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A mortgage is a big step toward homeownership, and the right one can save you big in the long run. Take the time to learn how they work, the types of loans available, top interest rates and how to compare your options.
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A mortgage is a loan designed to help you buy or refinance your primary home, a vacation house or any other type of investment property. When you take out a mortgage, you agree to repay the amount you borrow from a lender along with interest, which is rolled into your monthly payments.
In exchange for low interest rates, the lender secures your loan using your property as collateral. That means if you find yourself unable to repay your mortgage on time, the lender can repossess your property and sell it to recoup the loss.
How does a mortgage work?
A mortgage is similar to other types of loans secured with collateral. A key difference lies in the way your monthly payment is allocated.
When you apply for a loan, lenders assess their risk in taking you on as a borrower. Then often consider your credit score, down payment, assets, debt and income. Your risk ultimately determines approval and your mortgage’s interest rate.
The base loan amount you owe is the principal. In exchange for lending you the principal, your lender charges interest that’s applied to your principal each month. Your monthly payment is applied to both the principal and your interest based on an amortization schedule.
Retail and wholesale lenders
Mortgages are offered by either retail or wholesale lenders.
Retail lenders are banks like Citi, Chase, Bank of America, Wells Fargo and U.S. Bank. You can apply directly with these banks for a mortgage.
Wholesale lenders offer their mortgages through third-party lenders, such as mutual or building societies and credit unions.
Sometimes the lender funds loans with their own money, setting their own requirements and loan terms. This type of loan is called a portfolio loan.
More often, mortgages are funded with borrowed money and then sold to investors on the secondary mortgage market. This type of lender is called a mortgage banker.
What is amortization?
When you take out a mortgage, you agree to pay principal and interest over the life of the loan. Because your interest rate is applied to the balance, as you pay down your balance, the amount you pay in interest changes.
At the beginning of your loan, a hefty percentage of your payment is applied to interest. With each subsequent payment, you pay more toward your balance.
Let’s say you’re repaying a 30-year mortgage for $400,000 at 4.5% interest. According to your mortgage’s amortization schedule, your first payment is $2,027. But amortization means that payment allocates $1,500 to interest and only $527 to the principal. By the time you make your last payment, you’re paying only $8 in interest and $2,019 toward the balance.
What about interest-only loans?
As the name suggests, interest-only loans allow you to allocate your monthly payment toward the interest on your loan only for at least the first five or 10 years of your term. It could be an option for a property you don’t expect to own long.
Your monthly payment will be lower than for a traditional mortgage, but your payments don’t reduce your loan amount. These loans generally aren’t bought by Fannie Mae or Freddie Mac on the secondary market, and they require a good credit score.
You’ll find two main types of rates when you’re choosing a mortgage: fixed and adjustable. Fixed-rate mortgages offer a predictable payment each month, while adjustable-rate mortgages change with the market.
Most people opt for these mortgages that allows you to lock in a rate for 10, 15, 20, 25 or 30 years. Your rate and payments won’t change over the term, giving you the security of a reliable mortgage payments you can budget around.
Who is a fixed-rate mortgage best for?
Those with a solid budget. Your payments won’t change for the life of the loan, meaning you can rest easy knowing exactly how much you’ll pay each month.
An adjustable-rate mortgage — or an ARM — comes with an interest rate that fluctuates with the market. Over the course of your loan, your payments rise or fall depending on financial indices like the federal funds rate. While there’s a chance that you’ll pay less than you would for a fixed-rate mortgage, your payments could rise to an amount you can’t afford.
Another option is the hybrid ARM — also called a fixed-period ARM. These mortgages come with an initial fixed period of five to 10 years in which your rates won’t change. After the fixed period ends, your rate adjusts to match market conditions — raising or lowering your monthly payment.
Lenders typically cap how much your rate can go up or down at each adjustment period and over the life of the loan. But your rate could jump significantly during adjustment periods.
Who is an adjustable-rate mortgage best for?
Borrowers planning to sell their home within the fixed period. You’ll enjoy a lower rate for the initial fixed term before selling your home.
Those who afford significantly higher payments. If you keep the loan after the end of the initial fixed period, you could face lower rates, depending on market conditions. But you’ll want to budget for potential increased rates.
These mortgages aren’t part of government programs like VA or FHA loans. Their often low interest rates and fees come with meeting standards set by government-sponsored agencies Fannie Mae and Freddie Mac.
