How Does a Mortgage Work?
For most families, the dream of homeownership begins with the ability to secure a mortgage. If you're new to the concept, here's what you need to know.
What is a Mortgage?
A mortgage is a type of loan specifically used to purchase a piece of property such as a primary home, a second home, rental, condo, or apartment. A mortgage is an agreement between you and a lender, such as a bank or credit union, that gives them the right to reclaim the property if you fail to make the payments as agreed. The property is used as collateral to secure the loan; you won’t technically own the property outright until the mortgage has been paid in full.
A mortgage comes with terms and conditions related to the principal (the amount you borrowed), fees, interest rate, a repayment period (when it’s paid in full), and a payment schedule that tells you what the monthly payment is and when it’s due.
How Do I Qualify for a Mortgage and What is Involved?
Qualifying for a mortgage starts with finding a lender willing to offer you a loan based on your specific financial profile. You can apply directly with a lender or you can work with a mortgage broker, who will help you find a lender. The broker’s job is to compare lenders and find loan terms that work for you. They’ll also handle all the documents, verify your income, pull your credit score, and negotiate terms with the lender.
Typically, the lender will pre-qualify you for a mortgage that is worth a certain amount. Pre-qualification is a hypothetical: if you applied for a home loan, this is what we’d be able to offer you. You’ll need to provide some basic information about income, expenses, and debts, and possibly consent to a credit pull.
Getting approved is more involved. Most lenders will consider your credit score, which also partially determines the type of mortgage available to you. The higher your credit score, the better the terms regarding interest, loan principal amount, and other loan features. A low credit score might mean you don’t qualify for a mortgage with certain lenders.
Your loan officer will let you know what documents are needed, but they’ll likely ask for your recent tax documents (W-2s and returns from recent years), recent paystubs, and recent bank statements.
What is a Down Payment?
A down payment is the amount you contribute to the purchase of a home from your own funds. The bank loans you the balance remaining after your down payment to purchase the property. For example, if you purchased a $200,000 home with a $40,000 down payment, you’d need a $160,000 mortgage to complete the sale. You’d own 20% equity in the property, and the lender would own 80%.
Generally, the more you can pay upfront, the better. Larger down payments typically mean better terms. The less equity the bank has in your home, the lower the risk is to them, and the better the terms for you, including a more favorable interest rate. A larger investment also means a smaller mortgage and a smaller monthly mortgage payment.
However, it’s important not to sacrifice your financial security by stretching too thin for a down payment you can’t afford. You’ll want to seriously consider your budget before deciding on the amount of your down payment. Make sure you have enough in reserve for emergencies, home repairs, and other financial surprises.
Different Types of Mortgages
Lenders issue conventional mortgages to consumers with good-to-great credit (typically a 620 or higher FICO score) who can afford a substantial down payment. These mortgages aren’t backed by the federal government. If you put down less than 20% of the sale price as a down payment, you may be required to carry private mortgage insurance (PMI). Also, your debt-to-income ratio can’t be over 43% for most loan programs, though some allow as high as 50%.
These three government-backed loans are an option for certain homebuyers with lower credit scores and not much savings for a down payment:
The Federal Housing Administration (FHA) backs loans, typically for borrowers with lower credit scores. If you have a FICO score of 580 or higher, you can secure 96.5% funding. You’ll need to provide the other 3.5% as a down payment. For a lower FICO score (as low as 500) you can still get 90% funding with a 10% down payment.
FHA loans also require mortgage insurance, regardless of your down payment amount, but it functions differently from PMI. These loans include two mortgage insurance costs. One is called Upfront Mortgage Insurance Premium, an upfront fee of 1.75% of the loan amount, which you can roll into your loan amount or pay during closing. The other is called Mortgage Insurance Premium (MIP), a monthly premium, typically between 0.45% and 1.05% of the loan amount. You can’t get rid of the monthly premium unless you refinance into a different loan type.
VA loans are backed by the U.S. Department of Veterans Affairs, so they’re limited to members of the U.S. military and their families. Typically, a VA loan doesn’t require a down payment, PMI, or minimum credit score.
Backed by the U.S. Department of Agriculture, USDA loans are intended for low-to-moderate income families in rural areas. The property you’re purchasing needs to be located in an eligible rural area as defined by the USDA. Depending on your income level, you may or may not need to provide a down payment. You will have to pay an upfront fee of 1% of the loan value (can be rolled into the loan), as well as an annual fee, which is determined by loan amount, income level, and other factors.
Fixed-rate versus adjustable loans
Mortgages come with different time-frame terms and interest rates.
- Fixed-rate loans lock you into the same interest rate for the life of the loan. Typically, fixed-rate mortgages are for 15 or 30 years, but other term lengths may be available (up to 30 years). These loans provide consistency for budget planning.
- Adjustable-rate mortgages (ARM) come with variable interest rates, typically tied to market conditions. For the first few years, the rate is usually fixed and then begins regularly adjusting, sometimes as frequently as every six months. The interest rate may be lower than a fixed-rate mortgage during the “fixed” portion, but it can spike over time and become unaffordable. If you don’t plan to sell or refinance in the near future, an ARM is riskier than a fixed-rate mortgage.
- Interest-only mortgages let you pay only toward the interest for a certain period of time, usually five years. After that period, the payments increase as you start paying toward the principal. You might choose this option if you plan on selling or refinance quickly, or if your income will increase before the payments do.
- Balloon mortgages behave as a typical conventional 30-year mortgage does for 5-10 years, and then the remaining balance comes due all at once. It’s another product that’s best if you plan to sell or refinance before the big payment comes due.
Do I Need Private Mortgage Insurance?
You’ll likely need private mortgage insurance (PMI) if you take a conventional mortgage and can’t provide a down payment of at least 20% of the home’s purchase price. PMI provides extra protection to the lender if you default on the mortgage. When a lender owns more than 80% of the equity in a property, there’s an increased risk to them that they may not be able to fully recoup the original loan amount if the house is foreclosed and re-sold.
In the event of defaulting, the lender will want to re-sell the property to recoup the loan amount – but home values can be volatile. So, until you have paid down the balance below 80% of the original sale price, you’ll have to pay this added insurance cost.
We’re Here to Help You Navigate This Process
Thinking about buying a home? MMI offers education and counseling specifically for new homebuyers. We would be happy to help you prepare yourself and your money for the unique experience of homeownership.