You just decided to purchase a home. A good move for your future!
Now, what’s next is to get a mortgage. Unless you are among the wealthiest people, you most probably cannot purchase any real estate outright.
A mortgage alleviates this problem. Take a deep breath, though; you may not have seen that many zeroes in your life just yet.
Buying your very own home is rewarding, but the financial side may overwhelm you. But knowing the concept and terms related to a mortgage will make it much more manageable.
You can either do your homework or read this clear and concise guide for understanding just what is in a mortgage loan agreement.
What Is A Mortgage?
When talking about buying real estate, the word “mortgage” often pops up. Well, a mortgage is one essential financial decision you will make in your lifetime, so it is vital to know what you are signing up for before deciding on getting a mortgage loan.
The Concept of Mortgage
A mortgage, also known as “liens against property” or “claims against property,” is what is called a debt instrument. An entity that issues a debt instrument has the right to receive periodic payments over time as stipulated in the agreement, or until the amount they provided has been fully repaid.
A mortgage is a loan from financial institutions that will help you purchase a home. The collateral for the loan is the home you will buy itself, so if the lender defaults, the financial institution can exercise their right to sell the house and recoup their money.
So this won’t happen, make sure that you have enough money to at least pay the monthly amounts.
Who Enters Into Mortgage Arrangements?
Business and individuals both take advantage of the benefit a mortgage provides, that is the ability to make purchases of costly real estate without paying the entire amount up-front. Over the years, the borrower repays until the property is “free and clear.”
“Free and clear” means that the loan is completely paid off and that there are no prior claims against the house, such as unpaid real property taxes.
So basically, those who enter into mortgage agreements are those individuals or businesses who will buy real estate but do not have the luxury of affording a lump-sum single payment.
What Is In A Mortgage Payment?
Your regular mortgage payments can cover several parts of the cost. What constitutes a mortgage?
The loan principal is the face amount you borrowed, less any payments charged to that balance. For example, you borrowed $1,000,000. That is the face amount and the initial principal balance.
If you have repaid $50,000 toward that balance, then the new principal amount will be amounting to $950,000.
For mortgages that amortize, such as a fixed-rate mortgage that runs for many years, a part of your monthly payment applies to the principal, and some apply to the interest. This arrangement will lead to the full balance, both principal and interest, being paid fully at the end of the loan term.
The interest rate on the mortgage shows how much you will need to pay the lender in exchange for the loan. In essence, this is the cost you will pay to finance your needs and capital, so interest expenses are commonly referred to as finance costs.
There are mortgage arrangements where the lender may collect, in addition to mortgage payments, property taxes on your real estate purchase.
The lender will keep the tax payments in an escrow account and will use it to pay, on your behalf, your property tax upon its due date.
In the event of an incident that damages your home, homeowners insurance will come in handy. It provides you financial protection when your house is damaged or destroyed by fires, accidents, storms, quakes, and the like.
In some arrangements, lenders require the collection of homeowners insurance premiums, along with mortgage payments. As with taxes, they are kept in an escrow account and are paid by the lender to the insurance provider when the premiums are due.
Most lenders typically require a borrower to pay for fees known as mortgage insurance when the down payment is less than 20 percent of the home’s purchase price. The mortgage insurance is in place to protect the lender from the risk that a borrower will default on the loan.
A borrower can pay the premiums separately, or through an addition to the monthly mortgage payment. There are two kinds of this type of insurance: private mortgage insurance (PMI) and those required for government-sponsored loans (such as Federal Housing Administration loans).
Types of Mortgage Loans
Mortgage agreements come in many forms, mostly differing in length of term and interest rates. Some mortgages are short, while others may extend up to decades; some have fixed interest rates while others fluctuate.
There are many types of mortgages, and it is up to the homebuyer to choose a mortgage option based on their needs.
A home loan not insured by the government is referred to as a conventional mortgage. These are further subdivided into two types: non-conforming and conforming.
Non-conforming loans are those that do not adhere to the guidelines set by Fannie Mae (Federal National Mortgage Association) or Freddie Mac (Federal Home Loan Mortgage Corporation). On the other hand, conforming loans, well, conform to the standards set by these authorities.
Many conventional lenders require you to pay a PMI.
- Can be used on a wide variety of assets, such as primary and secondary homes, and investment properties
- Overall borrowing costs (interest plus other expenses related to borrowing debt) are commonly lower than other types of mortgages, even if interest rates are higher
- For loans backed by Fannie Mae or Freddie Mac, you can pay a downpayment of as little as 3 percent
- Once you have paid at least 20%, you can then cancel the PMI.
- Minimum FICO (Fair, Issac, and Company – a data analytics company focused on giving credit scores and ratings) score must be 620 or higher
- A significant amount of paperwork and documentation is required to verify your assets and income, and employment
Conventional mortgage loans are the most viable for borrowers with a good credit score and a stable source of income from employment or business.
A jumbo mortgage is a type of a non-conforming conventional loan. Jumbo mortgages exceed federal loan limits. For 2018, Fannie Mae and Freddie Mac loan limits amount to $453,100 for normal areas and $679,650 for high-cost areas.
Jumbo mortgage loans are more prominent in high-cost areas and require more documentation to verify.
- Interest rates are at least competitive versus other types of mortgage loans.
- You can borrow more money to buy a home, usually in an expensive area
- A down payment is needed, usually 10 to 20 percent
- While some lenders will accept a minimum FICO score of 660 when availing a jumbo mortgage, a FICO score of 700 or higher is generally needed.
- Significant asset amounts must be shown in cash or savings accounts, amounting to at least 10 percent of the loan price
- A debt-to-income ratio of higher than 45 percent means that your application for a jumbo mortgage will be denied.
Many reputable lenders offer jumbo loans at excellent rates. This type of loan is sensible for those affluent buyers with excellent credit ratings and high incomes, especially if they want to purchase an expensive, high-end house.
The government does not directly offer mortgages, but they do help in turning their citizens into homeowners. Three agencies: the Federal Housing Administration (FHA), the U.S Department of Veterans Affairs (VA), and the U.S. Department of Agriculture (USDA), all provide backings of mortgage loans.
- FHA loans are perfect for those who do not have a lot of money saved up or do not have the cleanest of credit ratings. To get FHA’s maximum 3.5% financing (interest rate), the borrowers would need a FICO score of at least 580. If you agree to pay at least 10% down, then a credit score of 500 is accepted. FHA loans, however, require the payment of two mortgage insurance premiums, one up front, and the other annually for the term of the loan if you paid less than 10% down payment.
- VA loans are the low-interest and flexible mortgages offered to the active duty and veteran members of the U.S military. VA loans do not require a PMI or down payment but charge a funding fee (usually a percentage of the loan amount) to offset the cost of the program. Additionally, closing costs (expenses associated with the closing of a real estate transaction, such as attorneys and appraisal fees) are capped and are generally paid by the seller. Those closing costs over the cap, as well as the funding fee, can be paid upfront during closing or combined with most VA loans.
- USDA loans are for the middle- to low- income borrowers in rural areas. To qualify, you must meet a certain income threshold, and purchase a home in a USDA-accredited area. Some USDA-backed loans grant eligibility for low-income earners, allowing them not to pay a down payment anymore.
- Government-backed loans are best when you do not qualify for conventional mortgage loans.
- You do not need a large down payment, and credit standards are much more relaxed
- They are available to both first time and repeat buyers.
- Some loans do not allow the cancellation of mandatory mortgage insurance premiums.
- There will be higher overall borrowing costs.
- You are expected to provide more documentation to prove eligibility.
Government-sponsored mortgages are perfect for those who have little in the way of cash savings, less-than-clear credit ratings, and who cannot qualify for a conventional mortgage.
Fixed-rate mortgages have the same interest over the loan term, which may also mean that the periodic mortgage payments also stay the same. These types of mortgages come in terms of 15, 20, or 30 years, so they have quite the extended payment term.
- You can precisely budget month to month because the monthly principal and interest payments stay the same throughout the term.
- Interest rates of fixed-rate mortgages are typically higher than adjustable-rate mortgages.
- You will generally have to pay more interest costs.
- It will take longer to build home equity.
If you are planning to stay in the purchased home for an extended period, say for 10 to fifteen years, then a fixed-rate loan is for you.
The interest rates of adjustable-rate mortgages (ARM) fluctuate with the market conditions. Most ARMs have fixed rates for a portion of the term; then, it resets to a fluctuating interest rate for the rest of the payment period.
- The first few years would let you enjoy a lower interest rate.
- You can save money because of low-interest payments.
- Home values, however, may fall in the coming years. If you are planning to sell your house to refinance the loan, then you may have a harder time.
An example of an ARM is a 5/1 ARM, where for the first five years, the interest rate is fixed. The ‘1’ means that for every year after, the interest rate is adjusted. The adjustment is typically based on a standard index, such as benchmarks published by the Federal Reserve or the London Interbank Offer Rate (LIBOR).
With ARMs, you are exposed to some level of risk. ARM could let you save on interest payments if you are not planning to stay in your home beyond a few years.
These are the major types of mortgages, though there are more kinds based on the arrangement agreed upon by the buyer and lender on payments and interest rates.
Other Types of Mortgages
- In an interest-only mortgage, you only pay the interest dues and not the principal. Upon the end of the mortgage term, you have to pay the total amount in a single lump-sum.
- A standard variable rate (SVR) mortgage has an interest rate set by the lender. Each lender is free to choose their rate and set the adjustments. Technically, there is no SVR mortgage because it is essentially a mortgage beyond a deal period.
After a mortgage deal expires, many borrowers find that they are paying SVRs, which may not be the best interest deals for them.
- A discounted rate mortgage is when an SVR is discounted, after a set time. The lender can still change the interest rates, so your payments can change each period.