Banks or private lenders consider a borrower’s credit history, debt-to-income ratio and down payment when evaluating a conventional loan application. Down payments can be as low as 5%, but putting down 20% or more can help you avoid having to pay private mortgage insurance (PMI).
To lower risk for the lender, borrowers are required to pay PMI until building at least 20% equity in their home — or until you’ve reached a loan-to-value (LTV) ratio of 80%. PMI rates often range from 0.3% to 1.2% of the loan amount per year added to a borrower’s monthly mortgage payments or paid as a lump sum.
Who is a conforming loan best for?
Most borrowers. About 60% of people who apply for mortgages get a conventional loan.
Those buying a residential, second home or rental property. These loans are often easy to qualify for, even if you don’t have excellent credit.
Nonconformingloansthat are over the government maximum are considered jumbo loans. They are considered a riskier loan for lenders to offer, and so they often come with higher interest rates, down payments and credit requirements than conforming loans.
Who is a nonconforming loan best for?
Those buying a commercial property. Commercial properties can run higher than the maximum limits.
Borrowers with poor credit. Nonconforming loans can help if you have trouble qualifying for a conforming loan. But they come with higher rates than their conforming counterparts.
Insured by the Federal Housing Administration, FHA loans are designed to accept lower down payments and lower credit scores that other mortgages. Eligibility considers your employment history, debt ratio and similar requirements.
Borrowers with FHA loans typically face an upfront mortgage insurance premium and annual premium that’s paid in monthly installments until the borrower builds at least 20% equity in their home.
Who is an FHA loan best for?
Those who can’t afford a 20% down payment. FHA loans accept as low as 3.5% down on your new home.
Borrowers with low to moderate income. Credit and income requirements are often more lenient than conventional loans.
If you or a family member has served in the military, a mortgage backed by the Veterans Affairs (VA) may not require a down payment or mortgage insurance. VA loans also come with low interest rates and no prepayment fees.
Who is a VA loan best for?
Military members. VA loans require that you or a spouse has served between 90 and 181 days in active service or over six years in the Reserves or National Guard.
Families of fallen soldiers. The VA extends mortgages to borrowers with a family member who’s died in the line of duty.
This mortgage backed by the US Department of Agriculture is designed for low- to medium-income borrowers looking to buy real estate in a rural area. USDA loans don’t require a down payment, but you’re often required to pay private mortgage insurance until you’ve built at least 20% equity in your home.
Who is a USDA loan best for?
Low-income borrowers. The USDA focuses on families whose incomes falls near the poverty level for their area, in need of clean and safe homes and unable to get loans elsewhere.
Those with an acceptable debt-to-income ratio. Your complete mortgage —including interest, PMI and taxes — can’t exceed 29% of your income.
State and local programs
Many states and cities offer programs to help Americans become homeowners. Such programs tend to focus on those with low incomes, members of minority groups and other vulnerable populations. Talk with a housing counselor in your local area to learn about programs you might qualify for.
The best mortgage for your situation will meet your needs while providing the lowest rates and terms you’re eligible for.
Decide on a loan type. Do your homework to ensure whether a fixed or adjustable rate is best for your plans and budget.
Shop for a loan. Compare at least two banks and lenders based on your loan type and how much you can afford up front.
Compare APRs. Because it includes your loan’s fees, an APR can be a more accurate way to compare loans than fees or base rates themselves.
Learn about rate locks. If you find a rate you like, ask about locking it in until you settle on your home to avoid an increased rate when you’re ready to apply.
Consider prepayment penalties. Paying more than your minimum payment can shave years off your loan. Make sure your loan applies any extra to your principal without penalty fees.
Ask for a loan estimate. Lenders are legally required to provide your interest rates, payments, closing costs and key figures to compare like information across loan offers.
Repeat, if needed. You can ask for estimates from as many lenders as you’d like until you find a loan you’re happy with.Back to top
How can I get the best rate on my mortgage?
Look to our six tips to landing the strongest rate on any mortgage:
Compare multiple lenders. Get quotes from at least two lenders for the mortgages you’re interested in.
Get your credit score in order. A credit score of 740 or higher can open the door to competitive interest rates, low down payments and special government programs, like FHA and VA loans.
Consider paying for points. Points are upfront charges you can pay to reduce the interest rate on your loan. Crunch the numbers to see how much points can save you in the long run, especially if you don’t plan on keeping your home for the full term of your loan.
Qualify for special programs. Government, state and local programs may offer more competitive rates and terms than traditional mortgages from your local bank.
