What is a mortgage loan and how does it work?
What is a mortgage?
A mortgage is a type of loan consumers use to purchase a house and agree to repay in small, equal, fixed monthly amounts over a certain time span, or term. For many homebuyers, the mortgage process is an essential part of the homeownership experience, though it can be a lot to wrap your head around if you’re going through it for the first time. Here’s a look at everything you need to know about mortgages, how they work and what your monthly payment actually covers.
When should you get a mortgage?
In so many words, the time to get a mortgage is when you’re buying a house but can’t afford to pay the entire price of the home in full and upfront. Think about it this way: If you’re looking to buy a house, you most likely won’t want to pay the full price of the home right then and there, and in cash.
The way to bypass that gigantic one-time transaction is by offering to pay a portion of the home’s value upfront — this is called making a down payment — while also taking out a loan from a bank to cover the rest of the home’s price. The money you’re borrowing from the bank (which is your mortgage) will need to be repaid with interest and in exchange, you’ll get to occupy the home and renovate it as you wish.
How do you apply for a mortgage?
Before applying for a mortgage, you’ll want to do some prep work. First, check your credit score to make sure it’s as healthy as possible and take a look at your credit report to ensure there are no inaccuracies that could be bringing your credit score down. Mortgage lenders will be checking both of these to determine your future interest rate. The higher your credit score, the lower your interest rate will be, which means your monthly mortgage payments will be lower.
You can view your credit score and credit report for free with Experian. If it turns out your credit score could use some improvement, try using a service such as *Experian Boost™, which links to your bank account and analyzes your transactions for regular utility and subscription service payments, then uses this activity to help bump up your FICO® Score.
Once you feel your credit score is in good enough shape, start thinking about the type of mortgage you’re looking for.
Conventional mortgages are the most common option, often requiring a down payment of only 3%. Note, however, that this type of mortgage carries strict debt-to-income ratio requirements and may not always be the most feasible option for every homebuyer.
Federal Housing Administration, or FHA, loans let buyers get away with having a higher debt-to-income ratio and only require a 3.5% down payment. Jumbo loans are offered to those who need to borrow more than $647,200 — note that this is the amount for 2022, limits tend to change every year and some states even set their own.
Veterans Affairs, or VA, loans are meant for veterans and their spouses, while U.S. Department of Agriculture, or USDA, loans are aimed at people who want to purchase a home in a rural area, allowing them to do so by making a 0% down payment.
It can also be helpful to know which loan terms you’re looking for. Most lenders will offer terms ranging from 10 years to 30 years, while 15-year and 30-year mortgages tend to be very common. If you were to choose a 15-year mortgage, you would have to make monthly payments for 15 years, at which point you should have paid off the home. At the same time, if you went with a 10-year mortgage, you would have 10 years to pay it off, or 30 years to pay off a 30-year mortgage. The longer your term, the smaller your monthly payment is, but over time, you’ll end up paying more in interest.
After you figure out which kind of mortgage you’re looking for and how long you want to be on the hook for payments, start researching the best mortgage lenders — there are a ton out there and many offer their own sets of perks. SoFi, for instance, offers many ways to save money, including a 0.25% discount on your interest rate when you lock in a 30-year rate for a conventional loan and a $500 discount on your mortgage loan if you’re already a SoFi member (you can sign up for free). PNC Bank also offers a special loan option to medical professionals looking to buy a home, which waives private mortgage insurance and allows folks who fall into this category to apply for loans up to $1 million.
When you have an idea of which lender you want to go with, it’s time to get pre-approved for your mortgage loan. In other words, this is the part where the lender tells you (and the potential seller) that you are approved to borrow up to a particular amount of money at a particular interest rate to buy a home. It’s highly recommended that you go through the pre-approval process before you even begin visiting homes since it’s so important to know how much you can afford from the get-go.
To get pre-approved, lenders will look closely at your:
- FICO credit score
- FICO credit report
- Personal income
- Employment history
- Debt-to-income ratio
- Loan-to-value ratio
Lenders will typically provide homebuyers with a mortgage pre-approval letter once you have been pre-approved for a loan amount. These letters are usually valid for 60 to 90 days — once you have it, you’ll want to start looking at homes as soon as possible before this timeframe expires.
After you’ve made an offer on a house you like, and the seller has accepted that offer, go back to the lender and submit your mortgage application, which is about five pages long and asks for more information about your debt, credit history, income, assets, and employment history, among other financial details. You can actually submit more than one mortgage application to more than one lender, just make sure to do so within a span of 45 days — that way, you’ll only end up with one hard credit inquiry and your credit score won’t take that much of a hit.
