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- A mortgage is a type of loan for buying a home; a company lends you money, and you pay back the lender in monthly installments for a predetermined amount of time.
- A conventional mortgage requires a certain credit score, down payment, and debt-to-income ratio; a government-backed loan has more lenient requirements.
- You'll choose between a fixed-rate mortgage, which locks in your rate for the entire life of your loan; or an adjustable-rate mortgage, which offers the same rate for the first few years, then changes periodically.
- You can receive a mortgage by getting your finances in order, shopping around for lenders, and applying for approval.
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What is a mortgage?
A mortgage is a type of loan. A financial institution lends you money to buy a home if you can't pay completely in cash, and you pay the company back over an agreed-upon amount of time.
A mortgage is a secured loan. With a secured loan, you put an asset up as collateral in case you fail to make payments.
In this case, the collateral is your house. If you don't make mortgage payments for an extended period of time, then the financial institution can take your home from you, or "foreclose."
This is opposed to an unsecured loan, such as a student loan. If you don't make payments on an unsecured loan, a company can take legal actions. But they don't take physical property from you as they would with, say, a mortgage or car loan.
How a mortgage works
When you're ready to buy a home, you may not have enough liquid cash to buy the home. You might have enough cash for a down payment, but for the rest, you'll need a mortgage from a lender to buy the home.
Once you've chosen a lender, the two of you agree on an amount of time you'll spend paying back the loan, month by month. You might choose 15, 20, or 30 years, for example.
The lender will also tell you what your interest rate is. A lender may offer you a lower rate if you have a good credit score, more money for a down payment, and/or a low debt-to-income ratio.
There are consequences if you don't make mortgage payments on time each month. You'll pay late fees, and the lender sends you a notice of default. If you still don't make payments after receiving the notice, then the lender starts the foreclosure process, and you can lose your home.
Types of mortgages
There are several types of mortgages, but many can be broken down into two categories: conventional or government-backed mortgages.
A conventional loan is a type of mortgage offered by a private lender, or by federal companies Fannie Mae or Freddie Mac. It's not secured by the government.
Conventional mortgages typically require a good credit score and at least a 3% down payment. But during the coronavirus pandemic, your credit score and initial payment may need to be higher.
There are two basic types of conventional loans: conforming and non-conforming.
- Conforming loan: The loan amount is within the limits set by the Federal Housing Finance Agency (FHFA). The FHFA sets the limit for conforming loans every year, and in 2020, the limit is $510,400 in most parts of the US. In areas with a higher cost of living, such as Alaska, Hawaii, Guam, and the US Virgin Islands, the limit has been bumped up to $765,600.
- Non-conforming loan: A non-conforming loan doesn't meet standards set by the FHFA. For example, a jumbo loan exceeds the borrowing limit set by the FHFA. You'll need a higher credit score, bigger down payment, and lower debt-to-income ratio to qualify. You'll also pay a higher interest rate.
Government-backed mortgages are issued by the federal government. They typically have looser requirements surrounding credit scores, down payments, and debt-to-income ratios.
There are three common types of government-backed loans:
- Veterans Affairs (VA) loan: You may qualify if you're affiliated with the military
- United States Department of Agriculture (USDA) loan: You may qualify if you're buying a home in a rural or suburban part of the country.
- Federal Housing Administration (FHA) loan: An FHA loan isn't for a specific group of people, like VA and USDA loans are. But it comes with some restrictions, such as minimum property standards that could prevent you from buying a home that isn't in great condition.
Once you've decided between a conventional and government-backed loan, you have another decision to make. Do you want a fixed-rate mortgage or an adjustable-rate mortgage?
A fixed-rate mortgage locks in your rate for the entire life of your loan. Although US mortgage rates will increase or decrease over the years, you'll still pay the same interest rate in 30 years as you did on your very first mortgage payment.
Fixed-rate mortgages are often good options if you plan to live in the home for a long time. Keeping the same rate for years gives you stability.
The most common fixed-rate mortgage term is for 30 years, but you can choose a different length.
An adjustable-rate mortgage, or ARM, keeps your rate the same for the first few years, then periodically changes over time — typically once a year.
With an ARM, your rate stays the same for a certain number of years, called the "initial rate period," then changes periodically. For example, if you have a 5/1 ARM, your introductory rate period is five years, and your rate will go up or down once a year for 25 years.
ARM rates typically start lower than fixed rates, so they could be good if you plan to move before the initial rate period ends. This way, you'll benefit from a lower rate without dealing with an increased rate later.
What goes into a mortgage payment
You'll make monthly payments on your mortgage, and various expenses make up a monthly payment.
The principal is the amount the lender gives you upfront. If you borrow $200,000 from the bank, then the principal is $200,000. You'll pay a little piece of this back each month.
When the lender approved your mortgage, you agreed on an interest rate — the cost of your loan. The interest is built into your monthly payment.
The amount you pay in property taxes depends on two things: the assessed value of your home and your mill levy, which varies depending on where you live. Your property taxes can add hundreds or even thousands to your mortgage payments annually.
Homeowners insurance covers you financially should something unexpected happen to your home, such as a robbery or tornado.
The average annual cost of homeowners insurance was $1,211 in 2017, according to he most recent release of the Homeowners Insurance Report by the National Association of Insurance Commissioners (NAIC).
Private mortgage insurance
Private mortgage insurance (PMI) is a type of insurance that protects your lender should you stop making payments. Many lenders require PMI if your down payment is less than 20% of the home value.
According to insurance-comparison website Policygenius, PMI can cost between 0.2% and 2% of your loan principal per year. If your mortgage is $200,000, you could pay an additional fee between $400 and $4,000 per year until you've paid off 20% of your home value and no longer have to make PMI payments.
How to get a mortgage
If you've decided you want to apply for a mortgage, you can follow these steps.
Get your finances in order
Having a strong financial profile will a) increase your chances of being approved for a loan, and b) help you score a lower interest rate. Here are some steps you can take to beef up your finances:
- Increase your credit score by paying down high-interest debt and making payments on time. A score of at least 700 will help you out — but the higher, the better.
- Save more for a down payment. You don't necessarily need a 20% down payment to get a good rate, but the more you save, the better your rate will likely be. If you don't have much for a down payment right now, then it could be worth saving for a few more months, since rates are likely to stay low.
- Lower your debt-to-income ratio. Your debt-to-income ratio is the amount you pay toward debts each month, divided by your gross monthly income. Lenders want to see a debt-to-income ratio of 36% or less. Consider paying down some debts to get a lower ratio.
You shouldn't necessarily just apply with your personal bank or with the lender your friends have used. Shop around for a lender that will offer you the lowest rates, charge you the least in fees, and make you feel comfortable.
If you're early in the homebuying process, apply for prequalification and/or preapproval with several lenders to compare and contrast what they're offering.
Choose the home and apply for approval
Once you've chosen the lender you want to work with, choose the home you want to buy. After selecting the home, apply for a mortgage approval.
The lender will check back in with your finances, then set up an appraisal for the home to make sure everything is above board. If everything passes the test, then it will you approve you for a mortgage.
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