We’ve hit the home stretch in our Guide to Homeownership, and it’s time to talk about that pivotal final piece: the mortgage. First, if you missed any of our previous articles in this series, be sure to read them, as they walk you through a few essential steps to follow before applying for a mortgage.
If you’re pre-qualified, pre-approved, and ready to make an offer on a home, let’s not waste any time. Here’s what you need to know about mortgage loans.
How a Mortgage Works
Since a home is a relatively costly purchase, mortgages make it possible for more people to buy homes. The alternative is to pay all-cash for a home, an option that is not on the table for many buyers. A mortgage loan allows a home buyer to purchase a home for a fraction of the cost upfront, and then pay the remaining cost (plus interest) over time. The home is collateral for the loan, meaning that if the buyer fails to make payments, the lender can seize the home through a process called foreclosure.
Terms to Know
It’s helpful to get familiar with the main components of a mortgage so that you can speak the language – or at least understand it – when communicating with lenders. The most important mortgage terms to know are:
Interest – The percentage rate you will pay in order to borrow the money (example: 5%). Interest varies based on the amount borrowed, financial or credit rating, lender, and type of mortgage.
Principal – The original amount of money borrowed and the amount owed as payments are made.
Amortization – The schedule by which the loan is repaid in incremental payments of principal plus interest through the maturity date.
Term – The length of time it will take for the loan to be repaid based on amortization, which is typically 30 years for 1st mortgages.
Down Payment – The cash amount up front that you use to buy the home with a mortgage used to pay for the remaining cost.
Origination Fees – Charges that are frequently charged by the lender to provide you the loan, such as application fees, credit reports, appraisal, and other fees associated with the mortgage processing and approval.
Mortgage Insurance (PMI) – A policy required by the lender to help offset losses in the event of mortgage default by the borrower.
Fixed vs. Adjustable Rate
The traditional mortgage is a 30-year fixed rate loan. This means that the interest rate is “locked in” and will not change over the course of the loan. The length of the mortgage is 30 years, after which the lender is scheduled to have fully paid off the loan. If you expect to live in your new home for the foreseeable future, this is usually the safest bet.
A 15-year fixed rate loan has the same stability and predictability of a 30-year fixed-rate loan but is paid off in half the time. Because the loan is paid off more quickly, interest rates in 15-year fixed mortgages are usually lower than those in 30-year fixed mortgages, however, total payment amounts are higher.
Adjustable Rate Mortgages (ARMs) offer lower interest rates that “adjust” to a predetermined market rate versus a fixed rate for the life of the loan. There are a wide range of ARM type of loans. Also, if you don’t plan to live in your new home for more than a few years, an ARM might be right for you.
Please note that this is only a quick guide and should not be relied upon solely. There are many different types of mortgages within these two main groups, as well as special loan programs such as FHA loans and VA loans. Be sure to consult your financial professional and/or realtor to decide which type of mortgage suits your needs, qualifications, and how much you can comfortably afford.
Your credit score and debt-to-income ratio are the key factors that will determine your mortgage. Even after being pre-qualified, it’s a good idea to check your credit score again before shopping for a mortgage. You should also calculate your debt-to-income ratio by subtracting your monthly debt from your gross monthly income. Having these figures in hand, along with your pre-approval letter, will enable you to keep your expectations realistic and approach lenders with confidence.
Once you have compared your options, it’s time to apply! Submit an application with your preferred lender, and expect the process to move very quickly barring any holdups. When the approval is confirmed, you will sign the mortgage at closing and finally own the home you’ve worked so hard to attain. Congratulations!
We’re Here to Help
Credit.org is there with you every step of the way on your journey to homeownership. If you find our articles helpful, consider attending one of our home buyer education workshops in Southern California, take our online course, where we equip buyers with the tools and resources to successfully purchase a home, or take our mortgage readiness quiz.