What Is a Mortgage?
To start, let’s discuss what the word “mortgage” actually means. A mortgage is a type of loan usually used to buy a home or other forms of real estate. For most of us, getting a mortgage is a necessary first step on the road to homeownership.
Here’s why it matters: Using a mortgage to become a homeowner can help you build personal wealth, provides you and your family a sense of stability and is an investment in your future. And when you pay property taxes as a homeowner, you contribute to the financial well-being of your community.
How Do Mortgages Work?
A mortgage works by defining the financial relationship between you (the borrower) and the lender (the mortgage provider).
For the majority of mortgages:
- The lender agrees to provide you with the money you need to buy a home
- You agree to pay back the loan (plus interest) based on a defined set of terms
- To guarantee the loan, you agree to put up the home you are buying as collateral
- Once the loan is paid off, you become the sole owner of your home
With a mortgage, you’re a homeowner with all the rights and responsibilities involved and can build equity in your home, as long as you continue to meet the terms of the mortgage.
It’s the difference between the value of your home and the balance of your mortgage debt. You can borrow against the equity in your home, or if you sell, the equity is the profit you make from the sale.
What Is a Mortgage Lender?
You may be familiar with the terms “mortgage lender” or “broker” through your research of the home buying process. A mortgage lender is a bank, financial company or financial institution that can provide you with a mortgage. In simple terms, your lender is the party who loans you money to purchase your dream home.
To find a lender for your mortgage, you can:
- Visit your local commercial bank, community bank or credit union
- Apply for a mortgage online through a “non-bank” mortgage lender
- Work with a mortgage broker
Shopping for a mortgage lender can be an intimidating step in the process. Learning about the different types of mortgage lenders out there can be a great help in identifying the right lender for you. This is an important step early on in your process to receive a mortgage preapproval.
What Is Mortgage Preapproval?
Mortgage preapproval is a process lenders use to figure out how much money they’re willing to lend you. Being preapproved for a mortgage lets sellers know that a mortgage lender is willing to lend to you, which makes it easier for you to negotiate in good faith.
To preapprove you, lenders will request:
- An application form that allows them to perform a credit check
- Proof of employment and income (If you’re self-employed, you’ll need to provide an accounting of your income history.)
- A statement of assets (If you have financial assets that don’t appear in your bank statement, you may need to provide these to help make your case.)
Once the lender reviews these materials, they’ll give you a letter stating that you are preapproved. You’ll show that letter to potential sellers when you make an offer. Since the home-buying process can be a lengthy affair, ask your lender about a rate lock. A mortgage rate lock can guarantee the interest rate of your loan for a specific period of time while you find your dream home.
The Two-Week Window
When you get preapproved for a mortgage, lenders will perform a hard credit check, which can lower your credit score. Because credit agencies view multiple hard credit checks performed within a 14-day period as a single pull, it is in your best interest to submit all your applications at the same time.
What Are Mortgage Terms?
Mortgage terms define the basic agreement between you and the lender regarding the length of time you have to pay your mortgage and the overall cost of the mortgage.
Mortgage payments are distributed over extended periods of time, usually between 10 to 30 years. The longer you have to pay off your mortgage, the lower your monthly payment will be. But consider this, more payments also mean you’ll pay more in interest.
Interest is the cost of borrowing. The higher the interest rate, the more it will cost you to borrow.
The interest rate for your mortgage will usually be based on two factors: a current index rate based on the federally determined national interest rates and your creditworthiness.
To get the lowest mortgage interest rate possible, you’ll want to know your credit score in advance, look for ways to improve it and be ready to present your financial situation in the best possible light.
Other factors that may affect your interest rate are:
- Your ability to make a down payment of at least 20%
- Whether you use a fixed-rate or adjustable-rate mortgage
- Whether you qualify for a government-backed FHA or VA mortgage
- Whether you choose to purchase mortgage discount points
When mortgage lenders promote their current mortgage offers, they usually advertise their prime rate. This is the best rate that they can offer you and assumes excellent credit and income. If you don’t meet these standards, you’ll be offered less favorable terms.
Your Offer Was Accepted! What’s Next in the Mortgage Process?
The mortgage process includes the steps that you’ll need to follow to secure your mortgage after you’ve been preapproved and the offer you made on a home has been accepted.
Once you and the seller agree on a price, you will enter the escrow phase of your home buying journey. An escrow company is a neutral third party that collects the required funds and documents involved in the closing process. This provides protection for you and the seller during the final phase of selling the home. As the buyer, you will be required to make a “good faith” deposit (earnest money), which usually equals 1% to 2% of the purchase price of the home.
During the underwriting step of the mortgage process, the mortgage lender will perform a more thorough review of your finances and credit history. They may ask for more information such as previous tax returns, verification of employment, confirmation of where deposits have come from and detailed information about assets and debts you may have.
This allows the lender to feel secure in the knowledge that you’ll be able to afford the mortgage. If underwriting says that you don’t qualify, the mortgage lender can deny your loan, so you’ll want to do your best to maintain your credit rating and give them as much information as possible.
The lender will also request a home appraisal, an independent assessment of the value of the home you wish to buy. Because a mortgage uses the home that you plan to buy as collateral, the lender wants to make sure that you aren’t overborrowing.
To ensure impartiality, the lender will hire a certified appraiser to provide an assessment of the value of the home, while you’re responsible for paying the bill. The property’s appraisal value is based on:
- Recent sales of similar properties in the area
- Current market trends
- A visual assessment of the inside and outside of the home
If the sale price of your home is less than or equal to the fair market value determined by the appraiser, you’re good to go!
Congratulations! You’ve closed on your house. But what does closing really mean in mortgage terms? Closing or “settlement” is the final step in the mortgage process. During closing, all the parties involved in the sale of the home come together and sign the necessary documents. Once you’ve completed this step, the home is yours and you become responsible for the mortgage.
Keep in mind, buying a home comes with additional costs, often referred to as “closing costs.” Depending on your mortgage lender, you may be able to fold these fees into your mortgage, or you’ll pay them at closing.
What Is Included in a Mortgage Payment?
When you get your first mortgage statement, you’ll see a breakdown of everything that is included in your mortgage payment.
The money that goes toward the purchase price of your home.
The money that goes toward the interest you owe the lender.
When you get your statement, you may notice that a lot more of your monthly payment goes toward interest than principal. That’s due to your amortization schedule.
Your mortgage may include a monthly escrow payment. This is money set aside to cover expenses like property taxes and homeowners insurance.
Private Mortgage Insurance (PMI)
If you can’t pay 20% down on your home, you may be required to pay for private mortgage insurance (PMI). This is an additional fee that you’ll need to pay each month. The fee can average around 1% of the value of your home. According to Freddie Mac, that can add between $30 and $70 a month for every $100,000 borrowed.
The most important thing about a mortgage is this: You need to be consistent in paying it down. If you can, make it a monthly automatic payment, so you never forget about it.
Now that you are familiar with the mortgage process, you can take the next step to find the mortgage that’s the right fit for you! To get started, you can search for appealing rates and figure out what home prices you can afford. A financial advisor can also be a valuable resource in helping you determine if buying a home is right for you and what you might be able to afford.