What Exactly Is a Mortgage?

When the time came to purchase my first condo, I had a general understanding of securing a mortgage. As I prepare to purchase my next condo, my experience increases my confidence in the process.

Knowing how to qualify for a mortgage, how the payments work, and how to compare interest rates helps you receive the best value. The following information can help.  

What a Mortgage Is

A mortgage is a loan from a lender to finance a home. The contract promises loan repayment plus interest according to agreed-upon terms.

The home is used as collateral for a mortgage. Therefore, failing to make the scheduled monthly mortgage payments gives the lender the right to foreclose on the property.

A mortgage might be the biggest and longest-term loan you secure. Understanding how a mortgage works helps you choose one that is right for you when purchasing a home.  

Parties Involved in a Mortgage

These parties are involved in a mortgage:

• Lender: The financial institution or mortgage company lending the money.

• Borrower: The individual responsible for making loan payments according to the schedule.

• Co-borrower: A spouse, partner, or other individual who shares the responsibility of paying back the loan.

 

How a Mortgage Payment Works

Each mortgage payment is split into at least four categories:

1. Principal: The portion paid with each payment; additional payments accelerate the loan payoff

2. Interest: The monthly rate the lender charges; the cost of borrowing money

3. Taxes: One-twelfth of the annual property tax bill

4. Insurance: Required to cover hazards such as fire, theft, or accidents

Depending on the mortgage, part of each payment could go toward the following:

• Mortgage insurance premium: Federal Housing Administration (FHA) loans require an upfront fee and annual payments, typically divided into monthly installments. The cost depends on the loan amount, term, and loan-to-value ratio. The mortgage insurance premium can last for the entire loan or when 20% home equity is attained.

• Private mortgage insurance: Homebuyers with less than 20% down might need to pay for insurance to protect the lender in case of loan default.

Important facts about mortgage payments:

• Interest makes up most of the mortgage payments in the early years. In time, more of each payment goes to the principal until the loan is paid off.

• The lender provides an amortization schedule showing the breakdown of each payment. This schedule shows how the loan balance drops over time and how much principal and interest are paid.

• If the down payment is less than 20%, the mortgage lender puts the homeowner’s insurance and property tax funds into an escrow account for payment.

Types of Mortgages

The main types of mortgages include:

1. Institutional lender loans: Banks, credit unions, and other financial institutions offer programs with lenient requirements and lower expenses for first-time homebuyers.

2. Conventional conforming loans: These loans conform to Federal Housing Finance Agency (FHFA) guidelines and are purchased by Fannie Mae and Freddie Mac.  

3. Government-issued mortgages: Institutional lenders offer these mortgages, which are insured or guaranteed by the government:

• Federal Housing Administration loans: FHA-backed loans require lower down payments for first-time home buyers with credit issues.

• Veterans Affairs loans: The U.S. Department of Veterans Affairs (VA) offers loans for veterans, active service members, and surviving spouses with no down payments and no private mortgage insurance.

• U.S. Department of Agriculture loans: Home buyers in rural areas can benefit from 100% financing without a down payment and reduced mortgage insurance, interest rates, and long-term expenses.

4. 30-year mortgage: Extending payments over 30 years helps keep them low.

5.15-year mortgage: Higher monthly payments save on interest and lower the total cost of the loan.

6. Fixed-rate mortgage: The interest rate remains the same, and payments are predictable.

7. Adjustable-rate mortgage: The interest rate adjusts with the market, making payments unpredictable and potentially higher than a homebuyer’s budget.

Mortgage Interest Rates

Interest rates on a mortgage depend on many factors:

• Homebuyer’s credit score

• Property type and location

• Loan type and purpose

• Loan-to-value ratio

• Risk assessment

• Market conditions

 

These factors help homebuyers secure lower interest rates on mortgages:

• Increasing credit scores

• Demonstrating a stable work history

• Waiting until interest rates drop

Tips for Comparing Mortgages

Look for these factors when comparing mortgages:

• Loan size

• Loan term

• Interest rate and associated points

• Type of interest rate and whether it can change

• Annual percentage rate (APR)

• Lender’s fees

• Closing costs

Beware of potentially risky features:

• Prepayment penalty: The lender charges a fee for paying off a mortgage before the due date to gain lost interest income.

• Interest-only feature: Lower initial payments covering the interest later convert to higher payments covering the principal and interest that could exceed the homeowner’s budget.

• Negative amortization: Because the monthly payments do not cover the accrued interest, the unpaid interest is added to the principal, increasing the loan balance.

• Balloon payment clause: The last payment is significantly higher than the previous payments, potentially exceeding the homeowner’s budget.

These strategies can help you choose a mortgage:

• Focus on affordable payments rather than qualification limits: The amount lenders are willing to loan often exceeds how much homebuyers are comfortable repaying monthly. Carefully consider your income, expenses, and priorities to determine a comfortable monthly mortgage payment that fits your budget.

• Consider additional homeowner costs: Homeowner’s insurance, property taxes, and private mortgage insurance increase monthly mortgage payments. You can get estimates from local tax assessors, insurance agents, and lenders to help determine reasonable mortgage payments and price ranges for homes.

• Ask about early repayment penalties: Many homeowners make double payments when possible to pay off their mortgage early. Ensure your desired mortgage does not include additional fees for early repayment.

Steps to Secure a Mortgage

These steps can help you secure a mortgage:

1. Use an online affordability calculator: Many financial institutions that offer mortgages provide an online affordability calculator to determine how much a homebuyer can spend.

2. Get preapproved: Demonstrating the ability to purchase a home increases the likelihood.

3. Gain final approval: When ready to make an offer, the lender finalizes the mortgage details.

4. Close on the mortgage: Sign the mortgage documents and become a homeowner.

How to Qualify for a Mortgage

Lenders typically consider the following when reviewing a mortgage application:

• