How does a mortgage work?

How does a mortgage work?

Before we go into the depths of the necessary explanations, let’s answer the most basic question. What is actually a mortgage?

A mortgage is a loan used to finance your home purchase, and it is the most used option in contrast to buying a house in a lump sum.

 In other words, you borrow the money you need and agree to repay it to the lender in an arranged period of time, usually 30 or 15 years.The repayments can be made at different intervals, although are typically done monthly, and accounted for a family or individual budget.

Every payment is made of a “principal” portion, which refers to the original amount you borrowed, and interests, that are given to the lender for the service it is providing. However, that wouldn’t be enough to consider just these two components: you will have also to pay property taxes, fees, and home insurance, which can be escrowed into the mortgage account.

By definition, a mortgage is a secured loan, which means if you can’t repay what you are borrowing, the house itself becomes the reference asset to fill the debt toward your lender, and it will be taken from you to be sold, through a legal procedure (foreclosure). In fact, until your mortgage is fully paid, the property is legally not considered 100% yours, but shared with your lending company, being it a bank or a private servicer.

These are the main types of mortgage available in the U.S.:

– Fixed-rate conventional mortgage (aka FRM): the interest is locked for the entire mortgage duration, which is typically 30 or 15 years. A higher rate will be applied to the longest term. This kind of mortgage has usually precise eligibility requirements, with some differences depending on lenders: the most common are a credit score of 620-640, a 3.5% minimum down payment, and a certain ratio between your pending debts and annual income (DTI).

– ARM (Adjustable-Rate Mortgage): with this mortgage, you will have an introductory period of a few years, typically 3, 5, 7, or 10 years, where you are charged a lower than standard fixed-rate. Once this period expires, the remainder of the loan period will have a variable rate, that can go either up or down, following the market fluctuations.

– Jumbo loan: a mortgage that is used for houses more than $510,400 worth, that is the considered limit for a conventional loan.

– FHA (Federal House Administration) loan: this is a kind of federal-backed mortgage designed to make a home purchase more affordable to people with incomes considered to be low or moderate. It comes with a lower credit score requisite, usually in the range of 580-600, and lower rates, but at the price of a greater cost in the long run.

– VA (Veterans Administration) loan: a mortgage tailored to people currently or formerly serving the military forces, and their spouses. The benefits of this loan are possible exemption from the payment of PMI, which is discussed later, and eligibility for no down payment, which means 100% of home’s value financing.

Understand the typical terminology of a mortgage

 

– Home purchase price: this is the total amount you can borrow. The limits on allowed amounts for every type of mortgage are federally regulated. A down payment is required in most cases, which means you won’t finance the whole price of your house .

– A down payment is called the portion of the home purchase price you will make in advance toward your mortgage. In most cases, lenders will require to pay at least 20%: if that was too much for you, you will have to pay a yearly insurance fee, namely the PMI, in order to keep their investment (your house) protected. Let’s say your house is worth $225,000: assuming a 20% down payment, it would mean a minimum of $45,000 upfront. Beyond that percentage limit, a higher down payment has the advantage to decrease the loan duration and potentially lower the applied interest rate.

– Interest rate is the percentage amount the lender will set for borrowing money to finance your home purchase. Interests vary both depending on lenders and are subordinate to the market conditions. Typically, the rate is fixed and set at beginning of the mortgage: as the payments are made, the amount of principal will diminish over the course of the loan.

– APR (Annual Percentage Rate) isn’t the same as the interest rate but will include service fees and other charges, of a kind and extent depending on lenders. Besides, annual interest is diverse from interest applied monthly. For instance, a 4% annual interest rate equals to 0.33% of monthly interest (APR divided by twelve), so for the mentioned $225,000 house, it would equal to $750 per month. However, mind that there will be a slight adjustment of APR vs the fractioned installments. The total interests are usually covered in the earlier years of a typical 30-yrs mortgage.

– The loan term is the established duration of the mortgage, the time within which you have to fully repay it, and that can be manipulated during the loan lifetime, by making extra-payments. The most signed mortgages last 30 or 15 years, both intended with a fixed interest rate; other possible terms to choose from are 10, 20, or 25 years, based on a certain lender’s availability.

Most homeowners decide to undergo a 30-years mortgage because it is more affordable in the short term. Monthly payments are way easier than with a 15-year term so that they can budget in other recurrent expenses. Many experts agree that no more than 25-28% of one’s gross income should be put into house expenses.

On the other hand: while the installments of a 15-years mortgage are, of course, more expensive, interest rates will be lower and last half the time, so you will get big savings in the long run: several tens of thousands of dollars can be generally spared.

