Beginner's Guide to Home Loans
Maurie Backman is a personal finance writer who covers everything from savings to retirement to healthcare. Her articles have appeared broadly on major outlets such as CNBC, MSN, and Yahoo.
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What is a mortgage?
A mortgage is a loan you take out to purchase a home. When you sign a mortgage, your lender agrees to loan you, the borrower, a certain amount of money so you can buy your home. You, in turn, agree to repay that amount, in monthly installments, over a preset period of time -- usually 15 or 30 years. Keep in mind that some people use the terms "home loan" and "mortgage" interchangeably.
What goes into your mortgage payment?
Your monthly mortgage payment is determined by taking the principal amount of your loan -- the sum your lender lets you borrow -- and then applying the interest rate your loan calls for to that sum and spreading what you owe out over your loan's repayment period. Generally, you can choose between a 15-year or a 30-year repayment period. With the former, you'll pay less interest over the life of your home loan, but your monthly payments will be higher.
Sometimes you'll owe more than just principal and interest on a monthly basis, though. This is because your mortgage lender will take charge of paying your quarterly property taxes and annual homeowners insurance premiums. In that case, you'll pay your lender additional money each month that goes into an escrow account. Your lender will then dip into that account as your property tax payments and homeowners insurance premiums come due.
Property taxes are the taxes you pay to your local municipality when you own a home, and homeowners insurance protects you from financial losses when your home sustains damage, or someone gets injured on your property. Property taxes are unavoidable, and while it's technically possible to own property without having homeowners insurance, mortgage lenders generally won't give out a home loan if you don't buy a homeowners policy.
In the early stages of your mortgage repayment period, more of your money will go toward your loan's interest portion, and less toward its principal. But as time goes on, you'll eventually pay more principal than interest. The process by which this happens is called amortization.
What is a promissory note?
A promissory note is a secondary agreement that gets signed in conjunction with a mortgage. In it, you pledge to repay your home loan, plus interest, as per your lender's repayment schedule.
What is a second mortgage?
Your initial mortgage is a home loan that makes the purchase of your property possible. A second mortgage, on the other hand, lets you borrow against the value of your home once you're living in it.
Second mortgages can come in the form of a home equity loan or home equity line of credit. Equity refers to the percentage of your home you actually own outright, and it's calculated by taking your property's market value and subtracting your outstanding mortgage balance. If your home is worth $200,000, and you owe $150,000 on your mortgage, you have $50,000 worth of equity, which you can borrow against.
- With a home equity loan, you borrow a lump sum of money and pay it back, at a preset interest rate, over time.
- With a home equity line of credit, you're granted a specified amount of money you can borrow from during a certain period of time. You don't need to borrow the entire sum at once; you can borrow some money one year, and borrow more money the next year as the need arises.
You can take out a second mortgage to make home improvements or repairs to your property, but that money isn't limited to home-related spending; you can borrow it for any purpose. By contrast, your regular mortgage can only be used to buy a home.
What's the difference between a loan and a mortgage?
Loans and mortgages are similar but have a few key differences. Standard loans can take on different forms -- personal loans, student loans, and business loans are all common examples. In these situations, you're getting a loan either based on your credit score (more on that later), or based on financial need in the case of federal student loans (private student loans do take your credit score in to account).
Mortgages, meanwhile, are loans specifically designed to enable you to buy a home. While your credit score does play a role in helping you qualify, as is the case with regular loans, one key difference is that mortgages use your home as collateral.
When you take out a regular loan, there's no specific asset your lender can come after to recoup its money if you don't make your payments. Mortgages, however, are secured loans, and if you don't pay yours back, your home is the asset that's used as collateral. That means your lender can force the sale of your home via foreclosure and use the proceeds from that sale to get repaid.
Applying for a mortgage
Securing a mortgage can be a time-consuming process, but it doesn't have to be a daunting one. The first step involves researching lenders to see which are offering the best mortgage rates. The interest rate you pay on your mortgage will determine what that loan costs you over time. The better your credit, the more likely you'll be to snag the most competitive rate a given lender is offering.
Mortgage rates are either fixed or adjustable. With a fixed mortgage, you'll pay the same interest rate over the life of your loan. With an adjustable-rate mortgage, that rate can vary over time, so you may start out paying very little interest but then see that rate climb down the line. In some cases, the rate on an adjustable-rate mortgage can go down over time, too. But if you want the security of knowing what rate you'll be paying throughout the life of your loan, then a fixed-rate mortgage is the way to go.
Things you'll need to secure a mortgage
Lenders don't give out mortgages easily. To get one, you'll need:
Credit scores range from 300 to 850, and a score of 670 or above is considered good. You may qualify for a mortgage with a lower credit score, but if you do, you probably won't snag a favorable rate on your home loan. If your credit score isn't great, it pays to work on boosting it before securing a mortgage. You can do so by paying incoming bills on time and paying off a chunk of your existing debt.
