What Is a Mortgage? A Beginner’s Guide To Mortgages
Homeownership can cost much more than you’re willing to spend all at once. That’s why families and individuals alike take out mortgages to make paying a little more manageable.
However, mortgages can be intimidating and confusing for both seasoned and first-time buyers, and that’s why we’ve prepared this guide. Whether you’re looking for a mortgage refresher or you’re doing research for the first time, we have you covered.
In this comprehensive guide, we’ll cover the basics like “what is a mortgage?”, “how do mortgage payments work?” and other questions would-be homeowners might ask themselves before taking the plunge.
Simply put, a mortgage is a loan that can be used to either buy or refinance a home. Lenders expect each buyer to pay off the entirety of their loan in predetermined amounts over a fixed amount of time. Mortgages are secured loans, which means that borrowers pledge their home as collateral to act as a financial safety net for the lending agency.
Because a borrower’s home is put up as collateral, there’s always a risk of repossession or foreclosure if a borrower fails to make payments on time. However, many lenders assess an individual borrower’s capacity to fulfill their monthly dues before granting a mortgage.
Mortgage Jargon Explained
On top of the fees and paperwork, applying for mortgage loans means encountering a wide array of technical terms and jargon that can confound many home buyers. Even a basic understanding of mortgage-related terms can make a world of difference when deciding on the loan that’s right for you, so we’ve outlined some of the most common ones:
Lender: the organization or financial institution that grants loans
Borrower: the person applying for a loan or mortgage
Amortization Table: lists each mortgage payment and how much of each payment goes to interest and how much to the principal.
Down payment: the initial payment made when applying for a mortgage. A down payment is usually equivalent to about 20% of the home’s total value.
Escrow account: an account from a third-party where the lender deposits part of your mortgage insurance expenses and other fees.
Annual Percentage Rate (APR): the yearly sum of your total interest payments plus additional fees. If you have no other fees, your APR is equivalent to your interest rate.
How Do Mortgage Payments Work?
Taking a mortgage means that you’ve agreed to your lender’s payment terms and promise to make payments on time. But how do mortgage payments actually work?
If you’re wondering about money, your monthly payment is determined mainly by your mortgage's size and term length. Loan size refers to how much money you borrow while mortgaging your house, and term length is how long you have to pay it back.
As for your billing term and schedule, payments usually begin one month after closing the deal on your new house. Expect to receive each subsequent invoice on the first of every month, with every charge corresponding to the month that just passed. For example, a bill received at the start of February will be for the entire month of January.
Mortgage Payment Components (PITI)
Your lending bank or institution will give you an amortization table, which is a detailed breakdown of your monthly fees. On this table, you’ll find that each monthly mortgage payment is broken down into four components: principal, interest, taxes, and insurance – otherwise known as PITI.
But knowing the breakdown of costs is only half the battle – understanding what each of these components actually means will help you stay on top of each payment.
The principal is the total amount of money borrowed from your lender or financial institution. A concrete example is if your loan was for $150,000, then that is the loan principal's size.
A portion of your monthly mortgage payment is reserved for paying back the balance on your loan’s principal. Many mortgage loans are structured so that your initial billing statements include a smaller amount of the principal, which increases as time goes on.
Your mortgage interest rate is the additional amount of money that needs to be paid on top of the principal. Interest acts as compensation for your lending bank or organization for taking a risk and loaning money. There are two kinds of interest rates, fixed and adjustable, but we’ll expound on that later.
Interest rates directly impact how large your monthly mortgage payments are, however, these payments can vary from person-to-person.
Real estate or property taxes are evaluated by government agencies and allocated to fund public services like schools, infrastructure, and local fire departments.
Property taxes are typically calculated yearly, but you may also opt to include them as part of your monthly mortgage payment. These smaller payments are calculated by dividing your total tax amount by the number of payments you have on your mortgage in a year. Until taxes have to be paid, your lender will hold them in escrow.
Property Insurance And PMI
Similar to payments made toward your property taxes, your home mortgage insurance's monthly payment is held in escrow until the bill is due. Given this, two kinds of mortgage insurance may be applicable when you buy a home:
The first kind of insurance is property insurance, which protects your home and your belongings in case of fire, theft, or natural disasters. The other type is private mortgage insurance or PMI, which is required if you provide less than a 20% down payment on your home’s total cost. PMIs exist to protect the lender against the possibility of the borrower defaulting on their payments.
The length of your mortgage, or your mortgage term, has a significant impact on the amount of money you have to put down for your monthly payment. Standard mortgage terms can be 10, 15, or 30 years, but many lending institutions have options for borrowers that would prefer to complete their payments within a shorter period. However, shorter mortgage terms involve a higher monthly payment for better mortgage rates.
What Happens If I Don’t Pay My Mortgage?
As we mentioned earlier, there is a risk of foreclosure when monthly payments are not made on time. However, foreclosure doesn’t happen immediately. Usually, lenders will give borrowers up to 15 days to settle their monthly payments. If the borrower still hasn’t settled their balance after this grace period, lenders might reach out with reminders and a bill for late fees.
If the payments remain unfulfilled at this stage, the lender may file a “notice of default”. At this point, lenders will put the house on the market to either be sold to another buyer or auctioned off to settle the loan’s balance.
How To Qualify For A Mortgage
Now that you have the basic necessary knowledge on mortgages, you may be wondering how to qualify for one so you can buy a home. One of the first things to consider is that there isn’t an unlimited amount of mortgages available to everyone. Mortgage availability depends on the lender’s total capacity or how in-demand loans are, but this isn’t the only thing to consider.
