How Do Mortgages Work? Understanding the Basics of Mortgages
Most people would love to own a home, but the reality is that a majority of us simply can’t pay for a home with cold hard cash.
In fact, for many people, even saving up the funds for a down payment is a hefty burden in and of itself.
To make it possible for people to buy a home, lenders offer “mortgages” as a way to finance the purchase.
How Do Mortgages Work?
A mortgage is a loan that a financial institution will give you to help you finance a new home purchase. The home itself serves as collateral in case you fail to pay back your mortgage.
Mortgages consist of 3 main components:
- The Principal – The principal is the full dollar amount you borrowed to purchase your home. So, for example, if you purchased a $100,000 home, put $20,000 as a down payment, and borrowed $80,000 from the bank, your principal amount is $80,000.
- The Interest – The interest is the monthly fee that you pay for borrowing money from the bank. The amount you pay in interest depends on many factors, including the amount of your down payment, how much you borrow, and what interest rate you qualify for. Like with any loan, the interest you pay is on top of the principal, and is essentially “the cost of doing business.”
- The Amortization Period – The amortization period is the period of time during which you make monthly payments to repay the loan. The most common amortization periods are 10, 15, 20, and 30 years in length. The longer the amortization period, the lower your monthly payment. Just keep in mind that you’ll end up paying more in interest.
Each time you make a monthly payment, a percentage of it will go towards the principal, and the remainder will go towards the interest.
Due to the nature in which many mortgages are set up, most of your payments will go towards interest in the beginning. As you pay down the balance, however, more of your payments go towards the principal instead of the interest.
How Do You Qualify for a Mortgage?
To determine how much money a financial institution is willing to lend you, they will first run a credit check.
The higher your credit scores, the better off you’ll be since high credit scores demonstrate financial responsibility and that you have a successful track record of paying your bills on time.
This will play a critical role in the interest rate you are able to qualify for.
In addition to reviewing your credit, lenders will also look at:
- Your assets – They will review how much money you have in the bank, as well as other assets, like 401ks, IRAs, and annuities.
- Your job history and how much money you make – The more stable your job history and the more money you make, the easier it is to prove that you will be able to pay your monthly mortgage payments.
- Debt-to-income ratio (DTI) – This ratio compares the total amount you earn every month to the total amount of recurring monthly expenses like credit card payments, student loans, and auto loans, in addition to what your new mortgage payment will be. So, for example, if you make $5,000 per month, and have a car loan payment of $325 per month, student loan payments of $250 per month, and credit card payments of $275 per month, with a new mortgage payment of $1,300 per month, your debt-to-income ratio would be 43% ($2,150 in expenses divided by your income of $5,000), which is the max that many lenders are willing to approve. Historically, borrowers with higher DTI ratios than this have trouble making their monthly mortgage payments.
What Is a Conventional Mortgage?
A conventional mortgage is a loan that isn’t insured or guaranteed by the federal government. Maximum loan amounts vary depending on which state you live in, and adhere to the guidelines set forth by Fannie Mae and Freddie Mac.
Conventional loans are the most popular type of mortgage, and always require some type of down payment, although amounts vary depending on the financial institution.
Conventional loans can either have a fixed or an adjustable interest rate.
- A fixed interest rate will have the same rate for the entire length of the loan.
- An adjustable-rate mortgage (ARM) typically has a 30-year term, with a low fixed rate at the beginning for a specific period of time, followed by periodic adjustments according to a specific short term interest rate benchmark, typically LIBOR (London Interbank Offered Rate), or the U.S. Treasury Bill Index.
If you put less than 20% of the purchase price as a down payment, you’ll also probably have to pay private mortgage insurance (PMI) as well. PMI, which is an additional fee on top of the principal and interest, essentially protects the lender in the event you default on your payments.
Once you have at least 20% equity in your home, you can request that this requirement be removed from your monthly payments.
What Are Government Backed Home Loans?
The US government offers several programs that make it easier for people to buy a home.
These loans are easier to qualify for than conventional loans, and often require little-to-no down payment. The most popular are:
- VA Loans – If you or your spouse served in the military, you may be able to apply for a VA loan. VA loans require no money down and have competitive interest rates.
- FHA Loans – FHA loans have lower credit score requirements than most loans, and allow you to purchase a home with as little as a 3.5% down payment. You can even apply for an FHA loan if you’ve gone through bankruptcy or foreclosure. The downside is that in most cases, you will be required to pay for mortgage insurance, and you can only purchase property types approved by the Department of Housing and Urban Development (HUD).
- USDA Loans – USDA loans are zero down payment loans available to certain rural and suburban home buyers. To qualify, you must have an income under 80% the median income for the area. You must also lack proper housing and have the ability to afford mortgage payments, taxes, and mortgage insurance for the property.
Consult an Expert
If you’re thinking about buying a new home or determining how much mortgage you can afford, speaking with a mortgage expert is a fruitful way to learn more about what mortgage options are available to you, as well as which ones make the most sense based on your present financial situation.
At Embrace Home Loans, we have over 30 years of lending experience. So whether you’re a military veteran hoping to purchase a new home with little down or a 30-something who’s been penny-pinching for years to save up for a down payment, we are here to help!