What Is a Mortgage?
A mortgage is a loan secured by the collateral of real estate. Mortgages typically have 15 to 30-year terms and can have a fixed or adjustable interest rate. The borrower is bound to make monthly payments to the principal, which is your outstanding balance. In the case that you stop making payments, the lender can take possession of the property. Otherwise known as the process of foreclosure.
All in all, the lender holds the most stake in your home. Therefore, by making monthly payments, you’re always increasing the amount of ownership in the property. Lastly, here’s a fun fact for you: The origin of the word “mortgage” is Latin and then came from Old French, which initially meant a death pledge.
You need to be savvy
Suppose your mortgage lender says you’re approved for $300,000. What you must figure out is if you can comfortably afford the monthly note of such. For instance, you might be better off setting your budget at $280,000 instead. It is never wise to max yourself out.
A good rule of thumb is the 28/36 rule. You shouldn’t spend more than 28 percent of your gross monthly income on housing expenses. Your total debt, such as your mortgage note, car loans, and credit cards, shouldn’t exceed 36 percent. When calculating how much you can spend on a mortgage, you need to look at your principal, interest, taxes, and insurance. This is otherwise known as PITI.
What you should know about mortgage amortization
The word amortize is one of many mortgage terms that are vital to know. Amortization refers to how your monthly payments are broken up throughout the life of your loan. For instance, during the early years, a higher part of your payments will go towards interest. Then after a while, more will go towards the principal. Remember, the principal is a term for the amount you owe.
Given these points, the first part of your monthly mortgage note will pay interest on the loan. Then the second part will go towards paying off the principal. Most home loans are fully amortized, meaning the loan will be paid in full by the end of the term. On the other hand, a balloon mortgage, for example, is not amortized.
Instead, you’re going to be paying interest for a certain period. A large payment will then be due at the end of the loan term, otherwise known as a balloon payment. The amounts of such are usually scheduled to go beyond the loan term.
Negative amortization occurs when you do not make payments. Or if you only pay enough to cover the interest. The amount you did not pay will then be added to the principal of your loan. As a result, your monthly payment will henceforth increase.
What all comes with a mortgage?
Your lender may collect the property taxes of the home as a part of your monthly payment. The funds for such will be held in an escrow account, which the lender will use to make your property taxes when they’re due.
One of the next things that come with a mortgage is homeowners insurance. Sometimes the lender will collect the premiums for your insurance as a part of your monthly note. Likewise, the lender will place the money in escrow and make payments to your insurance provider when they come due.
Private mortgage insurance (PMI) is usually required by conventional mortgage lenders when the buyer’s down payment is less than 20 percent. However, PMI will automatically end once you’ve paid off half of your loan amount. PMI will also automatically terminate when your loan-to-value (LTV) ratio reaches 78 percent. However, you can request to have PMI removed once your LTV gets to 80 percent.
Last but not least are closing costs. These are the fees you’re going will pay to close on a home. Generally, they are at least 2 percent to 5 percent of the loan amount. The items included are title insurance, attorney fees, appraisals, taxes, etc.
Suppose your loan amount is $350,000. In that case, you’re going to pay at least $10,500 to $14,000 in closing costs. Fortunately, you and your real estate agent can negotiate with the seller to pay for all or some of your closing costs.
Things that can affect your mortgage interest rate
The interest rate on a mortgage is essentially a fee you’re paying to borrow money from the lender. Furthermore, the lower the down payment amount, the more risk the lender is taking by lending to you. Therefore, you will pay higher interest than a buyer who puts down 20 percent of the home’s purchase price. In short, the less skin you have in the game, the higher the interest will be and vice versa.
Moreover, your credit score will also be a deciding factor on how well an interest rate you can get. The higher your credit score, the lower the interest will be. Conversely, the lower your score, the higher the interest rate. Nonetheless, credit score requirements will vary per lender.
Next are mortgage points. These are fees paid to the lender at closing in exchange for a lower interest rate. By doing this, you can lower your monthly note. Generally speaking, each point will cost you 1 percent of the total cost of your home. In other words, that will be $1,000 for every $100,000. For example, if you bought a house for $200,000, you’re going to pay $2,000 in mortgage points.
Watch out for prepayment penalties
Prepayment penalties occur when you choose to make an extra payment to pay off your mortgage faster. Some people might decide to do this because they plan to sell their home before the loan term is over. Needless to say, you might not want to consider a mortgage with prepayment penalties.
Fixed-rate vs. adjustable rate mortgages
A fixed-rate mortgage is very straightforward to understand. The interest rate will simply stay the same during the loan term. On the contrary, the interest of an adjustable-rate mortgage (ARM) will periodically change. Afterward, the interest rate will become fixed after the initial period is up.
An example would be if you got a loan with a 5 to 1 (5/1) ratio. For the first five years of your loan, the interest rate will change once per year. That is your 5 to 1 ratio. After year five, your mortgage rate will become fixed.
The different loan types
First are government loans. There are three offered through agencies such as the Federal Housing Administration (FHA), the United States Department of Agriculture (USDA), and Veteran Affairs (VA). FHA loans generally require at least a 3.5% down payment, while USDA and VA loans do not call for one at all.
Different from government home loans, conventional mortgages are not backed by the government. Instead, they are funded by the lender. Their credit score requirements are generally stricter, and you will have to make a down payment regardless.
A jumbo loan is a non-conforming loan, meaning the mortgage amount is higher than the Federal Housing Finance Agency (FHFA) loan limits. Loans like the ones previously mentioned are conforming. Depending on your location, a jumbo loan could be needed if the property’s price is a tad over $500,000.
Some of the less popular mortgages
Interest-only mortgages are relatively uncommon nowadays and for a good reason. They can get you into a lot of financial trouble. How it works is you’re going to only pay on the interest for a set period, which is generally within the range of three to ten years. Once the time is up, the principal, your overall balance, will finally be coupled with your monthly payment. Thus turning it into a typical monthly note.
Many people found themselves in a bad situation during the early 2000s because they simply didn’t have the money to pay the principal. As a result, there was a myriad of foreclosures, which then led to the market collapse of 2008.
Last to mention are reverse mortgages, which are for homeowners 62 and older. They are typically used to help seniors offset some of their living expenses, such as healthcare. The workings of a reverse mortgage are anything but ordinary. Hence the name reverse.
It’s like the lender gives you a cash advance, which you get by taking some out equity in your home. So instead of you making payments to the bank, the bank pays you. The upside is you don’t have to pay anything back. But the negative part is you’re losing a certain amount of equity in your home. Finally, it should also be noted you must have at least 50 percent equity in the property to qualify.
Where to get a mortgage
A mortgage broker is a middleman who connects you to the lender. First, the mortgage broker will look over your finances and give you a general estimate of how much you can afford. Next, they will work with several lenders and banks to match you with the loan that suits you the best.
It is also recommended that you shop around with different banks to see what their loan offerings are. If you have a good relationship with your bank, they might lower your closing costs and interest rate as an incentive. Although large banks process their mortgages in-house, they typically offer a broad range of financial services. For this reason, their customer service could be lacking.
Credit unions are not-for-profit organizations. Even though they offer mortgages, you have to become a member to get one. If you’re already a member, there’s a good chance you will have lower closing costs and a lower interest rate.
Next are direct lenders, otherwise known as mortgage bankers, who create and fund their own mortgages. While mortgage brokers cannot approve your mortgage, a direct lender can, and they will give you money directly. The most significant advantage with a direct lender is that they handle the entire mortgage process. After you and your real estate agent have finally found the home you want, they will take care of your loan application’s processing. They will also get you pre-approved to unwrite your loan.