- In a flexible mortgage agreement, you can either underpay or overpay (pay less or more than what is required monthly), or even take a payment holiday (miss monthly payments). In exchange for flexibility, there is usually a higher interest rate than average.
Where Do I Find A Mortgage Offer?
Offers for many mortgages are aplenty. They are offered by banks, non-bank lenders, mortgage brokers, and many other financial institutions.
While shopping around for mortgage offers, know that not all mortgages are equal, and not all are for everyone. Some have more strict guidelines, while some are more lenient.
Determining the best lender for your situation will involve knowing the different kinds of mortgage, your overall credit score, financial capability, income, and employment.
To find the best mortgage deal for you, shop around for different lenders, and narrow down your choice to at least two. Compare the offers and particulars, and decide which one is the most advantageous to you.
Before submitting a mortgage application to anyone, remember these things:
- Check your credit score. Make sure that it is strong, if not flawless, or stellar, and that your credit report contains no errors.
- Know the type of mortgage you would want.
- Research, then compare the terms of the different lenders.
- After deciding on a provider, get pre-approved for the mortgage.
- Assemble your required paperwork.
After these, then it’s time to apply for the mortgage loan.
- Fill out the application form. Now that you have gotten the needed pre-approvals and made an offer for a house, it’s time to choose the provider you are going to settle with.
Phone lenders, visit their offices, and fill out the forms, either physically or online. Mortgage application forms roughly follow the format of the Uniform Residential Loan Application, with questions regarding debts, finances, employment, assets, and the property itself.
- Take a look at your loan estimates. There are loan estimates on the form itself, ask questions to your lender.
If all the numbers are dizzying, then taking a look at these numbers will make your task easier.
- Principal paid in five years
- Total cost in five years
- Principal paid in interest
- Annual percentage rate (includes interest rates, fees and other costs of the mortgage)
If the seller is not answering your questions or being vague, then look for another provider.
- You now have assessed your choices. After all of these, finally, choose a lender and commit.
- After these, the loan processing step happens. Everything you have provided will be scrutinized in this stage.
Be ready for more required documents and questions by the lender. Answering their requests will expedite the processing.
- If the loan examination and underwriting process succeed, then the loan will be cleared to close. The lender will then send you the Closing Disclosure form showing the final costs of your mortgage in detail.
Which is better? Renting or buying a home?
The decision will differ for everyone because circumstances and situations vary. There are benefits to both.
Any deal could be better, depending on the loan you choose, and how long you are going to stay in the same house.
What are the benefits of a home purchase?
There are compelling financial benefits to buying a house, such as the tax savings you may enjoy, seeing as interest payments on mortgages are generally tax-deductible (talk to your tax advisor about this).
Another is buying your own house will build your home equity, as opposed to renting.
How much can I borrow?
An individual’s financial situation varies, and what you are comfortable with borrowing will not always be the same as others. Generally, the maximum amount you can borrow depends on factors such as:
- Debt-to-income ratio
- Unrestricted cash in hand and bank
- The price of the property you will buy
- Your credit rating
Prequalification vs. Pre-approval. What’s the difference?
Prequalification entails giving the lender some of your financial information, such as your assets and income, along with a credit check. The lender will assess the information you provide and will give you an estimate of the amount they can let you borrow.
Note that getting prequalified does not guarantee that your mortgage loan request will be approved.
To get pre-approved, the lender will need financial papers such as bank statements, paycheck stubs, financial statements, W-2 forms, or whatever forms they request of you. These documents, along with a more formal credit investigation process, will help verify your financial capabilities and ultimately get your loan approved.
Should I get pre-approved or prequalified before a home purchase?
It is a good idea to get pre-approved or prequalified before buying a home, even if it is not required. Many real estate agents will take you more seriously if you have been pre-approved.
Furthermore, by going through these series of steps, you will have an idea of the price range you can afford from the borrowed funds.
What is loan-to-value (LTV)?
Lenders will look at your LTV ratio, which is usually expressed as a percentage. It is the amount of the loan divided by the purchase price or fair value of your home.
For example, the price of the home you chose is $500,000, and your loan request is for the amount of $200,000, then the LTV is 40% (200,000/500,000).
What does “locking a rate” mean?
When a lender locks your rate, he guarantees that the interest rate will not move for a set time. During this period, you are not affected by fluctuations in the market.
Locking a rate, in a way, will entail costs because a lender will pay to “reserve” your rate. The longer the lock-in period, the higher the costs of the mortgage.
The word mortgage originates from Mort, a Latin word which means death. So a mortgage may mean that “this debt is until death.”
While it sounds ominous, mortgages are more flexible than what its origin implies. Many of them do not run for the rest of your life.
But while flexible, they are still substantial legal commitments that prompt you to repay your home loan. But if in exchange for periodic payments you get your very own home that may last for years to come, then that is a worthy debt, indeed.
Have you recently taken out a mortgage? Do you have any further questions?
Place your thoughts in the comments section below.
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