Mortgages

Buying a home is a big step, one that should only be taken after educating yourself on all aspects of the purchase process, and that includes understanding how a mortgage works and what your responsibilities are. There are different types of mortgages. Interest rates change periodically. Fees and closing costs vary between lenders. Below, we break it all down.

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What is a Mortgage?

A mortgage is a loan that is used to purchase a home or other piece of real estate. It is essentially a secured loan because the property itself acts as collateral. You can apply for a mortgage at a local bank, credit union, mortgage broker, or online. There are several websites where you can apply and receive multiple offers from mortgage lenders. 

Mortgages come in different forms. For instance, with a fixed-rate mortgage, you pay a set interest rate throughout the life of the loan. Adjustable-rate mortgages have an interest rate that periodically changes based on an index that tracks the current prime rate. There are also mortgages designed for specific situations, such as FHA, VA, and USDA loans.   

The total cost of a mortgage is determined by the type of loan, the term in years, and the interest rate.  The mortgage definition by the Consumer Financial Protection Bureau goes into additional details, including the seven aspects to look for in a mortgage:

  • Size of Loan
  • Interest Rate
  • Closing Costs
  • Annual Percentage Rate (APR)
  • Type of Interest Rate (fixed or adjustable)
  • Loan Term (Number of Years)
  • Penalties and Additional Fees

What is Mortgage Refinancing?

Mortgage refinancing is getting a new mortgage to pay off and replace the old one. The most common reason for doing this is to take advantage of lower interest rates, but that is not the only reason. In some cases, homeowners will refinance to get into a different type of mortgage, like switching from an adjustable rate to a fixed rate.

The mortgage loan steps for refinancing are like taking out the original mortgage. The borrower needs to apply and go through the lender approval process. Once that has done, the terms of the refinancing can be discussed. The old mortgage is paid off and the borrower is placed under a new contract with the updated terms. 

Unlike the first mortgage, the refinanced version will not be for the full value of the property. The borrower will have already paid a portion of that off. For instance, if the original home price was $250,000 and the borrower has $50,000 in equity, the refinancing will be for the remaining $200,000. This improves the chances of approval for the new loan. 

How Does a Mortgage Work?

A mortgage works like any other loan because it has the same components. There is a total amount borrowed, an interest rate, and a specific time frame in which the borrower must pay it off. The difference with a mortgage is that the borrower will own a piece of property at the end of the term. Conversely, if the borrower defaults, the property will be foreclosed on.

From a legal perspective, a mortgage is also classified as a “lien against the property.” This classifies it as a “secured loan.” If the property is foreclosed on due to missed payments, the residents can be evicted, and the home will be resold by the lender. The proceeds from that sale will go to pay off the balance of the mortgage. 

If the proceeds from a foreclosure sale do not cover the balance owed, the borrower will still be responsible for paying that remaining debt. This can happen when the property value goes down after the initial purchase, a scenario commonly known as being “upside-down” on your home purchase, where you are paying more than what the property is worth.

The amount that you borrow to buy a home does not change when the property value goes up or down. In cases where the property value increases, the borrower can choose to sell the home for a profit. The sale proceeds pay off the outstanding balance on the mortgage and the seller gets to keep the remainder as a capital gain.   

Which types of mortgages are there?

There are several types of mortgage loans, including conventional mortgages, fixed-rate mortgages, adjustable-rate mortgages, FHA loans, VA loans, USDA loans, jumbo loans, 2nd mortgages, and one or more of them could be the right fit for you. A mortgage is a multi-year commitment that involves a significant amount of money, so take your time and review the following to get started.

Conventional Mortgages

A conventional mortgage is a mortgage offered by a private lender that is not secured by a government entity. Borrowers can apply for a conventional mortgage at their local bank, credit union, or mortgage company. They are also available online. Conventional mortgages typically have a fixed rate of interest and require a down payment of at least 3% of the loan.

Most, but not all, conventional mortgages are also classified as “conforming mortgages.” This is a standard set by Fannie Mae and Freddie Mac, both of which are federally backed home mortgage companies created by the United States Congress. Their funding criteria include a dollar limit on conventional mortgages set by the Federal Housing Finance Agency. 

