The buying process doesn’t stop once you’ve found your dream home or investment property. Finding the right loan is also a key ingredient.
For the vast majority of homeowners in the US, your mortgage will be one of the largest sums of money you ever borrow, costing you hundreds of thousands of dollars over the life of the loan. On the plus side, your mortgage will eventually give you full ownership of a home and all the benefits that come with it.
Taking out a mortgage isn’t something you should rush into. Take the time to find out about how they work, the types of loans on offer, the rates available to you, and how to run an effective comparison, and you’ll save thousands by taking out a loan that actually suits your circumstances.
A mortgage is a loan taken out by a borrower in order to purchase a residential property, whether it’s for a home or an investment. In exchange for being able to borrow this money, the borrower is charged a fee, known as interest, which is payable each month.
The property purchased by the borrower is used as collateral or security for the loan. If the borrower can’t repay the loan, the property can be repossessed by the lender and sold to recoup the loss.
How does a mortgage work?
Mortgages are offered by lenders, which can be either retail lenders or wholesale lenders. Retail lenders are banks such as Citi, JPMorgan Chase, Bank of America, Wells Fargo, and US Bank. You can apply directly with these banks and retail lenders for a mortgage.
Wholesale lenders allow their loans to be offered through third-party lenders such as mutual or building societies and credit unions.
Some loans are funded by the lender’s own money, known as portfolio loans. Portfolio lenders set their own requirements and loan terms.
Most mortgages in the US are not funded by portfolio lenders but rather from mortgage bankers. This means the loan is funded by borrowed money, and then on sold to investors on the secondary mortgage market once the mortgage is made.
When you apply for a loan, the risk you present to your lender will be assessed. You’ll either be approved or rejected based on the details of your application, including your down payment, credit score, assets, debt, and income.
The amount you actually owe is referred to as the principal. In exchange for lending you this money, your bank will charge you a fee known as interest.
The interest rate you’ll see advertised is applied to your principal each month, so it’s usually divided by 12 and then applied to what you owe each month.
What mortgage repayments are made up of
A 4% mortgage rate on a principal amount of $500,000 would require a monthly repayment of $2,387.
This is made up of:
- An interest charge of $1,666.67 (4% divided by 12 = 0.33%. 0.33% of $500,000 = $1,666.67)
- A payment towards your principal of $720.41.
What about interest-only loans?
What if you only planned on keeping a property for a short period of time and therefore weren’t interested in paying off the principal of a loan? In this case, you might be able to choose an interest-only loan. This eliminates the principal portion of the mortgage, which reduces your monthly repayments but doesn’t reduce any of the principal. This means that after 30 years of making interest-only payments, you’d still owe the same amount as when you first opened the loan. Interest-only loans aren’t generally bought by Fannie Mae or Freddie Mac on the secondary market and usually require a good credit score.Back to top
The above example is one where the interest rate doesn’t fluctuate over the life of the loan, something that’s possible with a 30-year fixed rate. In reality, there are many types of interest rates, from fixed rates of different lengths to rates that can vary each year.
Fixed rate mortgage
Fixed rates are what the vast majority of Americans opt for when taking out a mortgage, and they allow you to lock in a rate for 10, 15, 20, 25 or 30 years. During this time, your rate and your payments won’t change, giving you the security of mortgage payments that won’t fluctuate up or down.
Who is best suited to this type of loan?
- Those with a stricter budget. Your payments won’t change for the life of the fixed term, meaning you can rest easy knowing exactly how much you’ll need to budget towards your mortgage.
Adjustable rate mortgages (ARM)
An ARM is a mortgage with an interest rate that can fluctuate periodically (once per year, for example), meaning your payments might get higher or lower over the course of your loan.
Today, the most common type of ARM on offer is the hybrid-ARM, which has an initial fixed period (usually 5, 7 or 10 years), during which your rate and payments won’t change. Once this fixed period ends, the rate is then adjusted each year to match market conditions. This means each year the rate could be adjusted up or down, causing your payments to be higher or lower.
Usually, lenders will cap the amount the rate can go up or down at each adjustment period and also over the lifetime of the loan, so there is some security. But you should be aware that your rate could jump significantly during adjustment periods, so be 100% certain that you can afford the worst-case scenario.
Because of the shorter fixed period, rates are generally lower.
Adjustable rate mortgages are usually advertised with the initial fixed period first followed by how often the rate will be adjusted after that, so a 5/1 ARM will have an initial 5-year fixed rate, with the rate adjusted once per year after this.
