What is a Mortgage?
Most buyers do not pay the entire purchase price of a home in cash at settlement. Mortgage loans provide long-term financing options that cover a portion of the home purchase. The home buyer will then repay the loan in agreed-upon installments over the coming years.
Prospective borrowers will choose between various options for their mortgage. Lenders may offer borrowers various interest rates, terms, and fees, which impact their budget and monthly costs. Every lender may use slightly different criteria when approving a mortgage loan application. Understanding mortgages and their basic requirements can help you make the most beneficial decision when buying a home.
How Mortgages Work
Mortgage loans help prospective buyers afford the cost of a home. Typically, buyers cannot afford to finance their entire purchase by themselves and will request the help of a mortgage lender to front the remaining balance. The lender then assumes an interest in the property, which serves as collateral for the loan. The buyer agrees to pay the loan back over a set number of payments, including principal and interest amounts.
At the end of the loan term, the borrowers will satisfy their obligations by paying off all principal and interest. They will stop making payments, and the lender will remove their claim, giving the borrowers full ownership of the home. Should the borrower default on their mortgage payments before the end of the loan term, the lender may start a process known as foreclosure to take possession of the property.
Types of Mortgages
A prospective borrower’s situation will determine the type of loan they should acquire. While many homebuyers use conventional loans to finance their home purchase, other loans may appeal to those with lower income, buyers looking to purchase a home with a higher purchase price, or other varying conditions. Different entities, such as banks, the government, or private lenders, originate loans. Most borrowers will acquire one of the following mortgages:
Banks and private mortgage companies originate conventional loans, the most popular among borrowers. Conventional loans are less expensive than government-backed loans but have more strict requirements. Conventional loans are conforming or non-conforming.
Borrowers need a good credit score and a steady income to qualify for a conventional mortgage loan. If you haven’t saved at least 20% of the purchase price for a down payment, the mortgage lender will require you to pay for private mortgage insurance (PMI) when approving a conventional loan. PMI ensures that an insurance company will pay the lender in full if you default.
Conforming loans are conventional loans that meet the loan limit guidelines set by government-sponsored agencies Fannie Mae and Freddie Mac. The Federal Housing Finance Agency (FHFA) limits loan amounts, affecting how much a buyer can borrow with the conforming loan. In 2023, the FHFA set a limit of $726,200 for conforming loans. Areas with more expensive housing markets will have higher conforming loan limits. The New York City conforming loan limit for 2023 is $1,089,300. Conforming loans typically offer the lowest interest rates, as approved borrowers must have excellent credit.
Lenders originate and resell conforming loans to Fannie Mae and Freddie Mac on a secondary market. The agencies use the funds from the resales to provide liquidity to lenders, which helps the lenders make more loans.
Non-conforming mortgages do not meet the loan limit guidelines required for the lender to resell the loan to Fannie Mae or Freddie Mac. Examples of non-conforming loans include jumbo loans, which exceed the conforming loan limits and have unique underwriting guidelines. Jumbo loans are conventional mortgages but come with more risk and higher interest rates to protect lenders.
Borrowers must also make a larger down payment of at least 20% to qualify for a non-conforming jumbo loan. High-income earners with good credit and an extensive asset portfolio will use a jumbo loan to buy a higher-priced house.
Government agencies offer and secure government-backed loans. This financing option helps borrowers who do not meet conventional loan guidelines. A government-insured mortgage offers added protection for the lender if the borrower defaults.
FHA loans allow down payments as low as 3.5% of the purchase price and have less stringent income and credit qualification requirements. Single-family home loan limits for FHA borrowers currently range between $472,0303 in most areas to $1,089,300 in a high-cost housing market. FHA loans require borrowers to pay a mortgage insurance premium (MIP), similar to PMI required for conventional loans.
Veterans, current members of the U.S. armed forces, reservists and national guard members, or eligible surviving spouses may obtain a VA loan to purchase a home. You can get a VA loan without any down payment, and they do not require mortgage insurance. Borrowers pay a one-time charge between 1.25 – 3.3% of the loan amount as a funding fee.
Borrowers in rural farming areas can acquire USDA loans to fund their home purchases. Homebuyers will not have to pay a down payment and must meet income requirements for their area.
Specialized Mortgage Programs
Other non-conforming loans assist borrowers with poor credit, high debt, or recent bankruptcies. Some first-time homebuyer programs may offer loans for participants, and organizations like NACA help low-and-moderate income individuals achieve homeownership. Specialized programs may not follow all conventional or conforming guidelines.
Important Mortgage Definitions
Prospective borrowers should understand the various components of a mortgage to properly budget and ensure they agree to the terms that best suit their needs. Some important mortgage-related definitions include:
The amount of money you borrow from the lender. A portion of your monthly payments go toward paying off the principal balance.