– PMI (Private Mortgage Insurance)is typically imposed in a traditional mortgage if your down payment was below 20% of your home value, and it will be estimated as a percentage of your entire loan, in proportion with the deficit. A PMI can be anywhere between 0,5 and 1% of the loan, and largely around these limits. It will be mainly based on your credit score, which considers your payments history, and how many pending debts you have: the better your financial status, the lower the PMI. It applies annually until your payments reach 80% of the mortgage balance.

– Closing costs: these are fees that will be charged for both the services related to the home purchase and to the processing of the mortgage agreement. They mainly include: home appraisal and inspection fees, title fees, loan origination fee, application fee, attorney’s fee, broker’s fee (in case you are working with a broker), mortgage points. If your house is in a community of residences, you will also pay HOA fees. Altogether, they will factor anywhere between 2% and 5% of the loan amount.

– Points are optional fees that you may want to pay to discount your interest rate: each point costs 1% of the mortgage amount. This is clearly advantageous if you are taking a long-term loan, which means living in your house for 20 or 30 years, and you can sustain this upfront cost to save in the long term

How is the mortgage process like?

 

It is a common conception that getting a mortgage is a challenging and not easy task. However, that’s not necessarily the case, if you understand in advance what are the critical steps.

First and foremost, you should seriously assess your home affordability: that’s why a calculator comes to hand. Then, having a ballpark estimate of how much you are able and disposed to spend, you can start a home tour: you’ll know if a certain house can be actually purchased, or rather just dreamt of.

Once you have narrowed your decision by price and fit of the house to your preferences, you have to find a mortgage lender. When you get a mortgage through a bank, there will be usually multiple meets with an officer, discussions around your financial situation, and lots of paperwork and waiting times.

Fortunately, there are a variety of lenders that, by operating online and using web technology, can provide a more slender process. Regardless of your choice, there will be common steps to take.

The next is to actually apply for a mortgage offer. There is usually a pre-approving phase if you chose a bank, while a pre-qualification stage whether you went through an online application: you are presented with a form that generally asks you to specify a few information about yourself and your financial situation, including employment status and income. At this stage, a credit check will be conducted by lenders to discover your credit score and history, where it is basically shown if and to which extent you are able to manage payments of outstanding debts.

The submitted information is examined by the lender, who will give you a first-approval response: the result is one or multiple loans offers with estimated rates, terms, and a summary of monthly payments, in some cases. You are not still obliged to take any action at this point, but if you do, you will have to submit some documentation constituting proof of what you declared in the first place. The basic documentation involved is usually comprised of the following papers:

  • Recent pay stubs ( 1099 forms or other valid payment proof if you are self-employed)
  • Tax returns of at least past 1-2 years
  • Recent bank statements
  • Renter paychecks (only if you were renting a house)
  • Self-declaration of any negative issue in your credit history.

The lender in question will have to further investigate your credit history: a “hard check” will be made, which means a report inquiry from one of the credit bureaus. This is done to assess your capability of handling the repayments of mortgage installments, based on your past financial behavior.

Contextually to the verification of your application submission, a home appraisal will be conducted: the commissioner will check that the actual home’s value matches with your purchase price, and that there isn’t any lien on the property. This practice is to safeguard both you and the lender.

Then, if everything went right, you will get the actual approval. With this, two important papers will be generated: the “loan estimate” and the closing disclosure. The former is given to you first, then some days later you will receive the final disclosure, which will state and confirm all the terms and conditions of your mortgage. This happens in a matter of 6 days as average (depending on lenders). You will have to read very carefully all the terms and conditions before signing. Once done, it may take one or two weeks to be funded, largely depending on the lender involved.

Mind that the entire process can last, at the very least 30 days. However, you may want to consider a window time of 60 days, because of potential delays that can occur during the several phases of this process. On average, it’s safe to consider 45 days, according to many authoritative sources we were able to find.

A crucial factor when choosing a mortgage is to put in perspective its overall cost: financial experts recommend to plan your expenses over the long haul. A mortgage is an amortized loan: because the cost is spread over several years, and a certain interest applies, it’s best to know in advance how much you’ll pay in the future. With even small extra payments, you’ll able to save thousand dollars. To have a better comprehension of this matter, with practical examples, we suggest you to take a look here:  https://www.usbank.com/financialiq/manage-your-household/manage-debt/understanding-the-true-cost-of-borrowing.html

Online lenders tend to have more streamlined applications than banks, in some cases entirely online, more lax requirements, and a quicker funding timeline. Both banks and alternative lenders have flexibility in their offers, and are committed to create a painless experience, providing convenience. Check out our selection to find the most suitable lender for you.