What is a Mortgage? A Definitive Guide for Aspiring Homeowners

Key takeaways:

• A mortgage is a long-term loan from a bank that enables you to buy a house by using the house as collateral.
• Mortgage payments usually include principal (the amount borrowed), interest, property taxes, and homeowners insurance. They may also include a guarantee fee or mortgage insurance.

• There are various kinds of mortgages, such as VA, FHA, and jumbo loans, in addition to conforming conventional loans.

• When comparing mortgage offers, it's crucial to consider the loan type, loan term, interest rate, and total associated fees.

• The most significant financial commitment most people will ever make is getting a mortgage. That's why it's critical to know what you're getting into when you take out a loan to purchase or construct a home.

What is a mortgage?

A long-term loan used to purchase a home is called a mortgage. Mortgages are available with a range of loan terms, which refer to how long the loan must be repaid. Typically, these terms range from eight to thirty years. Although interest-only mortgages are available, most mortgage payments consist of principal and interest, in addition to escrow payments for homeowners insurance and property taxes.

How does a mortgage work?

When you take out a mortgage, you have a fixed loan term and an overall loan amount to repay. Interest, principal, or the loan balance will make up most of your monthly payment.

Robert Kirkland, a former mortgage industry professional now a financial advisor with Preal Haley & Associates in Greenbelt, Maryland, says that each month's mortgage payment will be split between principal (the amount owed on the loan) and interest. A significant amount of each payment will go toward the principal as the loan is repaid.

Most mortgages are fully amortized, meaning they are paid back over time in instalments. The final payment settles the loan at the end of the term and is typically made regularly at an equal rate. The rare balloon mortgage is the exception to this rule, in which you make a single lump payment after the loan term.

Mortgages are also secured loans, which means that your house is the collateral for the loan. If you default on your mortgage, your home may go into foreclosure, and your lender may take possession of it.

Even though you might think of a house as your own, according to Bill Packer, COO of Parsippany, New Jersey-based Longbridge Financial, "you don't technically own the property until your mortgage loan is fully paid." At closing, you will usually also sign a promissory note, which is your promise to repay the loan.

Types of Mortgages

There are several types of mortgages available to borrowers.

• Conventional loans: A traditional mortgage is made and guaranteed by a private-sector lender (bank, credit union, mortgage company); the government or any government agency does not back it.

• Jumbo loans: A jumbo loan has more robust underwriting requirements and is larger than the maximum size US government agencies allow. These loans are occasionally required for well over $500,000 for highly valued properties.

• Government-insured loans: These are more flexible about borrower requirements than many privately backed mortgages, including VA, USDA, and FHA loans.

• Fixed-rate mortgages: Typically, these loans have terms of 30, 20, or 15 years, and they have a fixed interest rate that does not change over time.

• Mortgages with adjustable rates: Interest rates on adjustable-rate mortgages (ARMs) vary based on overall changes in interest rates and developments in the financial markets. The first few years of a loan typically have a fixed rate, after which the variable rate applies to the loan term's balance. In a 5/1 ARM, for instance, the '5' denotes the first five years of fixed interest rates, and the '1' means the interest rate adjustments that occur once a year after that, according to Kirkland.

Home loans of the conventional fixed-rate variety are by far the most prevalent.

What is included in a mortgage payment?

Mortgage payments consist of four main components, referred to as "PITI": principal, interest, taxes, and insurance. The fee may also cover additional expenses.

• Principal is the money you borrow to buy a house from a mortgage lender. For example, your loan principal would be $350,000 if you purchase a $400,000 home and take out a $350,000 loan.

• Interest: Interest is the "cost" of the loan, the amount the lender charges you to borrow that money. The interest is calculated as a percentage based on the principal amount of the loan.

• Property taxes: The property taxes related to your house are usually collected by your lender and included in your monthly mortgage payment. When the taxes are due, the lender will use the funds typically kept in an escrow account to pay your property tax bill.

• Insurance for homeowners: In the case of a fire, disaster, or other occurrence that affects your property, homeowners insurance offers you and your lender a certain amount of protection. Usually, your lender includes the insurance premium collection in your monthly mortgage payment, sets aside the funds, and pays the insurance company on your behalf when the premiums are due.

• Insurance for mortgages: There may be a charge for private mortgage insurance (PMI) in your monthly payment. This kind of insurance is necessary when a buyer contributes less than 20% of the home's purchase price as a down payment for a conventional loan.

