Perhaps you’ve heard that there are no stupid questions, but there are still some that you probably feel you should know the answer to by now, and you might not feel that comfortable asking someone. Well, what is the internet for if not to answer exactly those questions? If you’ve been wondering what a mortgage is and you aren’t sure who you can ask, we’re going to walk you through the basics.
First: A mortgage is a type of loan you can use to purchase a home. It’s different from other loan products because it’s secured by the property itself. Being secured by the property means if the borrower violates the terms of the mortgage, the lender can claim the house back.
Who uses a mortgage?
Most homebuyers in the United States use a mortgage because few home purchasers have all the cash in hand they’ll need for home purchasing. Forbes Magazine calls a home the biggest purchase most Americans will make in their lifetime. The median sales price of a residential property was $335,300 in November 2020, while the median household income for 2015 to 2019 was $62,843 and the median savings account in the United States in September 2020 had a balance of $3,500.
So it’s not a surprise that 87% of recent buyers financed their home purchase with a mortgage according to the National Association of Realtors’ 2020 Profile of Home Buyers and Sellers. The average mortgage down payment is 12% of the purchase price, but for first-time homebuyers the average is more like 7%.
How do mortgages work?
When you decide you want to buy a home and you need to borrow money, your lender will look at your financial situation to determine how much money you qualify to borrow, and then you’ll pay that money back over a period of time. The lender will also charge you interest on the loan until the mortgage loan is paid off.
The mortgage process, simplified
Talk to a lender
If you want to have an idea of what price range you want to start looking into, you’ll want to get prequalified for your mortgage. A prequalification is when you go to a lender and self-report your income, debts, and credit score and a lender gives you an estimate of how much house you can afford, provided you qualify of course.
A prequalification is a good guideline for your current financial situation and how much you can afford, but it is not an airtight budget. Without verifying your information, a lender can only give you a rough estimate of what you can borrow. They’ll have to dig further into your finances to give you a more accurate number.
If you’re ready to contact an agent, you’ll want to get a loan preapproval. A preapproval will involve a similar conversation with a lender as the prequalification, but you’ll have to submit supporting documentation to show your income as well as your debts.
At this stage, your lender will also pull your credit report and go through your loan options with you. “A preapproval letter might be enough in some markets to allow you to make an offer,” says Richard Helali, one of HomeLight Home Loans’ expert loan officers.
An underwritten preapproval, known in some markets as verified preapproval, is a process through which “an underwriter is going to review the borrower’s entire loan application and financial documents before you even make an offer, which means the lender has taken extra steps to ensure the borrower qualifies and an offer will close successfully,” according to Helali.
Verified preapprovals tend to look better when attached to an offer in comparison to non-underwritten preapprovals because they signal to the seller that you can close quickly and without many (or any, ideally) issues. A verified preapproval can help you stand out in competitive markets and can allow you to close on time.
HomeLight Home Loans offers underwritten preapprovals so buyers can be fully prepared before entering the housing market.
Find your ideal real estate agent
To find the ideal agent for you, you’ll want to identify someone who is not only a good match for your personality, but who also understands your specific needs and the area of the country where you’re looking to purchase a home.
The most reliable way to find a good agent is to look at their past history. You’ll want to see how many homes they have sold in the past six to twelve months, how many days it takes them to close on a house, and how much more or less than the list price the agent usually sells for.
HomeLight’s “Find an Agent Tool” narrows thousands of agents around you by evaluating their historical transaction data, allowing you to quickly identify agents who are a good fit for you.
You’ll want to interview at least three different real estate agents before you make a decision.
Start touring homes
You’ll start attending showings and open houses, as well as looking at homes online.
Your agent can help make your search for a perfect home easier by weeding out any homes that are not a match for your budget or specific search parameters, identifying the investment potential and any problems that you might not see hiding behind cosmetic issues, connecting you to the right service providers, and helping you negotiate the perfect price for your dream home.
Make an offer
Once you’ve found your potential dream home, your real estate agent will help you consider every component of the deal and make a good impression on the seller by writing an offer.
Your agent will help you develop a solid offer that includes:
- The proposed purchase price
- Any contingencies depending on financing, inspections, and appraisal values
- Requests for the seller
- A deadline for the seller to respond — usually 24 to 48 hours — with an acceptance or a counter offer
- A timeline for deal to proceed
Going under contract
Once you and the seller have agreed on all the conditions of the deal, your agent will write a final offer letter, and you will officially be under contract.
While your deal is under contract, you and your agent will proceed with the home inspection and appraisal.
Finalizing the mortgage and closing
If you don’t have a verified preapproval, your loan will go to the underwriter at this stage of the buying process.
The lender will take a look at all your documentation, including any tax returns, credit reports, bank account statements, and so on, to confirm that you are able to assume this financial responsibility.
