How Exactly Do Home Loans Work? A Rookie’s Guide to Mortgages

There are several major milestones in life: graduating from college, getting married or committing to a long-term partner, having children, and, of course, buying a home. Settling down in a residence you own is exciting, but taking out a home loan is not a light undertaking, and it may, for a first-time buyer, even be a bit intimidating — there’s a lot of jargon and a very specific process to understand and follow. These aren’t loans like any other loan!

We created this quintessential guide to walk you through what we think you should know as you apply for your first home loan (we had to include some of the pesky jargon — but we also added clear definitions so you never feel lost).

Who will give you a mortgage?

Big banks

Big banks are those that have a national and sometimes international presence — places such as Chase, Wells Fargo, and HSBC. If a big bank is your primary financial institution, it’s possible that they’ll extend a special in-house loan offer to you, as thanks for being an existing customer.

Credit unions

A credit union operates just like a bank, except they aren’t a for-profit institution — they’re owned by their members, who are typically tied to a specific organization, such as a college, or to a specific profession (for instance, there are several credit unions just for teachers). Often, they have special programs for borrowers with less-than-perfect credit, and might have special programs for those buying for the first time.

Mortgage lenders

A mortgage lender is a non-bank financial institution, that focus exclusively on mortgages as their area of expertise and don’t offer other banking services, such as checking and savings accounts.

Companies like Quicken Loans are trying to streamline the mortgage process for borrowers by conveniently letting borrowers apply for mortgages online; there are no appointments to be made, no phone calls to make, and no documents to print.

Mortgage brokers

A mortgage broker acts like a middleman or woman between you and the lender. These professionals will take your application and collect all of your paperwork — bank statements, credit reports, et cetera — and send them over to lenders for underwriting and funding. This service comes at a cost, however: some mortgage brokers will charge up to 2.75% in fees.

Types of loans

Conventional loans

Conventional loans are offered by private financial institutions and aren’t insured by a government agency, such as the VA or FHA. Conventional loans don’t offer the same benefits as government-backed loans (which will often approve buyers who don’t have large down payments or have lower credit scores); however if you do have good credit and a fairly decent down payment, a conventional loan could help you lock in a great interest rate.

Conforming loans

Don’t confuse a conventional loan with a conforming loan, though — they’re different! The name is a giveaway: a conforming loan must conform to a set of guidelines issued by Fannie Mae and Freddie Mac, and they cannot exceed a certain amount; this amount is a limit set by the Federal Housing Finance Agency (FHFA).

While the FHFA sets a national limit, some higher-cost areas such as San Francisco and New York may have higher limits to accommodate more expensive housing markets. Other factors considered when it comes to qualifying a conforming loan include:

• Debt-to-income ratio (are you carrying more debt than your income can handle?)
• Credit history
• Your down payment (if less than 20%, you will be required to obtain private mortgage insurance)

Example: If you want to buy a home for $500,000, and need a mortgage for $350,000 to do so, you’ll qualify for a conforming loan, because $350,000 is below the 2020 national loan limit of $510,400.

There are a few advantages to securing a conforming loan. Typically, these loans have lower interest rates (based on your credit, of course), so they could help you lock in a lower monthly payment. In addition, many different lenders offer them, so you’ll have the opportunity to compare various offers.

FHA (Federal Housing Administration) loans

These loans are offered by mortgage lenders and banks, but are insured and backed by the Federal Housing Administration, providing a security to lenders offering loans to those with less-than-ideal credit (if you’re a borrower with a credit score below 620, you might need to seek out an FHA loan). As a borrower with an FHA loan, you won’t need a huge down payment (you can put down as little as 3.5%) — but with a down payment that low, you’ll be required to pay a 1.75% mortgage insurance premium at closing, and subsequently make mortgage insurance payments for the duration of the loan if your down payment is less than 10%.

VA (Department of Veterans Affairs) and USDA loans

VA loans are offered to veterans and are backed by the (Department of Veterans Affairs). These loans have more relaxed requirements than conventional loans, as there is no down payment required.

The USDA (United States Department of Agriculture) backs loans to those buying in designated suburban or rural areas. Typically, you’ll be able to qualify with a credit score as low as 640, and interest rates can be as low as 1%.

How do I apply?

While you’re preparing to apply for a loan, you’ll want to do a few things.

Get your credit in order

Now’s a great time to review your credit report and check for any mistakes that a credit card or other lender may have cited on your report in the past, and call those companies to fix those mistakes. This can boost your credit score, which will help you get the best rate for your home loan.

Get your down payment together

Knowing how much you have for a down payment will help you calculate your monthly payments and understand just how much more debt you can afford to take on.

Meet with a licensed loan originator (LO)

A licensed LO will be able to walk you through a few scenarios, given your financials, and can help you understand all the taxes in your area as well as other hidden costs and fees you might not know about. Even before meeting with your LO, HomeLight’s mortgage calculator can give you a ballpark idea of your budget.  From there you can shop multiple lenders, banks, or brokers to find out who has the best loan for you.

What decisions will I have to make?

After you’ve picked a lender and determined the best loan type for your scenario, there’s a few other important details to consider. These are critical: they will impact how long you’re paying your loan back and what your monthly payments will look like.

Mortgage ‘ceiling’

It’s important to determine just how large of a loan you can afford and what your absolute maximum ceiling is — remember that you’ll want wiggle room in your monthly budget to save money for things like vacations and college funds!