Who is best suited to this type of loan?
- Those who are planning on selling their home before the fixed period ends. This means you’ll be able to enjoy a lower rate for the initial fixed rate years and then sell after this.
- Those who can afford the worst-case scenario. If you choose to keep the loan once the initial fixed rate period ends, there’s always the possibility that rates can drop lower during the adjustable period, depending on market conditions. There’s also the possibility they can be raised higher than you can afford. Ensure that you can afford your repayments at the higher interest rate.
What types of mortgages may be available to me?
These are regular mortgage loans that are not part of any government loan program, such as Department of Veterans Affairs (VA) loans or Federal Housing Administration (FHA) loans. Conventional loans can be both conforming or non-conforming.
Conforming. A conforming loan meets the qualification standards imposed by Freddie Mac and Fannie Mae, such as maximum loan size, credit scores, the size of your down payment in relation to your total mortgage and your total debt. If your mortgage fits within their specific criteria, it will be bought by Freddie Mac or Fannie Mae.
Some counties may have higher maximum loan sizes, which Freddie Mac or Fannie Mae will still buy. These loans are known as conforming jumbo loans.
Non-conforming. A non-conforming loan doesn’t meet the criteria of a conforming loan and therefore isn’t usually bought by Fannie Mae or Freddie Mac in the secondary market.
- Jumbo loans. One of the more common types of non-conforming loan is the jumbo loan, which refers to a loan that is larger than the maximum loan size set by Freddie Mac and Fannie Mae. This limit is usually $417,000, but can be as high as $625,000 in states such as Alaska and Hawaii. The maximum amount you can borrow with a jumbo loan depends on your county.
- High LTV loans. LTV stands for loan-to-value ratio and refers to your down payment as a percentage of the property purchase price. For example, on a property worth $300,000, if you had a down payment of $30,000, your LTV would be 90% ($30,000 is 10% of $300,000). LTVs above 80% require private mortgage insurance (PMI) and may also be classified as non-conforming depending on the lender.
- Loans with lower documentation requirements. These loans are for those with complicated finances, such as the self-employed.
- Loans for non-standard properties. Non-standard properties that are difficult to appraise, such as those producing an agricultural income or those with large amounts of land, may require a non-conforming loan.
- Loans for credit-impaired borrowers. To qualify for a conventional mortgage, you’ll usually need a minimum credit score of between 580 and 640 depending on the lender. Those who have recently declared bankruptcy may also find it difficult to get a conforming loan.
- Loans for those with high total debt. Those with a high load of debt in proportion to their income may not qualify for a conforming loan.
This type of loan is insured by the Federal Housing Administration (FHA), and allows borrowers to purchase a property with a lower down payment and with less-than-stellar credit scores.
- You can borrow with a down payment of as little as 3.5% (this has a minimum credit score requirement of 580).
- You can apply with a credit score of as little as 500 (credit scores of between 500 and 579 require a minimum down payment of 10% of the purchase price).
- Requires two forms of mortgage insurance, both which are paid monthly
- Is assumable, which means that if you sell your property the buyer can take up your loan, making it more appealing
- Must be used for a primary residence
FHA loans have a number of other eligibility requirements, particularly around your employment history and debt ratio, so be sure to do your research before applying for one.
If you’re eligible, a Veterans Affairs (VA) mortgage can be a great way to buy a home with no down payment or mortgage insurance.
- No down payment depending on the borrower
- Competitive interest rates, usually 0.5-1% lower than conventional rates
- No mortgage insurance premium is payable
- Is assumable if the buyer is also eligible
- Allows you to prepay your mortgage with no penalty fees
- Must be used for a primary residence
- Backed by the Department of Veteran Affairs, but funded by private lenders
As with the FHA loan, a VA loan comes with a range of eligibility requirements. You will be required to fulfil one of the following conditions:
- During wartime: 90 days of active service
- During peacetime: 181 days of active service
- Over 6 years of service in the reserves or national guard
- Spouses of those who have fallen in the line of duty
You’ll also need to supply your lender with a certificate of eligibility, and you’ll need a stable income to pay your mortgage off, among other eligibility requirements.
A loan from the US Department of Agriculture is aimed at low to medium income borrowers who want to buy in a rural area. USDA loans offer benefits similar to a VA loan, including no down payment required, but still requires private mortgage insurance.