In addition to the underwriting process, the lender will also be looking at an appraisal of the property you’re buying to verify that the home’s value supports the amount of the loan you’ve applied for.
Besides the underwriting and the appraisal, most home selling deals include a home inspection as a contingency to the sale. A home inspector will look at the home from top to bottom and assess which repairs — if any — are necessary for the house to be in 100% functioning condition before it exchanges hands.
Before closing your home loan, a title company or an attorney will perform a title review to ensure the property is actually the seller’s to sell and that there are no additional liens or legal judgements that prevent the house from changing hands.
At the closing, you will be expected to review all of the paperwork regarding the loan (promissory note), the deed of trust (which allows the bank to foreclose on your home if you fail to make your payments), the escrow disclosure (all the charges your monthly payment covers), and your Closing Disclosure, which summarizes the entire transaction in one document. You’ll also bring a check to cover the closing costs.
The 5 main types of mortgages
A conforming, conventional loan is a privately-backed mortgage, and is the most common loan type in the market today. They’re considered “conforming” because they have a maximum loan amount of $548,250 in most counties and aren’t part of any government program.
While these conventional loans require a 20% down payment if buyers want to avoid mortgage insurance, qualified buyers can access a conventional loan product if they do pay mortgage insurance.
Conventional loans generally require a minimum credit score of at least 620, a debt-to-income ratio of 45% (although you may be able to go up to 50% if you qualify), and a minimum down payment of 3% to 5% depending on the qualifications of the buyer, but each lender can add their own requirements on top of the minimum standards. Buyers who put down less than 20% on a conventional loan are required to purchase private mortgage insurance (PMI) until they reach 20% equity in the home.
According to the November 2020 Origination Insight Report by Ellie Mae, 92% of the conventional loans closed in November 2020 had borrowers with credit scores higher than 700, with 46.51% of borrowers showing scores in the 750 to 799 range, and 26.1% of borrowers with credit scores at 800 or higher.
A conventional loan generally requires a maximum debt-to-income (DTI) ratio of 45%, but may go up as high as 50% if you meet certain reserve requirements. This means that up to 45% of your income can be allocated to debt (including your mortgage), but if you already have high monthly debt payments relative to your income, then you might have to pay down some of that debt to qualify for a mortgage.
A jumbo loan is a conventional loan that’s considered non-conforming because the loan limit is higher than the $548,250 conforming loan limit for most counties. The higher loan amount, with the fact that there is no government entity backing or buying these loans, makes jumbo loans slightly riskier for lenders and investors. Because of that, it tends to be more difficult to qualify for a jumbo loan.
General rules to qualify for a jumbo loan require a credit score of 700 or higher, and a down payment of at least 10% to qualify; but overall, the process of getting a jumbo non-conforming mortgage is similar to that of getting a conforming conventional loan.
Most jumbo loans require a maximum debt-to-income ratio of 43%.
A VA loan is a loan designed for a member of the United States armed forces, a veteran, or a qualifying surviving spouse. The program is backed by the Veteran’s Administration, and it’s available through VA approved lenders. The property purchased with a VA loan must be appraised at fair market value and buyers using these loans should have a credit score of at least 620 (though there are no hard-and-fast credit score minimums for VA loans).
The VA typically requires borrowers to have a maximum debt-to-income ratio of 41%, though the limit can go higher for certain qualified buyers.
An FHA loan is backed by the Federal Housing Administration and must be issued by an FHA-approved lender. They offer low down payments, and are easier to qualify for than conventional loans.
FHA loans require a minimum credit score of 580, a debt-to-income ratio of 45% (although a higher percentage may be acceptable if the borrower meets certain additional eligibility criteria), and they require mortgage insurance premiums for either 11 years or the lifetime of the loan, depending on the length of the loan and how much the buyer puts down when they get the loan.
The United States Department of Agriculture backs this type of loan product, which requires a 640 minimum credit score and is available through USDA-approved lenders. The good news? Some buyers can get a USDA mortgage with no money down.
The caveat? The USDA will only lend money for houses located in eligible areas deemed “rural,” and there’s an income cap after which you no longer qualify for this type of mortgage. The maximum debt-to-income ratio allowed for this loan type is 41%.
Loan terms and repayment options
A mortgage term is the amount of time it will take you to pay off the loan. The term is used to determine the monthly payment amount, the repayment schedule, and the interest paid over the life of the loan.
The typical terms are 10, 15, 30, or 40 years. “The 15-year fixed and the 30-year fixed are the most common loan terms we serve,” says Helali. “But when it comes to purchasing a home, most folks do just end up choosing a 30-year fixed after looking at how the payments go up exponentially for a 15-year. They just feel it’s going to be more manageable and safer.”
