If you’re looking to buy a house, and do not have a mountain of cash saved up, you’ll need to consider getting a mortgage to help you finance this large expense. But what exactly is a mortgage? Simply put, a mortgage is a debt instrument used to purchase real estate. A lender will loan a borrower money, and the borrower is obligated to pay the lender back. An agreed upon repayment plan is established between both parties, and various terms and conditions must be met.
How Does A Mortgage Work?
If you're wondering, how does a mortgage work - we’ll start at a high level and break it down step by step. A borrower borrows money from a mortgage lender and agrees to pay the mortgage lender back the full amount of the loan, plus any interest expense. The lender conducts their own research on the borrower before agreeing to lend them money. There’s a lot of parties and terminology involved in the process.
Who Is Involved?
The first step in getting a mortgage is to work with a licensed loan officer. Be sure whoever you are working with is licensed and registered to sell mortgages.
Loan officers help answer how to get a mortgage, and they’ll assist you with a variety of tasks. They’ll help you determine which mortgage works best for you, will shop for the best interest rate, and will even assist you with all the paperwork you need to complete. We’ll get into more of these details below.
You can select from a variety of mortgage options, each of them serves a purpose. The most common option is a fixed-rate 30 year mortgage. This means for the duration of the loan, 30 years, the borrower will pay a fixed interest rate and payment each month. This fixed rate concept can also be applied to 20 year, 15 year, and even 10 year mortgages, but those options aren’t nearly as common.
Basic Mortgage Terminology
The following are some common words associated with mortgages and mortgage transactions.
A down payment is simply the amount of money you put down on your home. If the price of the home is $300,000 and you put down $30,000 as your down payment, you put down 10%. Various mortgage types will require a specific percentage for a down payment.
The interest rate is what the lender charges you for borrowing their money, in addition to the principal balance. This rate is referenced as a percentage. For example, a borrower with a fixed interest rate of 3.5% will pay that flat borrowing fee for the life of their loan. Your loan can have a fixed interest rate, meaning it doesn’t change for the duration of the loan. Or, your loan may have an adjustable interest rate, meaning it can change over time. The lower the rate, the less expensive the mortgage.
This is a tricker concept, but amortization is the process of gradually writing off the initial cost of an asset. Remember, someone gets a mortgage for a given period of time. In the early years of the mortgage, the borrower’s payments fund mostly interest expenses. As the years progress, the borrowers interest expense lessens, and more of their monthly mortgage payment is allocated to the principal balance. Visually seeing this may help paint a clearer picture.
Escrow is another common term used in the mortgage or real estate industry. Escrow is a contractual arrangement where a legal third party receives, holds, and distributes property or money for two parties. Escrow is essentially an unbiased middleman between the buyer and seller, or the buyer and an insurance company. A buyer gives the escrow agent money to hold, and the homeowner selling their home gives the escrow agent the home. When the sale is finalized, the escrow agent gives the new homebuyer the home and the former owner the money. If the deal doesn't go through, the escrow agent is obligated to give the buyer back their money and the home goes back to the seller.
What Is a Mortgage Payment Comprised Of?
If you’re curious how to calculate a mortgage payment, there are a few components that give you the final monthly number.
The principal balance is the initial balance of the loan. Using the same example as above, if the home was $300,000 and your down payment was $30,000, or 10 percent, you borrowed a total of $270,000 from the lender. Each mortgage payment reduces the outstanding principal balance. The more principal balance you reduce, the more equity you have in your home.
Interest is the fee a lender charges you for borrowing the principal balance. The lower the fee is, the less money you pay. If you have a great credit score, a low debt to income ratio, and put down a sizable down payment, you’ll likely have a more favorable, or lower, interest rate. If your credit score is less than average, and you’re not putting down a large down payment, you may have a higher interest rate. The interest rate changes with various government involvement and economic conditions. But if you have a fixed rate interest rate, you’re locked into that rate for the life of the loan. Only when your mortgage is an adjustable rate mortgage do you have to worry about your payments being volatile.
All property is taxed. Taxes vary by state, county or even on a town level. The tax rate is also referred to as a mill rate. Some mortgage companies allow you to roll your tax expense into the monthly mortgage payment, leverage the escrow system we discussed above. If your taxes aren’t rolled into the monthly payment, you’ll be responsible for paying your town directly either once or twice a year.
Similar to car insurance, you must carry insurance on your home. How much you pay in insurance will vary, just as it does on a car. Variables that impact the insurance expense include; crime rate in the area, if the house has a pool, if the house is in a flood zone, and the value of the property.
Types Of Mortgages
Mortgages are not one size fits all. There are various types of mortgages you can choose from. Each one has a purpose; your goals, financial situation and comfort level will dictate which loan is right for you.