 Fixed-Rate Mortgage

Fixed-rate mortgages are exactly what they sound like – the interest rate is fixed for the entire life of the loan. This differs from an adjustable-rate mortgage where the interest rate changes based on market conditions. The terms of a fixed-rate mortgage range anywhere from ten to thirty years. This is the most common type of mortgage in the US right now.

Choosing a shorter term on a fixed-rate mortgage will result in a lower overall price to buy the property. Payments are amortized, which means borrowers pay more interest early in the life of the loan. As time goes by, the percentage of monthly payments that goes towards the principal increases, giving the borrower more equity in the property.   

Adjustable-Rate Mortgage

Adjustable-rate mortgages (ARMs) have an initial interest rate that adjusts after a certain period of time. This can be suitable for new homeowners with limited resources, but it is important to understand that monthly payments may go up when the interest rate adjusts. This can happen once a year, monthly, or in other increments according to the loan agreement.

ARMs, which are also known as “variable-rate mortgages,” typically set their interest rates based on an index that includes the “prime rate” used by banks. The variable interest rate will usually be set as a percentage above or below whatever the prime rate is on the date of adjustment. This makes adjustable-rate mortgages somewhat unpredictable.  

FHA Loans

The Federal Housing Authority (FHA) is not a lender, but they can guarantee a loan from a traditional lender. They also require that you purchase mortgage insurance through them. This minimizes risk for the lender since the FHA is guaranteeing repayment if the borrower defaults on the loan. The FHA also has a lower minimum credit score requirement (500+).

A 3.5% down payment is required for borrowers with a credit score over 580. 10% is required if your score falls between 500 and 580. The mortgage insurance premium is 1.75% upfront and 0.45% to 1.05% annually. Loan terms are either fifteen or thirty years. Most lenders encourage new home buyers to take the mortgage loan steps required to qualify for FHA loans.  

VA Loans

Like FHA loans, VA loans are not offered by a government entity. The Veteran’s Administration sets the standards and dictates the terms of the loan. A private lender will provide the funds. VA loans are available for active military, veterans, and surviving spouses. Lenders also have their criteria, but approval for a VA loan is easier than conventional loan approval. 

Two of the more attractive features of a VA loan are that down payments and private mortgage insurance (PMI) are not required. Closing costs are also smaller and prepayment penalties for buyers who want to pay off the loan early are prohibited. For lenders, VA loans are guaranteed against default by the Government National Mortgage Association (GNMA). 

USDA Loans

Guaranteed by the United States Department of Agriculture, a USDA loan is for homebuyers who live in rural areas with a population of 35,000 or less. There are two types of USDA loans: Guaranteed and Direct. The former guarantees at least 90% of the loan will be repaid to the lender. USDA direct loans come directly from the USDA. 

Direct USDA loans are offered in cases where there are issues with safety and sanitation. Guaranteed USDA loans require no assets, a debt-to-income ratio of up to 41%, and no minimum credit score. These loans are designed for those with lower incomes living in rural and often economically depressed parts of the country.  

Jumbo Loans

Larger property purchases that exceed the limits set by the Federal Housing Finance Agency require what is known as a “Jumbo Loan.” These mortgages can range from several hundred thousand to millions of dollars. They are not guaranteed or securitized by Fannie Mae or Freddie Mac, so the credit requirements from lenders are more rigid.

Jumbo loans are typically seen with luxury properties or more expensive homes in competitive real estate markets. Approval will require a credit score of 700 or better and a debt-to-income ratio of under 36%. Interest rates are comparable with conventional mortgages. The minimum down payment required is usually 10% to 15%, down from 30% a few years ago.  

2nd Mortgage

This is primarily a financial vehicle to secure more cash on hand. A second mortgage is an additional loan taken out on a property where a primary mortgage already exists. These are also known as “home equity loans” because the second mortgage is typically a loan for the percentage of the property that has already been paid off.  

The mortgage loan steps required for the second mortgage are identical to what you would go through taking out a first mortgage. The approval also means having an additional lien placed on your property. This step is usually taken when homeowners want to make improvements or have encountered a life situation that requires additional capital. 

Mortgage FAQs

Why do people need mortgages?

Can anybody get a mortgage?

How many mortgages can I have?

What does fixed vs. variable mean on a mortgage?

What is an FHA mortgage?

How does your credit score affect your mortgage rate?