When calculating how much you can spend, consider the following:

• Household income
• Current monthly debts (credit cards, student loans, etc.) — a lender typically won’t want you to exceed a 43% debt-to-income ratio, and when calculating that will take into account all of your debts (yes, your student loan counts, too) against how much you make per month
• How much you have saved for a down payment. Matt Healey, an agent who’s helped close more than 1,300 transactions, says buyers “think they need 20% down, but many folks only put 3.5% to 5% down.” Remember that if you have a smaller down payment, you might have higher monthly costs, and this will also affect what kinds of loans you qualify for.
• You might be able to qualify for an amount above what you can comfortably spend, so think hard about where your personal ceiling should be.

FRM vs ARM

An ARM (adjustable-rate mortgage) is a mortgage where the interest could fluctuate up or down after an initial fixed period. A fixed-rate mortgage (FRM) is the opposite: it’s a loan with a locked-in interest rate, which stays consistent from the first day right until the very last.

ARMs can be enticing; they often have very low interest rates for the first few years, but because that rate can change drastically after that initial period, they’re only a wise decision if you think you’ll be able to pay off the entirety of your mortgage quickly or you plan on moving before the initial fixed-rate period ends.

Mortgage term

The term refers to the length of time it will take for you to pay off your loan, assuming you stick to your repayment schedule. Typical term lengths are 10-, 15-, 30-, and 40-year; the 30-year loan is the most popular option, with 15-year being the second-most-popular term.

A longer term loan will often come with a higher interest rate, so it’s important to weigh a few things: How long do you plan to live in this particular home? Is it more important for you to pay less in interest overall, or to have lower monthly payments?

What needs to happen next to cross the finish line?

Now that you understand all the home loan terms and you’ve determined your budget, you’re ready to begin the process! Here’s a step-by-step guide — you can use it as a checklist — that’ll help you get through all the nitty gritty behind locking in a loan.

1. Get your Loan Estimate and preapproval letter

Your Loan Estimate will come from your lender and will include all the terms of your mortgage, showing how much you’re borrowing, your interest rate, and your monthly payment.

Your preapproval letter, also provided by your lender, will confirm that you have been preapproved for a loan, and for how much.

This letter is very important in the buying process; it shows sellers you’re serious about purchasing a home and that you’ve got the financials to back your intentions up (though to be clear: preapproval letters are still not a commitment to lend — there are several scenarios where your mortgage can fall through, even after preapproval, such as if you take on additional debt during the mortgage process or lose your job).

You could opt to get preapproval letters from several lenders in order to make the best decision for your budget.

Julie Aragon, a loan officer with Arbor Financial Group, said there are two main reasons you might choose one lender over another: “Speed and service quality are the two areas where lenders can set themselves apart in a big way.”

Aragon also recommends looking for a lender who’s well-versed and using the latest technology, cutting out several time-consuming trips to the bank to pull and print documents. If you can do everything online from the comfort of your living room, why wouldn’t you?

2. Find a house

Now that you’ve gotten the initial financial stuff out of the way, it’s time to go shopping!! Make sure to find a top real estate agent in your area to guide you through the process; they’ll often be able to share listings as they first become available on the market, and they’ll help you make a compelling offer on your dream home.

3. Make an offer that the seller accepts

There’s no one secret here — some of it comes down to luck, since you don’t know what others are offering — but you should make an offer that won’t come across as insulting to the seller (i.e. not too low) but also that you’re comfortable with. If you want, you can try to make an offer with an “escalation clause,” which states that you’ll match any other offers up to a certain amount, though be warned that some sellers and agents won’t accept these.

4. Pay your earnest money

Earnest money is a deposit to the seller, offered to prove that you’re serious about purchasing their home. It’s part of the down payment and usually equals 1% to 5% of the home’s purchase price, and the payment is held in an escrow account until all the paperwork is signed and everything is finalized.

5. Underwriting 

The underwriting process is when the lender goes through all your documents — your tax returns, credit reports, and so on — to analyze your financial position to confirm you’ll be able to pay your mortgage each month and to assess the property you would like to purchase to ensure it meets their parameters.

This usually happens after you’ve made an offer and have entered a contract with the seller, but sometimes lenders will offer pre-underwriting of your financials to expedite the process. Typically, this would happen after you’ve made an offer, but before a contract has been negotiated.

6. Appraisal

The appraisal is an unbiased assessment of the market value of the home. The lender will require an appraisal to ensure that the home’s value supports the amount of the loan you have applied for. If your appraisal comes in low, you might need to renegotiate with the seller or find a different lender who will approve the revised loan price.

7. Inspection 

Now it’s down to nuts and bolts — literally. The home inspector will be looking for anything that might make the home unsafe or unlivable. And lots of homes do need a few repairs — home inspections account for 16% of delays on home sales closings. If your house needs some work, you’ll have to figure out who will be paying for repairs before the sale closes.

8. Title search

Performed by a title company or an attorney, a title search confirms that the property does indeed belong to the seller and that there are no liens or judgments against the house.

9. Closing

Can you see the finish line?! Once all of the above is in the clear, you’ll be ready to sit down, sign papers, and hopefully walk away a homeowner.

Closing home loan paperwork includes (among other documentation): a promissory note (agreement that you’ll pay the loan), the mortgage or deed of trust (which gives the lender the right to foreclose on the property if you can’t pay your loan), the escrow disclosure (a summary of all charges rolled into that monthly payment, such as taxes and insurance), and your Closing Disclosure, which will summarize all the fees and costs associated with the transaction. You’ll also need a check to pay closing costs of between 2% and 5% of the total home sale.

As Healey says, most buyers feel at ease when they have a checklist and can see all the steps ahead of time — so we hope that this guide has given you the confidence and loan knowledge you need to talk with lenders, make strong offers, and close on a home. Congrats to you closers: you’re a homeowner!

Header Image Source: (Brooke Cagle / Unsplash)