How does a mortgage work?

How do mortgages work?

A mortgage is a type of loan that can help you purchase a home or property. If you can’t repay that loan, the lender can take away your home.

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When you take out a mortgage, you receive the money to purchase the home. With a mortgage, you have a set number of years—for example, 30 years—to repay the loan with interest. Interest allows the lender to make money off the loan. Your mortgage’s interest rate is determined by several factors, including:

• Your credit score
• The location of the home you’re buying
• The price of the home you’re buying
• The loan amount
• Your down payment (putting down a bigger down payment can get you lower interest rates)
• Your loan terms
• The type of mortgage you’re accepting
• The interest rate type (fixed-rate or adjustable-rate)

Each month, you must make a mortgage payment. Your mortgage payment consists of principal, interest, taxes, and insurance (PITI). Here’s a breakdown of what PITI means:

• Principal: the amount of your loan balance that you must pay before interest is included
• Interest: the monthly interest rates your lender requires based on your mortgage.
• Taxes: Property taxes are a part of your monthly payment. The amount of taxes you pay will depend on your home’s location and its value.
• Insurance: Homeowner’s insurance is required by lenders. This protects the lender if something were to happen to your home.

Missing a mortgage payment can affect your credit score. You may also have to pay late fees. If you miss four or more payments, the lender can foreclose your home.

Once you pay off your mortgage, you own 100% of your home.

Types of mortgages

Mortgages aren’t one-size-fits-all loans. There are a variety of mortgage types available. Understanding the different types of mortgages will help you choose the right one for your financial situation.

Conventional mortgages

Conventional mortgages are loans that aren’t offered or backed by the government. You have to get them from a private lender, like a bank. This is the most popular type of mortgage, but it’s also the most difficult to qualify for. To get a conventional mortgage, your credit score and debt-to-income ratio are considered. If you’re interested in a conventional mortgage, it’s important to note that you’ll need at least a 3% down payment on your home.

Fixed-rate mortgages

In a fixed-rate mortgage, your interest rate stays the same for the entire duration of the loan. Fixed-rate mortgages are usually either 15 or 30-year loans. Having the same interest rate for the duration of the loan is appealing for many people because it makes budgeting easier.

Adjustable-rate mortgages

Adjustable-rate mortgages (also known as ARMs) are 30-year mortgages with changing interest rates. Your interest rate will vary depending on the market.

With an adjustable-rate mortgage, you’ll start with an introductory period. During this introductory period, your interest is fixed. Introductory periods usually last for five, seven, or 10 years. For example, if you choose a 5/1 ARM loan, you’ll have fixed interest for the first five years of the loan, then your interest rate will vary each year for the next 25 years. The benefit of adjustable-rate mortgages is that you’ll experience lower interest rates in the introductory period. However, the market can be unpredictable, so your future interest payments can vary greatly.

Government-backed mortgages

Government-backed mortgages are insured by the federal government. These mortgages can benefit those with low credit scores or low income. To get a government-backed mortgage, you don’t apply for the loan through the government—you’ll need to apply through a private lender. The government simply covers the mortgage insurance costs for you in case you can’t pay back the mortgage. The three types of government-backed mortgages include:

• FHA loans: When you get an FHA loan, it’s insured by the Federal Housing Administration. Those with a minimum credit score of 580 can get an FHA loan by putting a 3.5% down payment on the home, or if you have a minimum credit score of 500, you can qualify by putting at least a 10% down payment on the home.
• VA loans: These loans are only available to veterans and service members. VA loans offer lower interest rates, and you can purchase a home with $0 down.
• USDA loans: These loans are insured by the U.S. Department of Agriculture. These loans help lower-income individuals purchase a home in rural areas. No down payment is required.

Second mortgages

If you already have equity in your home, you can use your equity and borrow against its value. Home equity lines of credit (HELOCs) and home equity loans are a type of second mortgage. Some people use second mortgages to make renovations to their home or to buy a second home.

Reverse mortgages

Those who are 62 and older can apply for a reverse mortgage. This type of mortgage allows homeowners to borrow money using the equity they have in their home. You only have to pay back the mortgage once you move.

Steps to get a mortgage

1. Figure out how much home you can afford. This includes determining your debt-to-income ratio, which lenders will examine to make sure you can pay back the loan.
2. Do your research. Make sure you choose the right type of loan for your financial situation.
3. Fill out an application. Once your offer on your home has been approved, you should apply for a mortgage with a few different lenders. This will help you figure out which lender to borrow from. Make sure you have the right documents before you apply—you’ll need your tax returns from the past two years, proof of income, bank statements, your Social Security number, and photo ID.
4. Review your options and choose a lender. Now that you have multiple options in front of you, you can choose the best lender for your financial position and close on your home.

With proper planning, finding the right mortgage doesn’t have to be stressful. After you secure a mortgage, learn how paying off your mortgage early can lead to financial freedom.