Most of a mortgage’s qualifying factors are well within the borrower’s control. To keep things simple, qualifying for a mortgage really comes down to credit score, debt-to-income ratio, your income, and your down payment.
Your credit score is the single most important consideration when applying for a home mortgage loan. Many lenders require a minimum FICO score of 620 for fixed-rate mortgages and 640 for an adjustable-rate mortgage. However, government loans typically are more lenient with their requirements and may accept credit scores as low as 500.
Lenders also assess buyers by their gross monthly income (which means their income before taxes). Compliance with income evaluations is usually limited to pay stubs and tax forms, which means that irregular income like signing bonuses aren’t counted. Other income sources, like dividends from investments or rental income, may also only be considered if pay-outs are regular.
Debt-To-Income Ratio (DTI)
The debt-to-income ratio is calculated by dividing your monthly loan payments by your gross monthly income. Computing for your DTI helps lenders assess an individual borrower’s capacity to manage monthly loan payments versus the amount of money they make. Most lenders require a DTI of 45%, or that the loan payments account for no more than 45% of your monthly income.
However, borrowers with a high credit score and at least two months’ worth of loan payments in reserves may qualify with a DTI of 50%. Reserves refer to money in bank accounts, investments, or retirement plans.
Based on your lender and their corresponding guidelines, you may qualify for down payments as low as 3% of your home's total value. Generally, borrowers with higher credit also qualify for lower down payments. However, most down payments equivalent to less than 20% of the total loan amount will require the borrower to pay for private mortgage insurance (PMI).
Types of Mortgages
The next step to getting a home of your own is exploring the many mortgage options on the market. Depending on your specific financial situation and credit rating, you may qualify for particular mortgages. We recommend considering several lending agencies or institutions to get an idea of what you need from your mortgage.
With a fixed-rate mortgage, your interest rate does not change over the entire tenure of your loan. Unlike other loan types, your principal and interest payments remain constant and do not fluctuate based on the housing market’s movements. A fixed-rate mortgage loan is also called a traditional mortgage.
Adjustable-Rate Mortgage (ARM)
Unlike fixed-rates, adjustable-rate mortgages start with specific interest rates but fluctuate over time. This loan’s initial interest rate may be lower than its fixed-rate alternative, but there is always a possibility of your loan payments increasing. Many borrowers opt-in for an adjustable-rate loan when housing market rates are likely to plummet.
Balloon mortgages are one of the riskier options when funding your home. Payments start relatively low and “balloon” into a much larger sum toward your loan's end. This type of loan appeals to borrowers that may experience an increase in their income or plan to sell the property before loan completion.
The Federal Housing Administration backs an FHA mortgage. While the FHA doesn’t grant loans, they reimburse banks and other lending agencies if a borrower defaults on their payment. This elevates a lender’s tolerance for risk, which improves the likelihood of getting a loan. This means that borrowers with lower credit scores have a good chance of securing this particular kind of mortgage.
The Department of Agriculture-backed USDA mortgage loan is reserved for homebuyers in rural or suburban areas. This loan is generally given to families that have a demonstrable need for financial aid. Therefore, interested parties may not have a household income that exceeds 115% of the area median income. Many qualified borrowers take this loan because of its 0% down and low-interest rate.
A VA mortgage is backed by the Department of Veterans Affairs and is an excellent benefit for qualified veterans and other service members. These mortgages one of the most lenient borrowing requirements while also having a 0% down and low-interest rate, making it an ideal choice for veterans and their spouses.
Similar to other government-backed loans, The Department of Veterans Affairs doesn’t provide VA mortgages. Instead, this mortgage is issued by recognized third-party institutions that are reimbursed by the VA in case of default.
Advantages And Disadvantages Of Getting A Mortgage
Now that we’ve reviewed some of the basics associated with applying and qualifying for different kinds of mortgages, it’s essential to consider the pros and cons of having a mortgage. Note that while every mortgage is different, they do have shared advantages and disadvantages that the discerning borrower should ponder:
Improved credit score: Making consistent payments on your loan increases your credit rating over time, impacting the kind of loans you can apply for in the future. A stellar credit rating qualifies you for a lower interest rate for future loans.
Affordable homeownership: Many people can’t pay for their entire home in cash. A loan split over manageable payments with an acceptable interest rate makes owning a home more accessible and more attainable for the regular person.
Tax benefits: Some mortgage insurance premiums may result in a tax deduction. For people that might be selling their homes, part of the sale may also count as tax-deductible.
Risk: Because mortgages are loans secured by your home, there is always a risk of losing it if you can’t keep up with the payments. If a borrower loses their home during foreclosure, the money paid until that point is also lost and cannot be retrieved.
Property value depreciation: As with any property, the home you buy may lose value over time. If the housing market drops, you may have a mortgage balance more significant than your actual home value.
The Bottom Line
Taking out a mortgage is a great way to make owning a home more financially feasible, but careful planning and research makes a significant difference. Mortgages are not a one-size-fits-all product, and that means it’s crucial to identify what your needs are as a borrower as well as what you can realistically handle in terms of monthly payments.
Your credit score, income, and DTI all determine what kind of mortgage you can qualify for. Some borrowers may opt-in for conventional fixed loans, while others prefer loans with adjustable rates. Potential homebuyers with lower credit ratings can also apply for government-backed loans, while people with higher credit ratings may get better interest rates overall.
Whatever your goals are, we can help you. Contact Wesley Finance Group for assistance in finding the right loan for your dream house!