Your debt-to-income ratio, meanwhile, measures the amount of money you owe each month on existing debts relative to your monthly earnings. If you owe too much, mortgage lenders will be less inclined to loan you money, so ideally, you'll want a debt-to-income ratio of 36% or lower. This means that if you bring home $3,000 a month, you shouldn't have more than $1,080 in existing monthly debts. If that ratio of yours isn't favorable, pay off existing debt or try boosting your income with a second job.
Finally, you'll need to put some money toward the purchase of your home, the amount of which will depend on the type of mortgage you get. Generally speaking, you'll need a 20% down payment when you take out a conventional loan to avoid private mortgage insurance, or PMI. PMI is a premium designed to protect your lender in the event you're unable to keep up with your mortgage payments. It usually gets tacked on to your monthly mortgage payment and equals 0.5% to 1% of the amount of your mortgage. For example, with a $150,000 mortgage, you'll generally be looking at $750 to $1,500 in PMI annually, spread out over 12 months.
What are closing costs on a mortgage?
When you finalize a mortgage, you're liable for a host of fees, known as closing costs. Closing costs typically equal 2% to 5% of your mortgage's value. You can pay your closing costs as a one-time expense, or you can often roll them into your mortgage and pay them off over time (with interest). Your lender is required to give you an estimate of your closing costs ahead of time so you're not caught off-guard.
Types of mortgage loans
Not all mortgages are created equal. Here are the different types of mortgages you should know about:
Conventional home loans adhere to the maximum limits set by Fannie Mae and Freddie Mac, which are the agencies that back most U.S. mortgages. As mentioned, you'll pay PMI if you fail to put down 20% on a conventional mortgage, but you may be able to put down as little as 3%. The borrowing limits for conventional mortgages change from year to year. In most of the U.S., the maximum conforming mortgage for one-unit properties is $510,400 in 2020.
These are conventional mortgages that exceed the maximum borrowing limits. Jumbo mortgages are harder to qualify for than conventional mortgages, and you'll generally need at least a 10% down payment, if not 20%.
These mortgages are backed by the Federal Housing Administration and are geared toward applicants who don't have great credit or don't have the funds for a substantial down payment. You can put as little as 3.5% down with an FHA loan if you have a 580 credit score or above. But, you pay certain premiums with an FHA loan (similar to PMI) that can make your mortgage more expensive.
These mortgages are available to active members of the U.S. military as well as veterans. VA loans don't require a down payment and don't charge PMI. There are, however, funding fees involved that get tacked onto your mortgage costs.
Backed by the U.S. Department of Agriculture, USDA loans help lower-income borrowers buy homes in rural areas. If you qualify, you won't have to make a down payment on your home, but that home must be located in a designated zone (buying in a suburb alone does not guarantee that you'll qualify).
Refinancing a mortgage
The mortgage rate you lock in initially doesn't have to be the rate you get stuck with for life. If you refinance your mortgage, you may manage to secure a lower interest rate on your home loan, thereby lowering your monthly payments.
Refinancing means swapping one loan for another, and you can do it for many types of loans -- not just a mortgage. The refinancing process is similar to that of applying for an initial home loan -- you shop around for the best rates and then compare the terms different lenders are offering with the terms of your existing loan to see if refinancing makes sense.
It often pays to refinance your mortgage if your credit score has improved a lot since you first applied for a home loan. If it has, then you may be eligible for a much lower interest rate than what you're paying right now. It also makes sense to refinance if you want to change the terms of your mortgage -- for example, if you can't keep up with your monthly payments under a 15-year loan, you may want to refinance to a loan with a 30-year term. Or, you may want to do the opposite -- switch from a 30-year mortgage to a 15-year mortgage.
If you're going to refinance, make sure you're planning to stay in your home long enough to recoup the closing costs involved. If you pay $1,800 in closing costs but your refinance enables you to save $120 a month on your monthly mortgage payments, then you'll break even in 15 months. If you plan to stay in your home longer than that, then refinancing makes sense, but if you think there's a good chance you'll move in a year, then you may want to stick with your original home loan.
The bottom line on mortgages
Applying for a mortgage for the first time can be stressful if you don't know what you're getting into. Now that you're familiar with how mortgages work, you can take steps to ensure that you're ready to apply for one, all the while increasing your chances of snagging a home loan with a favorable interest rate. No matter what type of mortgage you're looking at, or how much you're hoping to borrow, shop around, and give yourself time to work through the process. A little patience could make an otherwise intense process a lot less harrowing.