The amount the borrower will pay back in exchange for the ability to borrow money from the lender. A borrower’s monthly payment consists of the principal and interest.
The amount the borrower initially pays to secure the purchase of their home. Different lenders and mortgage types require their own down payment amount, typically varying from 3.5% to 20% of the purchase price. If borrowers have more than 20% of the purchase price saved for their down payment, they can include that to decrease the amount of their principal balance on the mortgage.
The process of spreading your loan into a series of payments to decrease the remaining principal. Borrowers may receive an amortization schedule that thoroughly explains each payment and how it affects their remaining balance.
The length of your mortgage loan payback period. Most loans have a term of 30 years, but borrowers can choose shorter or longer terms to best accommodate their budgets. Shorter terms will have higher monthly payments.
Lenders charge fees to cover the costs of setting up a new loan. Total fees range from about 0.5% – 1% of the total loan.
Annual Percentage Rate (APR)
A calculation of the average annual finance charge, including fees and other loan costs, divided by the amount borrowed. The annual percentage rate (APR) allows you to compare the actual costs of mortgage loans.
The APR considers a loan’s interest rate, origination fees, points, prepaid mortgage interest, mortgage insurance premiums, application fees, and underwriting costs. Therefore, the APR will be higher than the mortgage’s interest rate and more accurately reflects the costs a borrower can expect to pay.
The rate used to calculate interest as a proportion of the amount borrowed. Interest rates vary due to market conditions and can significantly impact a borrower’s budget and the amount they spend each month.
Borrowers with a down payment equaling less than 20% of the sales price may need to purchase mortgage insurance. Mortgage insurance repays the lender for their losses if a borrower defaults. This differs from a homeowner’s insurance policy, which lenders will require from all borrowers, regardless of their down payment amount.
An upfront fee borrowers acquire to pay down their interest rate. Borrowers can purchase points, where one point equals one percent of the loan balance. The points lower the interest rate by a set amount, such as .25%, helping decrease overall costs in the long run. Borrowers who plan to live in their home for a while before selling may favor points more than those who plan to sell within a shorter timeline.
Lenders also charge fees associated with the closing of a home purchase. These fees include underwriting, appraisal costs, title insurance costs, and loan processing charges. When shopping for a mortgage, ask about the lender’s fees and try to negotiate or ask for any available discounts.
Understanding Mortgage Structures
Borrowers may find varying interest rates and payment structures to consider within the framework for conventional and non-conventional mortgages. Some mortgages may accommodate your budget and payment preferences more than others, so it’s helpful to learn about your options before submitting a loan application.
Mortgage loans offer either a fixed interest rate or an adjustable interest rate. Fixed-rate loans maintain the same interest rate over the life of the mortgage, while the interest and the monthly payment for an adjustable-rate loan resets after a specified period.
Fixed-Rate Mortgage Loans
Fixed-rate loans offer the same interest rate over the life of the loan. Thus, monthly payments remain the same. An amortization schedule will show the calculation of principal versus interest in each payment. At the start of the loan term, a greater percentage of your mortgage payment will go toward paying off interest rather than the principal. By the end of the loan, you’ll pay off virtually all the remaining principal with each payment.
The stability of fixed-rate loans attracts those who want to stay in their home and not worry about fitting a higher payment into their future budget. While fixed-rate loans may not always offer the lowest interest rates, you could consider the option to refinance your loan if rates drop significantly.
Adjustable-Rate Mortgage Loans
Adjustable-rate mortgages, known as ARMs, typically offer a lower introductory rate that will reset based on an underlying benchmark, such as the federal funds rate, in the future. Lenders may label ARMs using two numbers, such as 5/1. The first number indicates the number of years the rate will remain unchanged. The second number refers to the rate reset frequency after the introductory period. A 5/1 loan will keep the introductory rate for five years, then reset yearly afterward.
Due to the potential for changing interest rates, your mortgage payments may change. An ARM’s lower initial interest rate may appeal to borrowers who will resell shortly. Borrowers who stay in their home longer may also choose an ARM and then refinance after their introductory period.
ARMs carry higher risk compared to fixed-rate loans. If you consider an ARM, ask your lender about a rate cap. This cap limits how high your interest rate can go when it resets and how much rates can change with each adjustment.
Balloon mortgages are not as common among borrowers. These short-term loans have a term of five-to-seven years but offer the amortization schedule of a 30-year loan. The borrower will pay a relatively low monthly payment during the term. At the end of the loan term, the borrower must repay the remaining balance in one large “balloon” payment.
Buyers might consider a balloon mortgage when planning to refinance or flip the home in a few years. However, the borrower also accepts the risk that their financial situation or the real estate market could shift, making it difficult to refinance or resell the home as planned. The borrower will then be on the hook for the large remaining payment and may need to acquire a second loan. Due to their high risk, most borrowers do not acquire balloon mortgages.
