histories. These government-insured mortgages are useful options for buyers looking to enter the market
Conventional Mortgages, a category that includes conforming and non-conforming mortgages, are regular mortgages and not government-insured or government-guaranteed. Conventional mortgage products are ideal for those who have good credits scores and who can make a substantial down payment. Although conventional mortgages typically require 20 percent down payment for a home purchase, they might offer a lower rate than government-backed mortgages. A down payment less than 20 percent typically requires a borrower to pay mortgage insurance, or PMI, which protects the bank in case a borrower can’t pay. Conventional Mortgages allow down payment as low as 3 percent. Nonetheless, many conventional mortgages allow the borrower to cancel PMI once they have accumulated 22 percent equity in their home.
Other Mortgage Options
Jumbo mortgages are large and considered too big to fail: they go beyond the conforming loan limits set by the Federal Reserve. These large mortgages are typically considered higher-risk products and therefore require higher down payments and higher credit scores.
With interest-only mortgages, monthly payments only cover the amount of interest charged on the mortgage, while leaving the body of the loan unchanged. One caveat, however, is that these mortgages typically have a balloon payment and your entire principal would be due at the end of the loan period.
Refinancing means taking out a new mortgage to replace your existing one in order to take advantage of a lower interest rate, a different term, or to access equity in your home. You should be aware that mortgage refinancing usually comes with significant closing costs at the lender’s discretion, so it’s important to weigh your options. A rate lock helps protect borrowers by freezing the interest rate, at least for a set amount of time, and usually comes with an additional closing cost.
Mortgage Costs
Besides the interest rate in your mortgage, which is the rate at which you’ll pay the bank for lending you money, there are a variety of fees and taxes associated with a mortgage loan. You should consider the amount of origination fee, discount points, appraisal fee, title insurance, recording charges, and other taxes associated with a mortgage.
Another important consideration is the Annual Percentage Rate (APR), which basically includes the interest rate and the fees associated with your mortgage. APR is helpful for comparing rates between mortgage lenders. However, when shopping, it’s still important to look carefully at the closing costs of each loan.
The amount of the down payment also impacts the monthly mortgage payment. As with a larger down payment, the principal is lower and thus monthly installments due are also lower. It’s important to put a sufficient amount of money into a down payment, but it shouldn’t empty your savings: it might be necessary to build a rainy-day fund to cover the repairs to the new house.
Mortgage Example
Let’s assume an example in which a borrower buys a $ $400,000 home with a $80,000 down payment on a $ $320,000. With a 30-year fixed interest rate of 6.5%, the estimated principal-and-interest payment is about $2,022 per month.
The borrower subsequently pays for their property taxes, insurance, and any condo/association fees. If the loan requires mortgage insurance, the borrower subsequently pays these as well: The resulting amount can actually be significantly higher.
Choosing the Right Mortgage
There’s no perfect mortgage option for everyone. The most suitable mortgage for you depends on your unique circumstances and preferences – income, credit score, savings, and personal financial needs, as well as the future outlook for your career and personal life. As such, it is a good idea to compare several mortgage offers: look at the overall costs, be mindful of the entire payment, compare the rates, and evaluate additional fees and charges to make sure you understand every detail of the loan.
Before signing any documents, make sure you have a full understanding of the loan term, the estimated monthly mortgage payment, APR, any additional costs and fees, and the ability to pay off the mortgage early. In particular, it is important that you have enough money saved to cover any contingencies after closing.
Closing Thoughts
A mortgage is a complex financial instrument and an expensive commitment. Understanding how it works is vital for anyone considering taking out a mortgage. You want to consider your options based on your unique set of circumstances and ensure your decision aligns with your financial profile and personal goals.
