It's spring and I can always tell because of a) the weather and b) because of all the homes in the neighborhood that pop up for sale each season. For the first time buyers who come to this site, I wanted to dedicate an entire post to breaking down what a mortgage is and how it works when buying a home.
Back in February (pre-baby), after years of back and forth about it, I actually got my real estate license. It was an eye-opening experience in a lot of ways: I was shocked at how little the folks in my class knew about real estate financing, and even after writing about real estate and prepping your finances for a home purchase for the last seven years, I even learned a few new things as well!
First, What is a Mortgage?
A mortgage is a type of loan that allows people to purchase a home. It consists of a legal document that gives the lender the power to take the mortgaged property if the person taking the loan doesn’t pay. Before you can get funding, you’ll also have to sign a promissory note, essentially legally binding your promise to pay the funds you’ve borrowed. (You sign the promissory note at closing, too.)
After closing, a copy of that mortgage is filed in county records as a claim against the home. Once the mortgage is paid in full to the bank, the bank writes a “satisfaction of mortgage” document saying you've paid off the house and now own it outright.
Pro Tip: Each state is different: in some states, you get the deed to the home right away, in others, (like in GA) you don't actually get the deed to the home until the mortgage is paid in FULL.
How Does a Mortgage Work?
Mortgage payments are made up of several things. Like most other loans, they’re made up of principal and interest (and in some instances, your taxes and insurance on the home are baked into this monthly payment, too.)
The principal is the original amount you owe subtracting the payments you’ve already made. For instance, if you have a $300,000 mortgage and you’ve paid $30,000, your remaining principal is $270,000.
The interest on the loan is how much you agree to pay the lender for borrowing the money. You'll get this interest rate quote when you initially shop for a mortgage. Right now, as I'm writing this article, mortgage rates sit between 3-4%, some of the lowest they've ever been. Using the $300,000 mortgage example above, this means you can expect to pay around 3% in interest on your mortgage balance each year.
At first, most of your payments will go towards interest. However, as time goes on, that’ll change and you’ll start paying on the principal
Again, when we say ” mortgage payments” we typically are talking about the full monthly payment which covers the principal, interest, taxes, and insurance.
Most lenders require you to get homeowners' insurance, and this is always a good idea as getting this insurance will protect you should anything happen to your home through circumstances beyond your control.
Pro Tip: Depending on how much you put down for your down payment, (if it's less than 20% in most cases) some lenders will require you to sign up for mortgage insurance. This protects them, should you not be able to make the payments as expected.
Are there different types of mortgages?
Oh, yes. Just like there are different types of student loans (federal vs. private) and personal loans, mortgages also come in many different flavors. After all, these are financial products – it's not a “one size fits all” kind of deal.
First, mortgages come in fixed or adjustable rates.
- Fixed rates mean the interest rate is set and does not change over time.
- Adjustable rates can change depending on several factors. These rates are tied to an index and margin, and when this changes, your rates will change as well. Factors that can influence changes in adjustable-rate mortgages include national economic health and Federal Reserve rates.
Conventional rate mortgages, or 30-year mortgages, last for 30 years. They have a fixed rate for the life of the loan and often come with lower monthly payments compared to 10 or 15-year loans.
Mortgages can also come in different terms, which means the amount of time you have to repay the loans. Long term mortgages range from 10-40 years, while short term ones are typically 10 or 15 years. The longer the mortgage, the lower your monthly payment, but 15-year mortgages mean you'll pay less in interest and pay off your home faster.
Mortgage loans can also differ by who is offering them. Most banks and online lenders offer mortgages, but there are also government-insured loans like FHA loans and VA loans. (I used an FHA loan to buy my first home!) There are dozens of other types depending on the type of property you’re looking to buy. .
How is a Mortgage Different From any other type of Loan?
Here's a recap of what we just covered:
- Mortgages are only used for the purchase or refinance of a home or other piece of real estate.
- They include much more than principal and interest, and have different regulations and stipulations attached.
- Mortgage lenders also specialize in what they do. Many of them will only offer home loans and homeowner’s insurance.
- Another key difference from loans is that with mortgages you have to pay property taxes. These taxes are calculated based on the land value, and the value of the home built on the land.
What Do I Need to Get a Mortgage on a Home?
Regarding financing, Depending on what type of mortgage you want, you’ll have different requirements for qualifying for the mortgage. At a minimum, here's a broad overview of what a lender will look at:
- One of the most important factors is your income. Lenders want to ensure you’re capable of paying off the loan, and they need a way to prove how much you make. Lenders will also want you to have a stable and reliable income. To do this, they need to see proof of income, like pay stubs, W-2s, and other documentation that shows you earn a good income.
- Most lenders also require you spend only 28% or less of your pretax income on housing. The amount of income you have will then limit the size of the mortgage you can qualify for.
- You’ll also need a good credit score . Most rates will require you to have a minimum credit score of 620. Government loans can allow for as low as 500, depending on the specific loan.
- You’ll also need a debt to income ratio of less than 45% to prove you’re capable of repaying the loan, so they'll look at how much debt you have in other places…like credit cards and outstanding student loans.
- And of course you’ll need to provide a down payment In order to get pre-qualified, lenders will want to see a down payment sitting in the bank.