What is a mortgage?
If you’ve been thinking about becoming a homeowner, you might be concerned how you’ll be able to pay for such a huge expense. The asking price for most properties is well beyond the purchasing power of the average person, so how have so many people been able to buy a home? Rather than paying for the entire home up front, most buyers decide to finance their purchase by taking out a mortgage.
What is a mortgage in simple words?
A mortgage is a loan used to buy a home. Rather than paying hundreds of thousands of dollars all at once, most homeowners choose to work with lenders and organize a purchasing plan that can be paid off over time.
When the mortgage process is finalized, the home itself serves as collateral, meaning your lender has the right to foreclose the property if your monthly mortgage payments are continually missed. As a first-time homeowner, this regular installment will likely be your largest monthly expense. In addition to paying off the loan’s principal, these mortgage payments cover a variety of additional charges.
What is interest?
On top of repaying the purchase price of the home, your lender will include an interest charge on every monthly bill. Simply put, the interest rate on your mortgage is the cost of borrowing money from your lender. Taken as a percentage of your overall loan amount, interest rates are determined by current market indexes and margins, as well as your personal financial history and cash on hand. Depending on what type of mortgage you apply for, the amount you pay each month can vary. While conventional loans carry significant costs, some government-backed loans, like FHA mortgages, might offer more affordable options.
Let’s say you decide to apply for a 30-year fixed rate mortgage with an interest rate of 3%*. The loan’s repayment plan would be stretched out over the course of three decades with an annual 3% interest included on each bill. As you continue making timely payments, you’ll start to gain equity in the home, expanding your ownership stake in the property and opening up further financial opportunities.
Mortgage terms to know
There’s a lot that goes into home financing, and newcomers to the field can quickly feel overwhelmed by confusing real estate jargon. In the early stages of the mortgage process, you’ll likely come across a few terms you might not fully understand, but are important to know. Here’s some key mortgage terminology for a better grasp on what goes into a home loan:
- Down Payment
- Private mortgage insurance
- Loan officer
- Closing costs
Down payments are an initial investment in your new home that establishes your ownership of the property. Down payments typically amount to 20% or more of the home’s sale price, but that can vary depending on which type of mortgage you choose.
The rest of the sales price is loaned by your lender, establishing their lien on the property as well.
Down payments can be one of the largest hurdles for buyers to overcome. Most mortgages require a minimum down payment option of 20%, which would amount to $40,000 on a $200,000 home. If you aren’t able to cover this upfront expense, your lender might require you to pay for private mortgage insurance.
Private mortgage insurance
For most mortgages, an application that falls short of your lender’s approval standards might come back stipulating the requirement for private mortgage insurance, or PMI.
Most of the time PMI is required if you’re unable to contribute 20% or more to a down payment. This shortfall might indicate that you carry a bit more risk and will need to pay for PMI to ease your lenders concern.
While it is paid by you as the borrower, PMI is designed to protect your lender’s investment in the mortgage and allows them to to recoup any losses they encounter if the loan should fail.
By providing lenders with this security, PMI lets lenders issue loans that would otherwise carry too much risk to be approved and allows borrowers to purchase a home sooner without having to save up as much of a down payment.
When shopping around for a mortgage, a loan officer, or LO, acts as an intermediary between you and your lender. These professionals work to identify your specific needs and match you with a mortgage that can provide a suitable financing package.
By taking a close look at your credit score, financial history and available funds, loan officers are able to estimate your borrowing capacity and recommend mortgage options based on their expertise.
They’ll also act as a liaison throughout the approval and underwriting process. Any required documents are collected and organized by the LO before being passed on for further review.
Your annual percentage rate, or APR, is the total cost of borrowing money from your lender. In addition to your interest, APR encapsulates any additional expenses your lender expects to be paid in part each month, as well as one time costs such as discount points, lender fees and other closing costs.
Origination charges, some closing costs and mortgage insurance (if applicable) are all included in your APR. Because of these added expenses, your APR will always be a bit higher than your interest rate.
APR allows you to get a true idea of the full cost of your mortgage. By understanding the APRs offered by multiple lenders, you’ll get a better sense of who can truly provide the best financing package for you.
When you first begin the mortgage process, your lender is required to provide a “loan estimate” laying out the many additional costs associated with processing a home loan. As the estimate may show, the cost of appraisers, real estate agents and underwriting add up to an expense that needs to be settled in order for the loan to be officially finalized.
These “closing costs” are usually handled with a single payment at the very end of the homebuying process. In addition to covering the lender’s costs of operation, this collection of fees pays any expenses associated with third-party service providers that were involved in the sale.
What are the different types of mortgages?
