Understanding mortgage basics

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Do you ever window shop for the perfect home, whether by browsing online or taking a stroll through your favorite neighborhood? You’re not alone. It’s fun to dream about owning a place all your own.

If you’re getting more serious about buying a home, you’re probably aware that some of the next steps are, well, not quite as fun. One of those is acquainting yourself with the mortgage process.

A mortgage loan, a loan to buy a home or other real estate, provides people with the opportunity to purchase a home without having all the money upfront—which most people simply do not have.

While it is wonderful that mortgage loans open up homeownership to so many, taking out a mortgage is also a big responsibility. This home affordability calculator estimates what might be in your budget.

Taking the time to learn about mortgages before you dive headfirst into the buying process may be the way to go.

Related: What is mortgage amortization?

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What is a Mortgage?

Understanding mortgage basics

A mortgage loan, also known simply as a mortgage, is issued to a borrower who is either buying or refinancing real estate.

The borrower signs a legal agreement that gives the lender the ability to take ownership of the property if the loan holder doesn’t make payments according to the agreed-upon terms.

The homebuyer will pay monthly principal and interest payments for a specific term. The most common term for a fixed-rate mortgage is 30 years, but terms of 20, 15, and even 10 years are available.

A shorter term translates to a higher monthly payment but lower total interest costs.

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A Buffet of Mortgage Choices

Understanding mortgage basics

When homebuyers apply for a loan, they’ll need to choose whether they want a fixed interest rate or an adjustable rate and the length of the loan.

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1. Fixed-Rate Mortgage

Understanding mortgage basics

The interest rate doesn’t change, so the monthly principal and interest payment remains the same for the life of the loan.

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2. Adjustable-Rate Mortgage (ARM)

Understanding mortgage basics

With an ARM, the interest rate is generally fixed for an initial period of time, such as five, seven, or 10 years, and then switches to a variable rate of interest. The rate fluctuates with the rate index that it’s tied to.

As the rate changes, monthly payments may increase or decrease. These loans generally have yearly and lifetime interest rate caps that limit how high the variable rate can adjust to.

Next, borrowers will need to decide what type of mortgage loan works best for them.

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3. Conventional Loans

Understanding mortgage basics

Conventional loans are loans that are not backed by a government agency, aand must adhere to the requirements of Fannie Mae, Freddie Mac, or other investors.

Private mortgage insurance commonly known as PMI, is generally required on loans with a down payment of less than 20%.

The coverage protects the lender against the risk of default. Your mortgage servicer must cancel your PMI when the mortgage balance reaches 78% of the home’s value or when the mortgage hits the halfway point of the loan term, if you’re in good standing.

PMI typically costs 0.5% to 1% of the loan amount per year.

Down payment: Generally between 3% and 20% of the purchase price or appraised value of the home, depending on the lender’s requirements.

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4. FHA Loans

Understanding mortgage basics

Loans insured by the Federal Housing Authority are attractive to first-time homebuyers or those who struggle to meet the minimum requirements for a conventional loan.

These loans usually require a one-time upfront mortgage insurance premium, which typically can be added to the mortgage, and an annual insurance premium, which is collected in monthly installments for the life of the loan in most cases.

Down payment: Starts at 3.5%

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5. VA Loans

Understanding mortgage basics

Loans guaranteed by the U.S Department of Veterans Affairs are available to veterans, active-duty service members, and eligible surviving spouses.

VA-backed loans require a one-time “VA funding fee,” which can be rolled into the loan.

The fee is based on a percentage of the loan amount, and may be waived for certain disabled vets.

Down payment: None for nearly 90% of VA-backed home loans.

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How Does a Mortgage Work?

Understanding mortgage basics

There are several components to a monthly mortgage payment.

  • Principal: The principal is the value of the loan. The portion of the payment made toward the principal reduces how much a borrower owes on the loan.
  • Interest: Each month, interest will be factored into payments according to an amortization schedule. Even though a borrower’s fixed payment may stay the same over the course of the loan, the amount allocated toward interest generally decreases over time while the portion allocated to principal increases.
  • Taxes: To ensure that a borrower makes annual property tax payments, a lender collects monthly property taxes with the monthly mortgage payment. This money is kept in an escrow account until the property tax bill is due, and the lender will make the property tax payment at that time.
  • Homeowners insurance: Mortgage lenders require evidence of homeowners insurance, which can cover damage from catastrophes such as fire and storms. Similar to property taxes, most lenders collect the insurance premiums as part of the monthly payment and pay for the annual insurance premium out of an escrow account. Depending on your property location, you may have to add flood, wind, or other additional insurance.
  • Mortgage insurance: When a borrower presents a down payment of less than 20% of the value of the home, mortgage lenders typically require private mortgage insurance.

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What is a Reverse Mortgage?

Understanding mortgage basics

reverse mortgage homeowners 62 and older to supplement their income or pay for health care expenses by tapping into their home equity.

The loan can come in the form of a lump-sum payment, monthly payments, a line of credit, or a combination, usually tax-free. Interest accrues on the loan balance, but no payments are required. When a borrower dies, sells the property, or moves out permanently, the loan must be repaid entirely.

The fees for an FHA-insured home equity conversion mortgage, by far the most common type of reverse mortgage, can add up:

  • An initial mortgage insurance premium of 2% and an annual MIP that equals 0.5% of the outstanding mortgage balance
  • Third-party charges for closing costs
  • Loan origination fee
  • Loan servicing fees

You can pay for most of the costs of the loan from the proceeds, which will reduce the net loan amount available to you.

You remain responsible for property taxes, homeowners insurance, utilities, maintenance and other expenses.

This HUD site details all the criteria for borrowers, financial requirements, eligible property types, and how to find an HECM counselor, a mandatory step.

If you’re considering a reverse mortgage, learn as much as you can about this often complicated kind of mortgage  before talking to a counselor or lender, the Federal Trade Commission advises.

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How to Get A Mortgage

Understanding mortgage basics

For lots of folks, it can be a good idea to shop around to get an idea of what is out there.

Not only will you need to choose the lender, but you’ll need to decide on the length of the loan, whether to go with a fixed or variable interest rate, and weigh the applicable loan fees.

The first step is to have an idea of what you want, then seek out quotes from a few lenders. That way, you can do a side-by-side comparison of the loans.

Once you’ve selected a few lenders to get started with, the next step is to get prequalified for a loan. Based on a limited amount of information, a lender will estimate how much it is willing to lend you.

When you’re serious about taking out a mortgage loan and putting an offer on a house, the next step is to get preapproved with a lender.

During the preapproval process, the lender will take a closer look at your finances, including your credit, employment, income, and assets to determine exactly what you qualify for. Once you’re preapproved, you’re likely to be considered a more serious buyer by home sellers.

When shopping around for a mortgage, it can be a good idea to consider the overall cost of the mortgage and any fees.

For example, some lenders may charge an origination fee for creating the loan, or a prepayment penalty if you want to pay back the loan ahead of schedule. There may also be fees to third parties that provide information or services required to process, approve, and close your loan.

To compare the true cost of two or more mortgage loans, it’s best to look at the annual percentage rate, or APR, not just the interest rate.

The interest rate is the rate used to calculate your monthly payment, but the APR is an approximation of all of the costs associated with a loan, including the interest rate and other fees, expressed as a percentage. The APR makes it easier to compare the total cost of a loan across different offerings.

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The Takeaway

Understanding mortgage basics

Is the world of mortgages a mystery? You’re in good company. Before taking on this colossal commitment, it might be best to soak up as much as you can about how mortgage loans work, what kinds of mortgages are available, potential landmines, and steps to qualify.

Learn More:

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org

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