Save a down payment of at least 20%. Often the larger your down payment, the lower your interest rate. And you’ll save even more by avoiding PMI.
Lower your debt-to-income ratio. Your total debt load affects the loans you qualify for. Try to pay down credit cards or loan balances when you’re shopping for the best rate.
Find a lender. Shop around until you find a lender and loan you’re comfortable with.
Apply for your loan. Provide the required information for a lender to assess your risk, and wait for a loan officer to review your details. An underwriter will review your application and credit report.
Schedule an appraisal. Your house is appraised and inspected to ensure it meets your bank or financial institution’s standards for lending.
Review your loan estimate. Carefully consider the details in your estimate before signing for approval.
Close on your house. Before your closing meeting, you’ll receive a closing disclosure that lists the fees and costs you’ll pay. Sign your documents — and get the keys to your new home.
Who’s involved in the purchase of your home?
The players can overlap but generally depend on the stage of your purchase.
When applying for a loan
Loan officer. This person guides you through finding a loan, applying for your mortgage and keeping you updated on its progress.
Loan processor. Collect your documents to support the application and checks necessary calculations for your loan.
Mortgage underwriter. Has the final say on your application’s approval or rejection after a full evaluation.
Closing representative. Oversees and holds the closing meeting and transfers funds between parties.
When buying a property
Real estate agent. A good agent is there to help you find a home and negotiate with the seller for the best price.
Real estate appraiser. Your lender will likely require an appraisal to suss out the true value of your home against similar properties and recent sales.
Home inspector. While optional, a thorough inspection can unearth structural or safety issues you might deal with unexpectedly down the road. With an inspection report in hand, you can ask a seller to fix the problems to your satisfaction or take money off the selling price to compensate straightening them out on your own.
Pest inspector. These experienced inspectors look for pests like termites that can destroy your home over time.
Loan estimates and closing disclosures
It’s a document that lenders and brokers are legally required to provide you. Your loan estimate breaks down what’s due at closing and details of your mortgage like:
The interest rate.
An estimate of the tax and insurance costs.
An estimate of your monthly payments.
You should receive a loan estimate within three days of submitting your loan application. You’re not required to use that lender, but the estimate becomes a tool that’s helpful when comparing lenders for the best rates.
Source: Consumer Financial Protection Bureau
A closing disclosure lists details about your mortgage, including:
Your loan terms — including how long your rates last.
Your monthly payments are.
Closing costs of your mortgage.
If you’re applying for a reverse mortgage, you’ll receive a HUD-1 and a truth-in-lending disclosure instead of a closing disclosure.
Source: Consumer Financial Protection Bureau
Buying a house is among the biggest investments most of us will make. Set yourself up for long-term success by narrowing down the type of mortgage that fits your needs, budget and property. A strong rate and term can provide peace of mind and save you thousands over the life of your mortgage.
Frequently asked questions
A strong credit score can result in more favorable rates and terms on your loan. Lenders consider your credit score and financial history when determining how much money you can borrow, the type of mortgage you’re eligible for, the size of your down payment, your rate and other costs associated with your loan.
Most lenders like to see a down payment that reflects 20% of the agreed-on home price. But FHA and other mortgages may allow you to put down as little as 3% of the purchase price of the home.
Closing costs are fees and taxes that come with transferring ownership of a property. These costs vary by lender, state and the size and type of property. Expect to pay around 1.15% of the cost of the home, depending on the lender, your state and the size and type of your property.
Your lender may set up an escrow account to collect funds for property taxes and insurance so that the money is available when your bills come due. With an escrow account, your lender pays your taxes and insurance on your behalf. Your monthly mortgage payment is divided into principal, interest and the money due to your escrow account.
PMI is insurance designed to reduce lender risk by protecting them against homeowner default on the mortgage. It’s often required when a homebuyer puts down less than 20% of the purchase price of the home. After you’ve built up at least 20% in equity, you can ask your lender to remote PMI from your mortgage payment.
PMI typically reflects 0.3% to 1.2% of your mortgage payment.
Yes, with many lenders. Locking in your rate protects you against rate increases for a specified time. But it also means you’re locked in at a higher rate if the market softens.
Some lenders offer a one-time float down that adjusts your rate to the new lower rate if the market fluctuates.
Julia Cameron is a writer and editor who has experience in finance, mergers and acquisitions, content marketing and immigration law. She has a passion for interior design and an affinity for Old Florida, where she lives with her family.
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