How Do Homeowner Loans Work: Everything You Need To Know To Get Started
For those under 30, owning a home is the logical next step in their lives – it’s a goal they aspire to achieve within the next five to 10 years. After all, owning a home gives you the stability and opportunities that renting can never provide.
But for most people, applying for your first mortgage can quickly become overwhelming, especially with all the confusing real estate jargon and procedures to follow. To help you out, here is a quick guide to homeowner loans and how they work.
Mortgage 101: Important Terms And Concepts
Before we go on a deep dive into mortgages, let's look at some of the terms and concepts you're likely to come across.
Generally speaking, there are two types of loans: secured loans and unsecured loans. With a secured loan, the homeowner must pledge an asset, such as a car or a piece of property, as collateral or “security”. If a borrower is unable to repay a secured loan, the asset can be seized by the mortgage lender. With an unsecured loan (also known as a personal loan), the borrower is not required to pledge anything, however, they will be more heavily scrutinized for their credit history and income.
A mortgage is a type of secured loan in which a house is used as the security. If you can’t pay back your mortgage, your house could be foreclosed. The mortgage payment is composed of the following:
Down payment: This is a percentage of the total loan amount that you pay upfront. Typically, down payments amount to 20 percent of the purchasing price, but this can change depending on your deal. Borrowers are encouraged to put as much money down as they can, as this reduces the cost of your monthly payments.
Principal: This is the amount of money your lender will loan you, minus the down payment. The principal is paid in increments over time – usually on a monthly basis. The amount of time you're given to pay off your principal is what is called the loan terms. Home loan terms usually last anywhere between 10 and 30 years.
Interest rate: The interest rate is a percentage of the loan amount that is added to your monthly payments. Interest is the fee your lender charges you for borrowing their money. Interest rates are how lenders make money off of loans.
Other terms to take note of:
Insurance: It is common for lenders to require their borrowers to purchase insurance for their homes. In the event of a storm, fire, flood, or theft, homeowners can claim insurance and avoid paying for the damages out of pocket.
Property tax: This is a tax that lenders roll into their borrowers’ monthly payments. Property taxes are used by the local government to develop and improve things like sewage, water, highways, and other services that benefit the community.
Home equity: Home equity is the portion of the home or property that you “own”. In other words, home equity is the amount of money you’ve paid your lender in the process of acquiring the home. So if you purchase a house for $300,000 and pay 20 percent down payment, your home equity amounts to $60,000.
Types Of Homeowner Loans
Whether you're getting your first ever secured loan or you're gunning for a second mortgage, it's good to understand the different types of homeowner loans:
A conventional mortgage is a home loan that isn't insured by the three government agencies that back mortgages – namely the Federal Housing Authority (FHA), the U.S. Department of Agriculture (USDA), and the Department of Veteran Affairs (VA). Conventional mortgages are typically harder to qualify for than the other types since they have stricter requirements.
There are two kinds of conventional mortgages: the conforming loan and the non-conforming loan. As the name suggests, a conforming loan conforms to the guidelines set by Fannie Mae or Freddie Mac – these are the government-sponsored enterprises (GSEs) that back mortgages in the States. Non-conforming loans are also known as Jumbo loans since they go beyond the maximum federal loan limit.
As mentioned, jumbo mortgages exceed the limits set by Fannie Mae and/or Freddie Mac. In 2020, the ceiling for conventional mortgages is $510,400 for single-family homes. In some places, it can be higher, especially if the cost of living is above the national average.
A jumbo loan can help a homeowner secure a loan in an expensive area. However, because homeowners are borrowing more than usual and using it to purchase a home in a neighborhood or town that's more expensive than usual, they should expect interest rates to be on the high side. This is because lenders are putting themselves at more risk, so they have to make up for it one way or another. Down payment has to be at least 10 to 20 percent of the loan amount too.
To apply for either a conforming or jumbo mortgage, you should have a good credit history, a stable and relatively high income, a good debt-to-income ratio (more on this later), and enough money to pay upfront as a down payment. Obviously, not everyone is capable of ticking all of these boxes. There are loans for people with moderate to low income as well, and this is where government-insured mortgages come in.
FHA loans: If you don't have a shining credit score and you don't want to shell out too much money for your down payment, you may get by with an FHA loan. If you want to qualify for a loan that requires only 3.5 percent down payment, you only need to reach a FICO score of 580. This is great for first-time homeowners or low to mid-income earners gunning for their second mortgage.
USDA loans: If you live in a rural area designated as a USDA-eligible area, you may qualify for a USDA loan. There are even some USDA-backed loans that don't require a down payment. There are income limits you have to meet though, so be sure to double-check with the USDA before applying.
VA loans: If you are a US military member, or if you have a relative who is an active duty member or a veteran, you may qualify for a VA-backed loan. These types of loans often require a low or no down payment at all.
Fixed-Rate Mortgages vs Adjustable-Rate Mortgages
As the name suggests, a fixed-rate mortgage is a loan in which the interest rate stays fixed until the end of the term. An ARM, on the other hand, may start with low interest for a certain period (also called the introductory period). The interest then increases once the introductory period is over.
Why go for one or the other? On one hand, fixed-rate mortgages are easier to plan for and payback. Since the interest always stays the same, you know exactly how much you're supposed to pay each month. On the other hand, ARMs may help you save money during the early days of your loan, especially if you can score an ARM with a low introductory rate.
Homeowner Loan Requirements
Before applying for any one of the home loans mentioned above, you need to work on the following requirements:
FICO Credit Score: Lenders use the FICO rating to determine whether a borrower is creditworthy enough to secure a loan. Creditworthiness is determined by your debts, your credit card history, payment history, and the like. Different types of loans have different "passing scores", depending on the riskiness of the loan to the lender. Typically, FICO scores in the 600 to 739 range are considered good. However, for government-backed loans, you usually only need a score of 500 to 580 to qualify.
Debt-to-income ratio: Your DTI is calculated by dividing the total of your monthly debt payments by your gross monthly income. A good DTI is somewhere between 45 and 50 percent. A borrower's DTI is important to a lender because it provides a quantitative representation of your ability to make monthly repayments.
Income and employment: Having a stable income is a prerequisite for most loans. A lender wants to be assured that you will consistently have enough money to meet the monthly payments. You will likely be asked to submit documents such as recent payslips and income tax returns.
Is A Home Loan Worth It?
Not everyone is sold on the idea of taking out a loan for years, maybe even decades, to own a home. In fact, fewer millennials are buying homes than their Gen X and Baby Boomer counterparts. But securing a home loan does come with its fair share of advantages.
For one, purchasing and eventually owning a home gives you stability and security that you won't get from renting. Essentially, you aren't at the mercy and whims of landlords. Getting a home loan also helps improve your credit score. The more consistent you are about paying off your loan, the better your chances are of getting offered lower interest on other loans like car loans (another form of a secured loan) or a credit card. And that's just the tip of the iceberg!
While it may seem intimidating, getting a home loan is pretty straightforward – it's just a matter of maintaining a good credit history, a decent amount of savings for your down payment and monthly repayments, and knowing which type of loan fits you best.
Whether you want to find out what kind of loan can help with home improvements or if you can pay a secured loan with credit cards, Wesley Mortgage, LLC can answer all your burning questions about homeownership and home financing. Get in touch and we'll guide you through all your financial woes today!