- A mortgage is a loan to finance the purchase of your home or property—it’s likely the largest debt you will ever take on. In exchange for the money received by the homebuyer to purchase the property, the bank or mortgage lender will get the promise that you will slowly pay the money back, with interest, over a designated period.
What is a Mortgage
Before the 1930s, only four in 10 American families owned their own home.1 Few people had enough money to buy a home in one lump sum and bank loans specifically designed to purchase a home were not available. Thankfully, we now have the option for a mortgage loan, which is an agreement allowing the borrower to use property (your new home) as collateral to secure a loan to purchase a house.
The bank or mortgage lender will typically loan about 80 percent of the price of the home. With a mortgage, you are signing an agreement that says your lender has the right to take action if you don’t make the required payments. If you fail to pay back the loan, the lender can take your home in foreclose on your home—which means forcing you to move out so they can sell the house.
Types of Mortgages
There are many different types of mortgage loans available today. By understanding mortgage types, an educated decision can be made when purchasing a home or property. The different types of mortgage loans include:
- Fixed-rate Mortgage: This is the simplest type of loan because you will make the same payment for the entire life of the loan. If you choose to pay more each month, then you will pay off the debt faster. Fixed-rate mortgages are typically 15 or 30 years, but other terms can be used. Given the principal loan amount, interest rate, and the number of years to repay the loan, your lender will calculate a fixed monthly payment.
- Adjustable-rate Mortgage: The interest rate can change at some point in the future with these mortgages. When the interest rate changes, your monthly payments will change as well. Rates will typically change after several years, and some limits will be set to determine how much the rate can move. These loans are generally riskier because you don’t know what your monthly payment will be later.
- Second Mortgage: Known as a home equity loan, a second mortgage allows you to add another mortgage and borrow more money. The second lender will be second in line, which means they only get paid if there is money left over after the first mortgage lender gets paid. Second mortgages can be used to remodel a home or pay for college.
- Reverse Mortgage: For those over the age of 62 who own their own home, reverse mortgages are used to supplement income or get lump sums of cash out of their home. With reverse mortgages, the homeowner doesn’t pay the lender each month. Instead, the lender pays you by converting part of the equity of your house into cash. These are complex arrangements and there are many risks and different types of arrangements to consider.
- Refinancing: To find a better deal, mortgages can often be swapped out. When you refinance a mortgage, you will get a new mortgage that pays off your old loan. This will cost money, but it can pay off in the long run if you do the proper research.2
With different types of mortgages, it is important to pay attention to which one best meets your individual needs. Talk with your mortgage lender to find out more and gain a better understanding of what is involved.
What are the different parts of a Mortgage?
Each mortgage loan shares some common components. Most mortgages will have the following:
- Down Payment: Banks or mortgage lenders typically want the borrower to start out with an ownership stake in the property. This is referred to as a down payment, and is typically 20% of the property’s purchase price.
- Principal: The sum borrowed for the mortgage is the principal. It can also be the original value of the loan.
- Interest: As a borrower, you benefit from a mortgage by owning a home, but the lender benefits by charging interest on the loan. Interest rates can be high at times, but the better your credit rating, the lower the interest rates will be.
- Collateral: Typical of most loans, mortgages require collateral. The property itself is the collateral, and if you default on the loan, the bank can repossess the home.
Each component associated with a mortgage allows both the borrower and lender to continue a mutually beneficial relationship.3
Applying for a Mortgage
If you have decided to purchase a home, your first step should be to acquire a copy of your credit report and check for any errors—this can save you a lot of time and hassle. Notice any incorrect information? Dispute errors because outstanding issues can cause a mortgage application to be rejected or lead to a higher interest rate.
After reviewing your credit report, contact a mortgage lender or mortgage broker to borrow money to purchase the home or property. Remember to think about what type of home you are looking for, how much you qualify for and what your budget can accomodate. The lender will receive an appraisal of the property to determine the value of the home (this is used as collateral for the loan). You will be charged a fee for the appraisal service, which is included in closing costs.
Once the mortgage application is complete, the borrower will be asked for a considerable amount of information. Be prepared with the following information for the lender:
- Bank information
- Three months of investment statements
- W2s, pay stubs, proof of employment and two years of income
- Tax returns and balance sheets if you are self-employed
- Debt currently owed (amount due and account numbers)
The lender will review your application and decide whether to deny or approve it. If you are approved, the last step in the process will be to meet for documentation completion and closing. However, if you are denied, it is important to talk to the lender to devise a plan and find out why the application was denied—there may be ways to fix the situation.4
How does Mortgage repayment work?
With a down payment (typically 20% of the purchasing price) the amount of money you must borrow will be reduced.5 As a result, your monthly payments can be less costly as well. The monthly mortgage payment is typically comprised of the following costs:
- Principal: The amount of money you are borrowing after your down payment.
- Interest: The money your lender will be charging for the loan.
- Taxes: The money used to pay property taxes is typically placed in an escrow account.
- Insurance: The purchase of hazard insurance to protect against losses from fire, storms, theft, flood, etc.
Monthly payments will also be determined by the type of mortgage loan you receive. For example, if you have a fixed-rate mortgage, your monthly payments remain the same for the life of the loan, but vary depending on the length. Mortgages can be as short as a couple years (with the right down payment), or as long as 50 years. The most common length for a mortgage is 30 years, but 15-year loans are also common even though they are not a popular option.6
Purchasing a home can provide you with a great place to live while also building wealth, but it can come with a cost. Careful planning can help you navigate through the process of purchasing the home of your dreams.
- “How Mortgages Work” How Stuff Works. Accessed February 8, 2017 from http://home.howstuffworks.com/real-estate/buying-home/mortgage.htm
- ““Mortgage Basics” Investopedia. Accessed February 8, 2017 from http://www.investopedia.com/university/mortgage/?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186
- “What is a Mortgage?” Fidelity. Accessed February 8, 2017 from https://www.fidelity.com/mymoney/what-mortgage
- ““5 Documents You Need to Get a Mortgage (Faster)” U.S. News. Accessed February 8, 2017 from http://www.usnews.com/news/blogs/home-front/2011/12/15/5-documents-you-need-to-get-a-mortgage-faster
- “Mortgage – Meaning and Explanation” The Balance. Accessed February 8, 2017 from https://www.thebalance.com/mortgage-meaning-and-explanation-315709
- “What is a Mortgage?” Redfin. Accessed February 8, 2017 from https://www.redfin.com/definition/mortgage-loan