According to the CFPB, a shorter-loan term will translate into a higher monthly payment, but a lower interest rate and total cost; while a longer-term loan will offer lower monthly payments at a higher interest rate with a higher total cost.
Factors you should take into consideration when choosing the term length include:
- How long you expect to stay in that home
- How fast you want to build equity in your home
- How soon you want to pay off your mortgage
There are two basic types of mortgage interest rates: fixed and adjustable.
A fixed interest rate offers lower risk and no surprises. The rate remains “fixed” or unchanged for the duration of the loan. According to the CFPB, 85% to 90% of buyers choose fixed-rate interest for their mortgage loan.
“I like fixed-rate loans because you know what your monthly principal and interest payment is on day one, and what it will be in 29 years and 11 months,” says Helali.
Also known as ARMs (adjustable-rate mortgages), these have a higher risk level and come with more uncertainty. Your interest rate will initially be lower than on a fixed-rate loan, and it will stay fixed for a period of time, but after that initial period, your rate can increase or decrease based on the market conditions.
Most ARM mortgages have a 30-year loan term.
According to Helali, “some of my clients don’t plan to stay in a house longer than five years, so to them, a 5/1 ARM makes sense.” (This means the introductory interest rate period will last for five years, and then the rate will adjust every year after that.)
It’s a good option because “they will be selling before their interest adjusts and have a lower payment for the years they do plan on staying in that property,” Helali says.
What’s included in a mortgage payment?
First of all, remember that mortgage payments are paid in arrears, meaning you pay this month for the last 30 days of your mortgage term. It’s the reverse of rent, which is paid the first of the month for the 30-day period that’s about to begin.
The mortgage principal is the amount you initially borrow from the lender, not including any interest or financing costs..
Mortgage payments are usually amortized. This means that at the beginning of your loan term, your payments have little money applied to the principal because most of it is going toward the loan interest. As you get further into the loan term, more of your mortgage payment will be applied toward the loan principal.
Mortgage interest is the interest rate you pay on your home loan, expressed as a percentage of the loan amount..
At the beginning of your loan term, most of your monthly mortgage payment will be applied toward your interest, and that amount gets reduced as your loan term goes on, and you pay more toward the principal.
Taxes and insurance
Real estate or property taxes get calculated by your city, state, and county every year. In most instances, your lender will “impound” your taxes and insurance. That means the full amount of your annual property taxes gets divided by the number of mortgage payments in a year, and the lender then collects that prorated amount along with your mortgage payment and then holds each payment in escrow until the taxes have to be paid once or twice a year.
A homeowner’s insurance policy is required by most lenders to protect the property that backs the loan.
If something were to happen to your home, you could face devastating financial consequences. Even if a homeowner’s insurance policy is not required by your lender, it’s simply a good idea to have just in case.
Like your property taxes, if your mortgage features impounds for taxes and insurance, your homeowners insurance payments are divided by the number of mortgage payments in a year, and your lender will collect that prorated amount along with your monthly mortgage payments. The lender will then disburse the funds out of the escrow account when the insurance policy payment is due.
These impound accounts will likely be required by your lender unless you put more than 20% down on your mortgage. If you do and you choose not to have your lender impound and manage your taxes and insurance, you will be responsible for paying these amounts directly and failure to do so could put your home in jeopardy as it could be deemed a default under the terms of your mortgage.
If your down payment was less than 20% of the cost of the purchase, you will be required by your lender to pay MI, or mortgage insurance.
The yearly cost of MI is usually 0.5% to 1% of the loan amount. This monthly fee will be divided by the number of mortgage payments in a year and will be added to your mortgage payment for the duration of the MI requirement on your mortgage.
How to find the right mortgage for you
The right type of mortgage will be different for each buyer. Consider some of these questions:
- What’s your credit score?
- What’s your current income?
- Do you qualify for a special loan like a VA loan?
- How long do you plan to stay in that home?
- How competitive is your market right now?
- How much do you have saved for a downpayment?
Relying on your lender to help guide you through the available options, your specific financial situation, and looking at the cost over the life of the loan, you can also use predicted monthly payments and the kind of income you’re using to qualify for the loan to help narrow down the choices.
According to Helali, looking at the predicted monthly payment is a defining factor for most of his clients. “At the end of the day, you need to agree to a monthly expense that feels right for the foreseeable future.”
If you have questions about getting prequalified, preapproved, or getting a verified preapproval, our team of professionals at HomeLight Home Loans can help you maximize your buying power and minimize your stress for whatever point of the purchasing journey you’re in with easy online applications, upfront underwriting and competitive fees; plus a handy free home affordability calculator if you’re not ready to start the conversation just yet.
Header Image Source: Jarek Ceborski / Unsplash.com