Mortgages are available in a variety of types, with some financing packages better suited to fit your real estate goals. Here are some of the most common home financing plans and how they might fit your property buying goals:
- Fixed rate mortgage
- Adjustable rate mortgage
- Jumbo Mortgage
- VA loan
- FHA loan
Fixed rate mortgage
A fixed rate mortgage establishes an unchanging interest rate throughout the course of the loan. Thanks to the fixed rate, you can be confident you’ll be paying the same amount month after month throughout the loan’s entire term. This guarantees stability in what is likely going to be your largest expense, freeing you up to more easily budget for the road ahead.
Since buyers can lock in the same rate for up to 30 years, fixed rate mortgages become much more popular when market average rates are low. Savvy homebuyers know that if they can get a mortgage at the right time, they’ll secure financing for a new home at a rate that will never budge. No matter how the economy or the real estate market fluctuates, fixed rate loans remain steady.
While some other mortgage structures adapt to current interest rates, the amount of interest on a fixed mortgage does not. This certainty allows you to plan for your financial future without the risk of unwelcome economic changes impacting your monthly bills.
Adjustable rate mortgage
An adjustable rate mortgage, or ARM, is a financing structure that comes with a fixed interest rate for a number of years, with periodic adjustments after the fixed rate term expires.
ARMs are usually represented as two variables, like “5/6” or “7/6,” with the first number indicating the length of the fixed rate period, and the second indicating how often it will be adjusted after the fixed rate term. A 7/1 ARM, for example, would start with a fixed rate mortgage for the first seven years. When that term is up, the interest rate would be readjusted annually.
The fixed rate period can range from 1-10 years on an ARM, depending on your lender and what loan options they make available. Following the fixed rate term, the amount you pay could be adjusted higher or lower than it was, depending on the state of the index and margins.
In order for your average loan to be approved, the size of the mortgage can’t exceed the limits established by the Federal Housing Finance Agency. The FHFA enacted these limits to maintain liquidity in a stable housing market. This policy also helps make mortgages more widely available. In the year 2021, the FHFA lending limit was $548,250.
If your mortgage were to exceed this cap, perhaps for a large new home, the standard mortgage structure is no longer applicable. Loans that surpass this limit are known as non-conforming jumbo loans and carry considerably more risk for your lender.
In addition to the large amount of financing provided, lenders take on a credit risk by issuing loans that don’t conform to the standardized limit.
Among other strict conditions, securing a jumbo loan will usually require an excellent credit score and lots of liquidity to cover the associated expenses.
VA loans were created to provide affordable mortgages for military veterans, active service members and their families by lessening some of the financial burdens associated with buying a home. Since its creation in the 1940s, the VA mortgage program has been a widely utilized program, helping millions of servicemen and servicewomen get started in the housing market.
Backed by the U.S. Department of Veterans Affairs, these mortgages allow lenders to issue financing with more flexible qualification standards. As an eligible VA loan applicant, you’ll get lower credit score minimums, no down payment requirement and comparatively lower interest rates.
Your lender will still provide the financing used for the home purchase. The VA cooperates with these private lenders to make affordable mortgages that guarantee the lender’s share of the home is protected should the home fall into foreclosure. This guarantee only extends to the lender and does not cover your share of the home. This added government assurance lets lenders expand home ownership opportunities for service members looking to apply for a mortgage.
Federal Housing Administration loans, or FHA loans are government-insured financing that help prospective buyers achieve homeownership when they meet the criteria to qualify.
If you haven’t got the credit score or cash on hand to afford a typical financing plan, FHA loans might provide a useful solution.
By providing government backing on FHA mortgages, lenders can be certain their investment is safe and insured, allowing them to lower certain credit or savings thresholds when approving a loan. If the buyer can’t keep up with payments and the home loan falls into default, the lender can foreclose the property and sell it back on the market with confidence that they’ll be able to recoup any losses. By insuring a portion of the lender’s financing, banks can be more flexible with their mortgage approval terms, creating new paths to homeownership for those who qualify for FHA financing.
Which mortgage plan is the best fit?
The ideal mortgage for you depends heavily on your personal financial background and real estate goals. Buyers with a military background might opt for a VA loan, while those looking to stay in their home for a short amount of time could go for a 7/1 ARM.
The best way to find the perfect mortgage for your situation is to meet with multiple lenders, get an idea of what the market has in store and work with a loan officer. That way, you’ll be able to begin the mortgage process with the confidence that you’ve found the best deal.
Simply put, mortgages make buying a home possible. By carrying the bulk of the sales price, your lender helps you achieve homeownership while steadily building your equity over time.
Once you’ve gained enough equity in the home, your property can be used as a financial asset, expanding your future investment opportunities.
*Sample rate provided for illustration purposes only and is not intended to provide mortgage or other financial advice specific to the circumstances of any individual and should not be relied upon in that regard. Guaranteed Rate, Inc. cannot predict where rates will be in the future