A conventional mortgage is a loan that is not secured by a government agency. Conventional mortgages are common, but they typically come with a higher interest rate as they are not insured by the federal government. A private lender, or Fannie and Freddie Mac issue conventional mortgages.
There are three government agencies that can issue a mortgage.
- Department of Veterans Affairs, also known as a VA mortgage. Veterans who served in the United States Armed Services can receive preferential mortgage terms and conditions if they elect to use a VA mortgage.
- The FHA, or Federal Housing Administration, is a government agency that makes obtaining a home possible for millions of Americans. The government agency insures these loans for the lender, which means a lender is more willing to lend money to those who have lower credit scores or those who cannot put together a large down payment.
- The USDA, or United States Department of Agriculture provides specific loans to those living in specific geographical regions of the United States, typically in rural areas. There is an income limit to obtain these loans, along with other qualifying factors.
A jumbo loan is used to purchase homes that cost more than what a conforming loan allows. This amount is variable depending on where you live, and can change year over year.
A fixed rate mortgage is when the interest rate on the loan remains the same throughout the duration of the loan. This can be a fixed rate 15 year mortgage, 20 year mortgage, or even 30 years—which is most common. The interest rate will not change, which makes budgeting easier.
An adjustable rate mortgage is the opposite of fixed rate. When you have an adjustable rate mortgage, your interest expense can go up or down throughout the life of the mortgage. Considering the rate can fluctuate, it makes budgeting a bit more difficult.
How Much Can I Afford?
Now with a better understanding of the various types of mortgages, how much mortgage can I afford may be the next question on your mind! Remember, the mortgage payment consists of; principal, interest, taxes and insurance. Let’s visit the qualification process.
What Can I Qualify For?
A lender (or bank) takes a lot of financial variables into consideration when determining your maximum monthly mortgage payment including: your debt to income ratio; credit score; annual household income; and your income potential. Two people with the exact same income can qualify for different mortgage amounts.
Person A makes $80,000/year, has no debt and a high credit score. Person B makes $80,000/year, has a high debt-to-income ratio, and a lower credit score. The lender is inclined to lend person A more money, as they have more confidence person A has the ability to pay them back.
How To Calculate My Mortgage Payment
Your lender, and various financial calculators, can figure out what your monthly mortgage payment is. But, it’s important to fully understand what that number is made up of.
Remember, your mortgage payment consists of; principal, interest, taxes, homeowners insurance, and potentially mortgage insurance. You’ll have to understand what the annual amount of each of those expenses are and divide by 12 to get your monthly rate.
The formula can get a bit complex considering the math you’ll have to do on the interest rate. It’s best to know what variables make up your mortgage amount and leverage an online calculator to get the final amount.
How To Get A Mortgage
Getting a mortgage doesn’t need to be complicated. In fact, in today’s modern world, you can get a mortgage right from the comfort of your own home.
The first step is to get pre approved for a loan. To do this, find a trustworthy lender you’re comfortable working with. All lenders will require a bit of paperwork from you. This includes bank records, pay stubs, insight into your expenses, identification, etc. Supply the lender with accurate records, and within a few days you’ll be pre approved for a specific mortgage amount. You’re now ready to start shopping for a home!
Shop For Your Home
Armed with the pre approval letter, real estate agents will be willing to take you on as a client. The pre approved letter helps you and the real estate agent determine what homes are in your price range.
You can look for homes in your desired price range and area from just about anywhere. Zillow and Trulia are popular real estate sites that will show you homes based on whatever criteria you give them.
Your real estate agent will likely take you to a few open houses and you’ll see many homes in person before finding the right place to call home.
Once you find the right place to call home, it's now time to finalize your loan. You’ll submit an offer to the seller, and if they accept, you’re ready to progress to the next step. Pending approval, you’ll go back to your lender and begin the loan finalization process. This includes getting the home appraised, inspected, and one final review of your financials. The lender wants to be certain your debt to income, and credit score, remains aligned with what they saw when you were pre approved.
If everything aligns, you’ll be ready to close. Generally speaking, there is a bit of a waiting period between submitting your offer, getting it accepted, and officially closing on the loan. Both the buyer and the seller will agree to a closing date at some point in the near future. Once that day comes, you’ll do one final walk through of the home before officially closing.
Wrapping Everything Up
A mortgage is a debt instrument used to help finance real estate purchases. Everyone has a different financial history, and various financial goals, so there are many different mortgage options you can choose from. Some mortgages have an adjustable rate, whereas some mortgages have a fixed interest rate. The duration of the loan can vary as well. The 30 year fixed rate mortgage is the most common.
Buying a house and obtaining a mortgage is a huge financial decision. It’s best to work with a professional throughout each process. They’ll help answer any questions that come up along the way, and will provide guidance where appropriate. Be sure to only work with licensed mortgage brokers when applying for a loan.
This page last updated: March 21, 2022