"The property is technically yours once your mortgage loan is fully paid off."

BILL PACKER, COO, LONGBRIDGE FINANCIAL

How to compare mortgage offers

Examine your financial situation, considering your income, assets, savings, credit history, and score to determine which mortgage best suits your needs. Additionally, take your time comparing rates from various mortgage lenders.

According to Kirkland, "Some have more stringent guidelines than others." "Some lenders may require a down payment of up to 20%, while others may require only 3% of the home's purchase price."

"Make sure you're thoroughly examining your options by visiting two or three lenders, or even more, even if you already have a preferred lender in mind," advises Packer. While a tenth of a per cent interest rate might not seem like much, it can add up to thousands of dollars throughout the loan.

When comparing offers, could you take into account all of their features? These are the primary components of offers that you should consider:

• The APR and interest rate: Your borrowing cost is the interest rate, expressed as a percentage of the loan principal. The total cost of your loan is represented by the annual percentage rate (APR), which also includes additional loan fees and the interest rate on your mortgage.

• Kind of rate: Are you considering a fixed rate for the duration of the loan, or are you looking at a variable rate that will change after a certain amount of time?

• Loan term: The amount of time needed to pay back the loan. Note: Although monthly payments on longer-term loans can be smaller, the total interest paid on the loan will be higher.

• Charges: Certain lenders impose fees, like origination, application, and prepayment penalties, that other lenders do not. When comparing offers, make sure you know the price of these costs.

Mortgage Terms To Know

What is the amortization of a mortgage?

Amortization is the process of repaying a loan, like a mortgage, over time through instalment payments. Each payment has a component devoted to interest and a portion to the principle or the amount borrowed.

What is APR?

The annual percentage rate, or APR, shows how much it costs to borrow for a mortgage each year. The annual percentage rate (APR), which goes beyond the interest rate, considers discount points, other loan-related costs, and the interest rate itself.

What is meant by "conforming"?

"Conforming" refers to a conforming loan, a type of mortgage that meets the requirements to be acquired by either Freddie Mac or Fannie Mae, the government-sponsored enterprises (GSEs) essential to the US mortgage market. These requirements include a maximum debt-to-income (DTI) ratio, loan limit, and other conditions in addition to a minimum credit score. Mortgage-backed securities (MBS) are created for the secondary mortgage market by Fannie Mae and Freddie Mac purchasing loans from mortgage lenders.

How does a non-conforming loan differ from a conforming loan?

A loan or mortgage that does not "conform to" or meet the requirements necessary to be acquired by Freddie Mac or Fannie Mae is "non-conforming." A jumbo loan is one type of non-conforming loan.

How does a down payment work?

The portion of a buyer's purchase price they pay upfront is called a down payment. Typically, buyers make a down payment equal to a portion of the property's value and borrow the remaining funds through a mortgage. A larger down payment can enhance a borrower's chances of receiving a lower interest rate. Minimum down payments for different types of mortgages differ.

What is mortgage escrow?

The amount of a borrower's monthly mortgage payment that goes toward property taxes and homeowners insurance premiums is kept in an escrow account. The earnest money the buyer deposits between the time their offer is accepted and the closing is also held in escrow accounts.

What is a mortgage servicer?

A mortgage servicer is a business that manages your mortgage statements and all other day-to-day loan management duties following loan closure. For instance, the servicer receives your payments and ensures your insurance and taxes are paid on time if you have an escrow account.

What is private mortgage insurance?

When you have a loan-to-value (LTV) ratio of more than 80%, which means you have less than a 20% down payment, the lender will typically purchase private mortgage insurance (PMI), which is an insurance policy that you, the borrower, will generally have to pay for. If you default and the lender has to foreclose, PMI will cover a portion of the difference between what the lender can get for your house and what you still owe on the mortgage.

What is a promissory note?

A promissory note is a legal document that outlines the specifics of a borrower's obligation to repay a certain amount of money under specific terms over a predetermined period.

What is mortgage underwriting?

Mortgage underwriting is the process by which a bank or mortgage lender evaluates the risk of lending to a specific individual. An application is needed for the underwriting process, which considers the value of the property the prospective borrower plans to purchase and their income, debt, and credit report and score. Many lenders adhere to the standard underwriting guidelines Freddie Mac and Fannie Mae provided when deciding whether to approve a loan.