Mortgages 101: What You Need To Know
A mortgage, basically speaking, is a loan. When you set out to purchase a home, no one expects you to have $500,000 in cash. So that’s where a mortgage comes in: You borrow the extra money you need to buy your chosen home, agreeing to pay it back in the coming years.
The considerable debt a mortgage incurs can be a burden. But its appeal lies in the fact that the mortgage helps you to buy an asset with the expectation that its value will increase over time, which adds to your financial portfolio, gives you a big tax break, and, you know, finances a place for you to live.
Along with being expensive, a mortgage can also be complicated, so we’re breaking down the basics for you.
Mortgages in a Nutshell
Since homes are pricey, a mortgage is a lending system that allows you to pay a fraction of a home’s cost (called the down payment) upfront, while a bank or private lending institution loans you the rest. You arrange to pay back that money, plus interest, over a set period (known as a term), which can be as long as 30 years. To make sure that you pay back the money you borrowed, you put your house up as collateral–so if you stop making payments, the bank can take the home away from you in a foreclosure process.
Why Researching a Mortgage Matters
Although you have a lot to gain from having a mortgage, it’s essential to understand the various ins and outs. If you take out a mortgage that isn’t right for you, leading to foreclosure, you’ll not only have to move–and, in general, wait between three and seven years before you are allowed to purchase another home–but your credit score will also suffer, and you could get a huge tax bill.
Ultimately, your choice of lender and the mortgage structure could save you (or cost you) thousands of dollars, so you need to understand the kind of research you need to do before taking out a mortgage. That’s where we come in.
How Do You Get a Mortgage?
The companies that supply you with the funds you need are “lenders.” Lenders can be banks or mortgage brokers with access to large banks and other loan lenders, like pension funds.
In 2012, the biggest lenders in the country included Wells Fargo, Chase, and Bank of America. Many community banks or credit unions will make a loan to you initially and then sell it to one of these larger institutions. You want to ensure that whoever you work with directly has a reputation for being reliable and efficient because any delays or issues with closing on a sale will only cost you more money. Government loans are available through the Federal Housing Administration, but the availability of loans differs depending on where you live. You can view the requirements on the FHA website if you think you might qualify.
Mortgage lenders don’t lend hundreds of thousands of dollars to just anyone, which is why it’s so essential to maintain your credit score. That score is one of the primary ways lenders evaluate you as a reliable borrower–someone likely to pay back the money in full. A score of 720 or higher generally indicates a positive financial history; a score below 660 could be detrimental, but there’s no official credit score below which a lender won’t grant a loan. Some lenders may reject your application if you have a lower credit score, but there isn’t a universal cutoff number for everyone. Instead, a lower credit score means you might have a higher interest rate.
A charge you might see imposed by a lender is one for “points.” These upfront fees (they typically work out to be about 1% of the loan amount) are usually a form of pre-paid interest. If you already have a reasonable down payment, paying points may be a way to reduce your interest rate on the loan further, but they’re generally just a way for the lender to get more money upfront. Points are paid at closing, so if you’re trying to keep your upfront costs as low as possible, go for a zero-point option.
How Mortgages Are Structured
You’ll pay the principal, interest, taxes, and insurance with a mortgage–PITI. Note that unless you are a high-risk borrower, you can pay taxes and insurance separately from your mortgage, giving you a lower mortgage payment. Just remember that it’s up to you to save that money monthly, so you can pay the annual bill when it comes! Banks mostly prefer to collect the tax and insurance money in escrow because they spend only a little to maintain the account and have access to those funds.
Here’s how each component of PITI works:
Principal
This is the original amount you borrowed to pay your mortgage. The bank decides how much it will lend you based on income, credit, and the amount you plan to give for a down payment. If your down payment is less than 20% of the home’s price, the bank may consider you a riskier lender and charge you a higher interest rate or require you to purchase private mortgage insurance, commonly called PMI. (More on that below.)
Interest
This is essentially the cost of borrowing money. When you take out a mortgage, you agree to an interest rate, which will determine how much you pay a lender to keep lending. It’s expressed as a percentage: 5% to 6% is considered somewhat standard, but the rates depend strongly on a person’s situation–income, credit–as evaluated by the lender. Since a higher interest rate means higher monthly mortgage payments, lower rates might mean you can afford to borrow more money or pay the loan off faster.
Taxes
Property taxes support the city, school district, county, and/or state infrastructure, and you can pay them with your mortgage. They’re expressed as a percentage of your property value, so you can roughly estimate what you’ll pay by searching public records for the property taxes for nearby homes of similar value. If you’re a high-risk borrower, your lender might establish an escrow account to hold that money until it’s paid to the proper recipient–in this case, the government.
Insurance
Any payments reserved for homeowner’s insurance to protect against fire, theft, or other disasters are also held in an escrow account. (Again, this is something that you can opt out of escrow unless you’re a high-risk borrower.) If you’re a high-risk borrower–or lack the 20% down payment–you must also have private mortgage insurance (PMI), which helps guarantee that the lender will get money back if you can’t pay it for any reason. After you’ve paid off a certain amount of your mortgage, you can sometimes cancel the PMI (although this depends on your situation). Remember that PMI is meant to protect the lender, not the borrower–so it won’t bail you out if you default on your payments.
Mortgages are structured so that the proportion of your payment that goes toward your principal shifts over time. At first, you’re paying mostly interest; eventually, you’ll pay mostly principal. Your actual charges will be the same and distinguished on the lender’s end in a process known as amortization.
Types of Mortgages
There are a few different forms of conventional mortgages:
30-Year Fixed
This is the most popular payment setup for a mortgage. The borrower will pay a “fixed” interest rate for the next 30 years. It’s an appealing prospect because homeowners will pay the same amount every month. Fixed mortgages are best for homebuyers who buy when interest rates are low or on the rise, are counting on a predictable payment, and plan to stay home for a long time.
15-Year Fixed
These mortgages carry a lower interest rate and only take 15 years to pay off. These are best for homeowners who want to repay their mortgages and build equity quickly. Interest rates for 15-year fixed mortgages usually also carry lower interest rates than 30-year mortgages.
Adjustable Rate Mortgages (ARM)
The interest rates on adjustable-rate mortgages are adjusted at predetermined intervals to reflect the current market. Some mortgages are a combination of fixed and adjustable: for the first three, five, or seven years, the rate will stay fixed and then be adjusted annually for the duration of the loan. In this case, the initial fixed rate tends to be lower than usual, but it may become more expensive than a 30-year fixed rate once the adjustable rate kicks in. This type of loan may be right for you if you plan to live in your home for approximately the same length as the original fixed term.
Remember:
Before applying for a mortgage, you can build credibility by establishing good credit and accumulating savings for a down payment.
A reliable, reputable lender is more important than a lender with unbelievably cheap rates–if it seems unbelievable, it probably is.
A mortgage is a debt, but it’s considered good debt. It doesn’t hurt your credit.