The mortgage application process can seem pretty daunting, especially if you’re afraid of accidentally inputting the wrong information. It’s a good idea to ensure the lenders you’re working with can support you online or in person, just in case. PNC Bank, for example, offers online support and has local branches you can visit if you’d prefer to talk through your application in person, while its online application makes things more accessible for those who don’t live near a PNC branch.
Once your mortgage application has been approved, compare offers for rates and fees from each lender and choose the one you want to go with. After making your choice, begin the loan processing stage. This is the part when your lender reviews everything you’ve included in your application with a fine tooth comb — you may also be asked to submit additional documents such as tax forms, pay stubs, bank statements and employer contact information — to verify that all the information you’ve provided is correct.
It’s important to note that your mortgage lender may not always be your mortgage servicer, as many lenders end up transferring servicing rights over to another company, which will then be the one to send you mortgage statements and handle all associated administrative tasks — the terms of your mortgage shouldn’t change, however.
An underwriter will then take a look at any financial factors that could influence your ability to make your mortgage payments on time and in full each month. They may review such factors as your income, loan-to-value ratio or credit report, or may even double-check that the title on the home is clear, or, in other words, that there are no liens on the house from creditors or other parties — a title fee is a common charge homebuyers sometimes have to pay during the process as a result.
When everything is confirmed and you’re approved to close on your new house, you’ll schedule a closing date and receive a closing disclosure form three days before that date, which lists out details such as the final costs of your mortgage, loan term, estimated monthly payments and fees and closing costs, among other important information. This is your chance to make sure everything is consistent with what you and your lender had discussed and approved initially.
Finally, once you sign the disclosure and close on the house, you’ll be the proud owner of a brand new home — and a new mortgage to go along with it.
What does your monthly payment actually cover?
Your monthly mortgage payments allow you to build equity, or ownership, in the home over time. Think of it this way: If you were to pay a 10% down payment, you’d own 10% of the home.
A mortgage is made up of four parts: The principal amount, interest, taxes and insurance. Remember that any time you borrow a loan of any kind, you’re expected to make monthly payments toward the balance you borrowed in addition to the interest. The same holds true for a mortgage; the principal amount is broken down into fixed, equal monthly payments over the span of your loan’s term.
Property taxes are yet another component of the home buying process. Whether you’re buying your home outright in cash or opting to take on a mortgage, you’re still responsible for paying these.
If you opt to pay cash for the home (or pay your home off and no longer have a mortgage), it will be your responsibility to pay your property taxes directly to the government. If you have a mortgage, you can opt to have your property taxes included in your monthly payment and put into an escrow account. Then, when your taxes are due, the lender will take the money out of that account and use it to pay your property taxes.
Escrow accounts are meant to make it easier for homeowners to pay property taxes in small chunks each month instead of making one huge payment each year. Keep in mind that your lender may require you to pay three months’ worth of property taxes upfront when you buy the home in order to open the escrow account. Each lender has different requirements that can vary based on local laws and policies, so be sure to ask ahead of time for escrow policies when you’re shopping for the best lender.
Finally, your escrow account will cover the homeowner’s insurance payments so you’ll be covered in the event of a claim such as hurricane damage, for example. However, each policy covers different events at different amounts, so be sure to read your insurance disclosures to understand what you’re home is protected against.
There’s another type of insurance payment that’s worth keeping in mind: private mortgage insurance, or PMI, which isn’t part of your mortgage payment, per se, but is an additional monthly cost, much like a homeowner’s association fee or your water bill. Private mortgage insurance essentially protects the lender in the event that you stop making your mortgage payments, but it’s only charged if you were to make a down payment that was less than 20%.
PMI costs can range anywhere from 0.5% to 1.5% of your principal payment amount. Once you’ve made enough payments to build 20% equity in your home, ask the lender to waive your private mortgage insurance or refinance your loan to get rid of it.
What happens after you pay off your mortgage?
When you’ve finally made it to the end of your mortgage, you officially won’t have to make monthly payments anymore and your lender may send you a document indicating you’ve paid off the loan in full. Note that you’ll still need to pay your property taxes and while homeowner’s insurance isn’t federally required, its still a good idea to keep your coverage going in the event your home suffers a bad fire or other damage from natural disasters in the future.