- No down payment required
- Loans are either guaranteed by the USDA and issued by private lenders, or they are direct loans from the USDA, or they are smaller loans and grants for home improvement
- The loans must be used for primary residences
- Applicants must have 24 months of stable income and an acceptable credit history
- Debt ratio and credit score requirements also apply
State and local programs
In addition to conventional loans and special program loans like those from the FHA, VA or USDA, there are a range of state and local programs to help Americans buy a home. These include programs targeted at those with low or moderate incomes and other groups, so be sure to speak to a housing counselor in your local area to see what may be available.Back to top
- Decide on a loan type. First, decide whether a fixed rate or adjustable rate mortgage is more suited to your plans and budget. This is also a good time to find out what your credit score is and know what loans are available to you.
- Shop for different loans. Compare what different banks and lenders are offering for your chosen loan type and down payment.
- Use the APR. The annual percentage rate (APR) is an interest rate that includes some of the fees and charges of your loan. This can be a more accurate way to compare loans, but be aware that this is only an indication of the cost of your loan over the full term. Getting out of your mortgage early will make the effective APR much higher.
- Be wary of advertisements including points. When comparing loan rates, some lenders might advertise rates inclusive of discount points. This isn’t necessarily bad, but when comparing loans you’ll want to exclude discount points on all loans to make your comparison fair.
- Find out about rate locks. If you’re interested in a loan, you might want to know if you can lock in a rate so that it doesn’t go up during the application process. Find out what fees will apply if this is a feature you’re interested in.
- Be mindful of prepayment penalties. Make sure you check potential loans to ensure there are no prepayment penalties, as you will more than likely want to change homes in the future.
- Ask for a Loan Estimate. A lender must give you a Loan Estimate by law. This three-page document shows you the interest rates, repayments, closing costs and even has a section on the last page that gives you the key figures to use when comparing.
- Repeat until you find a loan you want. It’s normal to ask for Loan Estimates from more than one lender until you find a loan you’re happy with.Back to top
- Compare multiple lenders. Always get more than one quote when looking for a mortgage. This will ensure you get a good mix of options from different types of lenders.
- Get your credit score in order. A credit score above 740 can open the door to more competitive interest rates and loans, even special government program loans such as FHA and VA loans. Better credit scores can give you benefits such as lower required down payments.
- Consider paying for points. Discount points are upfront charges you can pay to reduce the interest rates on your loan. You should work out whether or not paying for points will have a beneficial effect on your total cost in the long run, especially if you don’t plan on keeping your home for the long term.
- See if you qualify for special programs. There are government, state and local programs that may offer competitive rates and terms, so be sure to check these out.
- Save a larger down payment. The bigger your down payment is, the less of a risk you present to your lender. Borrowers with lower risk are rewarded by lenders with better interest rates.
- Lower your debt-to-income ratio (DTI). Your total debt load will affect what loans you qualify for, which means you may be able to take out a lower rate. This makes it a good idea to pay off and close any other credit cards or loans you don’t currently need if you’re shopping for the best rate.
On average, you’ll pay 2-5% of the purchase price of a property in closing costs.
If you select a particular lender and mortgage, be sure to ask for a Loan Estimate (previously known as a Good Faith Estimate or GFE). This will include a full list of all of the closing costs you will be expected to pay.
Right before settlement, you will receive a Closing Disclosure (previously known as a HUD-1), which is a final listing of your costs and is more accurate than the Loan Estimate.
- Credit report fee. Your lender will want to know your previous financial history to get an idea of your risk as a borrower.
- Appraisal fee. An appraisal will be carried out on the property you wish to buy so that your lender can be sure it’s worth the sale price. In the event that they need to sell your property, they want to make sure they will be able to recoup their costs.
- Origination fee. This is a fee charged for processing your loan application and is generally a percentage of your loan amount.
- Title insurance fee. This fee covers the cost of protecting yourself and your lender from sellers or previous sellers who didn’t have the legal right to transfer property to you. This safeguards you from losing your home in the event that something untoward occurs and is usually made up of two policies: a lender’s policy and a buyer’s policy.
- Title search fee. This fee is charged to determine whether or not a seller has the right to sell a property to a buyer.
- Survey fee. In some states, a survey of the property is required to ensure property lines and boundaries are correct.
- Closing fee. You’ll pay this fee to the attorney or company handling the closing.