Designed for homeowners over the age of 62, reverse mortgages provide an inflow of cash to those who have paid their property taxes and homeowners insurance. As the name indicates, instead of paying the lender, the borrower can relinquish a part of their equity in their home in exchange for cash. The lender pays the homeowner in either a lump sum or by making payments to them over time. The borrower does not give up their property ownership and does not have to pay back the funds from the lender until they sell or vacate the home.
Due to their complexity and costs, it’s wise for homeowners to fully understand the loan requirements before making any financial commitment. Those wishing to cash out on their equity may want to evaluate other options before considering a reverse mortgage.
Finding a Mortgage Lender
When searching for a mortgage, you’ll want to work with a trusted, knowledgeable lender who can recommend the right loan product. If you have a checking or savings account at a local bank or credit union, you stop by or make an appointment to ask about mortgage options.
First-time homebuyers can attend a homebuyer’s workshop to learn more about the process and ask for the names of local lenders. When you begin shopping for a mortgage, plan to check at least two or three different sources to ensure you’re getting the lowest interest rates and best terms available.
The Mortgage Application Process
After familiarizing yourself with the different types of mortgages, loan structures, and important terms, you can talk to lenders about the application process. Before you apply for a mortgage, take time to review your financial situation. Lenders will evaluate your creditworthiness and your ability to make monthly payments. Presenting a strong financial picture can increase the chance of getting a lower interest rate or the type of mortgage you want.
If you want a conventional mortgage, you’ll likely need a debt-to-income ratio (DTI) of 28/36. The recommended DTI means that no more than 28% of your monthly income can go toward paying off your house, including the new loan payment. Further, only 36% of your monthly income can go toward your total monthly debt, including the mortgage payment. The lower your DTI, the more likely a lender will offer you a mortgage.
During the approval process, lenders will also ask about your employment history to ensure that you have a steady income. Additional earnings from part-time or freelance work count as income if you have an established stream of payments from clients or customers. While changes in income might not prevent you from getting a mortgage, the lender might not offer you the lowest interest rate. Finally, lenders will look closely at your credit report for late payments or other issues, such as a lack of credit history or too much overall outstanding debt.
Mortgage Pre-Qualification vs. Pre-approval
Before you begin a serious home search, you’ll want to set a budget and ensure you’re in the best possible position to present a strong offer. Knowing how much you can afford and having a prequalification or preapproval letter from a mortgage lender to back up your offer can help sway the odds in your favor in a competitive bid situation.
Use a mortgage calculator to learn more about how much you can afford. This interactive tool lets you input various housing prices and conditions to determine your anticipated monthly payment. Once you know your budget and the amount you will need to put on a mortgage, you can approach a lender for pre-qualification or pre-approval.
For mortgage prequalification, a lender estimates what you can afford to borrow based on your income level, debt, and credit information. The lender relies on information provided by the borrower but does not independently verify income or debt amounts. A pre-qualification is useful for the borrower to understand their expenses thoroughly but does not significantly help them acquire a mortgage.
To obtain a mortgage pre-approval, the borrower generally allows the lender to request a credit history report. Lenders may also ask to review income or tax documents to verify income. The extra time and attention allow a lender to get closer to the true amount they would approve for a mortgage loan. This more stringent process makes pre-approvals stronger than prequalification. Many real estate agents will not work with a prospective buyer until they have a pre-approval.
When you find a home and a seller accepts your bid, you will complete the mortgage application process. Lenders may ask for a long list of documents and information, including the following:
- Full name, birth date, and social security number of all applicants.
- Address history for the past two years or more.
- If you currently rent, you’ll need to show proof of rental payments and provide the contact information for your landlord for reference.
- If you currently own a home, plan to submit all related mortgage, insurance, and property tax figures.
- Names and addresses of all employers from the past 24 months for references.
- Income support, including prior year tax returns, supporting documents like W-2 forms, and recent pay stubs.
- Proof of additional assets such as your checking and savings accounts, retirement accounts, stocks, bonds, and other investments.
- A list of all debts, including but not limited to credit cards, student loans, car loans, etc. Debts will establish your debt-to-income ratio.
The lender will review the requested information and, if approved, provide you with a loan estimate that states the terms and costs associated with the mortgage. You can use this loan estimate to compare mortgage options before you move forward with buying a home.
Mortgage loans offer prospective buyers the opportunity to own a home when they cannot submit a full cash offer. Various loans offer their respective conditions, so borrowers can find a loan that best fits their needs. Before starting the home search process, buyers can use a mortgage calculator to understand how much they can afford to spend each month. From there, they can shop between lenders to learn about their mortgage terms, then request pre-approval. Borrowers will likely pay off their mortgage for many years and should take their time when researching their options.