By Cathie Ericson
May 15, 2022
What is a mortgage? In a nutshell, a mortgage is a loan that enables you to cover the cost of a home. Since you probably don’t have hundreds of thousands of dollars lying around, a mortgage loan makes it possible to purchase real estate by fronting you the money.
From there, you pay back the loan via monthly payments that last over the course of years or even decades. Consider it the biggest, longest, most life-changing IOU you’ll ever get!
If you’re a newbie to buying real estate, you may be confused by mortgage basics like the following: What do you need to do to persuade a mortgage lender to give you a home loan? And how do you pay it back? Read on for tips on how to find a mortgage and the different types you’ll need to consider.
Mortgage basics: 3 terms you’ll need to know
When you apply for a mortgage loan to buy real estate, here are the main terms you’ll need to know:
- Down payment: This is the money you must put down on a house to show a lender you have some skin in the game. You’re best off making a down payment totaling 20% of the price of the home (e.g., $40,000 on a $200,000 home), because this will allow you to avoid an extra fee called private mortgage insurance (PMI). But if you don’t have a chunk of change that large lying around, never fear—certain lenders will accept smaller down payments like 10%, 5%, or even 0% based on your circumstances. Also know that most loans entail your paying upfront closing costs—additional fees that come with processing your home loan.
- Principal: This is the amount of money that you are borrowing and must pay back, which is the price of the home minus your down payment (taking the above example, you’d subtract $40,000 from $200,000 to get a principal of $160,000).
- Interest rate: Lenders don’t just loan you the money because they’re good guys. They stand to make money off you, too, since you pay them back plus interest—a percentage of the money you borrow. The interest rate you get will vary based on your lender and your own personal circumstances, so it pays to shop around for the best rate.
Mortgages are typically paid back gradually in the form of a monthly mortgage payment, which will be a combination of your paying back your principal plus interest (the one exception to this is an interest-only mortgage, where your monthly payment is interest only for a certain amount of time).
Another fee that might be baked in this mortgage payment is money to pay property taxes and home insurance premiums. These funds get set aside in an escrow account that your lender will use later to pay these bills as they come up.
When to get a mortgage
Believe it or not, you should shop for a mortgage before you start hunting for a house. It might not be as fun as checking out open houses, but it’s way more important.
You’re looking to get a mortgage pre-approval, an in-depth process where a lender will check your credit report, credit score, debt-to-income ratio, loan-to-value ratio, and other aspects of your financial profile. This serves two main purposes: First, it will let you know the maximum purchase price of a home you can afford.
Second, and more important, mortgage pre-approval shows home sellers that you are serious about buying a home, which is particularly crucial in a hot housing market, says Chantay Bridges with TruLine Realty in Los Angeles.
Just know that pre-approval is different from pre-qualification. Mortgage pre-qualification entails a basic overview of a borrower’s ability to get a loan without the paperwork to back it up. As such, pre-qualification is an easy and fast way to get a ballpark figure of what you can afford, but it’s no guarantee you’ll get a loan with this lender. So, don’t get your home-buying hopes up unless you’re pre-approved—that’s the real McCoy!
Another easy first step? Before you start browsing online listings or visiting open houses, plug your info into an online home affordability calculator, which will give you an idea of how large your mortgage can be.
Mortgage basics: Where to get a mortgage
Here are the main places you can get a mortgage loan:
- Banks: This can be a great place to start if you have an institution you work with that already knows you and your finances. That said, banks typically have only a few loan options so it’s smart to talk with your banker, and then compare the programs with a couple more options before settling on one.
- Nonbank lenders: These companies (e.g., Quicken Loans or PennyMac Financial) are often willing to work with borrowers that banks avoid due to their riskier profile. If you have a poor credit history or some other blemish in your financial past, you may have better luck landing a loan with nonbank lenders, which now provide more than half of all loans.
- Mortgage brokers: Mortgage brokers are specialists who can help walk you through a much wider variety of options to find a loan that’s right for you. They often work with many different lenders so they can help identify different rates and programs based on your specific situation.
Mortgage basics: An introduction to loan types
There are a surprising variety of mortgage choices available. So how do you figure out which mortgage is right for you? Here are the main types of home loans to consider:
- Fixed-rate mortgage: A fixed-rate mortgage is just what it sounds like: The interest rate will not vary over the life of the loan. While the interest rate on a fixed-rate loan might be slightly higher overall, a fixed-rate mortgage is a good choice for buyers who like the certainty of knowing their monthly payment will never go up.
- Adjustable-rate mortgage: An adjustable-rate mortgage (ARM), also called a variable-rate mortgage, will start with a lower interest rate for the first few years, and then that interest rate (and monthly mortgage payment) will “adjust” after a predetermined period (typically five years) based on market indexes. As such, a home buyer enjoys an initially lower mortgage payment. However, this type of loan can feel risky if interest rates rise a lot. Although there is a cap that can prevent too much damage, it’s still smart to check your loan terms and consider your personal situation carefully to determine if an adjustable-rate loan is right for you. Another option? You may be able to refinance an ARM before the rate adjusts. A refinance is where you renegotiate the terms of your loan later on, which could enable you to switch to a fixed-rate mortgage or other type of loan.
- FHA loan: A Federal Housing Administration loan, typically called an FHA loan, requires a down payment as low as 3.5%. As such, these loans are particularly great for first-time home buyers with meager savings for a down payment or a less than stellar credit score. The catch? These loans require you to pay for mortgage insurance.
- VA loan: If you’ve served in the United States military, a VA loan from Veterans Affairs can allow a qualifying home buyer to score a mortgage with no money down, no mortgage insurance requirements, and a great mortgage rate in terms of interest. The details: To qualify for a VA loan, you’ll need to have served 90 days consecutively during wartime, 180 during peacetime, or six years in the reserves.
- USDA loan: U.S. Department of Agriculture loans (USDA loans) are designed for families in rural areas. The government finances 100% of the home price (no down payment!) provided you qualify. The mortgage rate in terms of interest may be favorable, too.
How long do home loans last?
Mortgage loans have different “terms,” which means how long a borrower will make monthly payments to whittle the loan amount down to nothing. The two most common terms are 30 years and 15 years. The payment on a 15-year loan will obviously be higher each month you have it, but ultimately a shorter-term loan will save you money in interest, since the life of the loan lasts for a shorter time.
How to shop for a mortgage
Since loans come with different interest rates, time frames, closing costs, and more, it behooves a prospective borrower to shop around, much like you’d compare different laptops before settling on the best one for you.
And, since any interest rate offered by a lender might fluctuate daily—which will have a direct impact on what you ultimately pay—home buyers might also want to do all their research during the same time period as much as possible, says Brandon Haefele, president and CEO of Sacramento-based Catalyst Mortgage and a member of the board of directors of the California Mortgage Bankers Association. That way, you know you’re making a valid comparison.
Working with a qualified (and patient) loan adviser can help you sort out your options. This pro can help you determine which type of loan is best for your situation and walk you through what your payments would be for different types and terms of loans. The loan adviser will also break down the various closing costs that come with each loan.
By understanding what a mortgage is and all the different types available, you can make the choice that’s right for you and your budget.