- Private mortgage insurance (PMI). If you have a down payment of less than 20% of the purchase price, you’ll be required to pay PMI each month. PMI doesn’t cover you but rather your lender in the event that they have to repossess your home and sell it to recoup their costs. If they don’t recoup their costs, they’ll activate the PMI policy and you’ll have to deal with the PMI provider.
- Inspection fees. Home inspections and pest inspections will uncover any nasty hidden surprises within the structure of your new home.
- Homeowners insurance. Your lender will usually require that you take out homeowners insurance and possibly also flood insurance. This is usually paid each month.
- Points. Paying for discount points can reduce your interest rate, saving you money on your monthly payments. This is an optional cost and one you should consider the merits of before paying.
Other fees you might have to pay include courier fees to send your applications and documents to your lender and attorney fees.Back to top
- Decide on a lender and loan you’re comfortable with.
- Ask to start the application process. You’ll have to fill out a Uniform Residential Loan Application, which will include information about the type of mortgage you’re applying for, as well as information about the property and your assets and liabilities. You’ll also need to submit the required documents.
- Your application will be reviewed by a loan officer and you’ll have to sign it. An application/processing fee may be charged at this stage, depending on the lender.
- During this time, the appraisal will occur, your credit report will be examined, and other processes like the pest inspection will happen. Your application will also be examined and reviewed by your underwriter. You should also receive your Loan Estimate document. (Prior to October 3, 2015, you would have received a GFE and Truth-in-Lending disclosure statement. On the other hand, if you’re applying for a reverse mortgage, you’ll still receive these two documents rather than a Loan Estimate).
- You’ll receive your Closing Disclosure (formerly known as the HUD-1 Settlement Statement). This shows the exact closing costs you’ll pay.
- Attend your closing meeting. Here you’ll sign all the remaining documents and own your home.
Who will you be dealing with when buying a home and applying for a loan?
When applying for a loan:
- Loan officer. Your loan officer will be your first point of contact and the person who will help you find a loan when you approach a lender. Your loan officer will also help you complete your application and should keep you updated of its progress along the way.
- Loan processor. Once you’re ready to apply, the loan processor will collect the required documents from you to support your application and will check the necessary calculations for your loan.
- Mortgage underwriter. The final say on whether or not you’ll be approved for a loan rests with the underwriter, who will evaluate your application and either approve or reject it.
- Closing representative. This person will oversee and conduct the closing meeting and the transferring of funds between parties.
When buying a property:
- Real estate agent. A good real estate agent will be your point of contact to find a home and help you negotiate with the seller so you get the best price.
- Real estate appraiser. Your lender will require an appraisal of the property you’re purchasing, so this professional will calculate its value.
- Home inspector. A home inspector isn’t always mandatory, but it can be well worth it if they find something wrong with your potential home. A home inspector is trained to look at the property and ensure there are no nasty structural surprises or safety issues. They will be able to tell the overall condition of the property you’re buying.
- Pest inspector. This professional will evaluate your property for pests like termites, which can destroy wood over time.
What is a Loan Estimate?
A Loan Estimate is a document lenders and brokers are required to give you by law. It gives you an estimate of the costs required when closing a particular mortgage.
Note that for anyone applying for a mortgage after 3 October 2015, a Good Faith Estimate will be known as a Loan Estimate.
The Loan Estimate will display information such as:
- The interest rate of the loan
- A breakdown of the closing costs of a loan
- An estimation of the tax and insurance costs of a loan
- An estimate of your monthly payments
By receiving a Loan Estimate, you’re not obligated to proceed with a specific lender. It’s just a good method of comparing loans accurately from more than one lender.
You should receive your Loan Estimate within three days of receiving your loan application.
What’s a Closing Disclosure?
You’ll receive a Closing Disclosure at least three business days before closing. It lists all the important information about your mortgage, including:
- Your loan terms, such as how long you’ve fixed your loan for
- What your monthly payments will be
- The closing costs of your mortgage
For those who applied for a mortgage before 3 October 2015, or those applying for a reverse mortgage, you will receive a HUD-1 and a Truth-in-Lending Disclosure instead of a Closing Disclosure.
Where to from here?
Now that you know about the basics of a mortgage and how they work, you might want to start asking yourself what type of mortgage will suit you. Do you want the stability and security of a 30-year fixed rate, or are you more likely to sell your property in the medium-term and therefore like the sound of a hybrid-ARM? Think about what features you want out of your mortgage and what may suit you before you start your comparison.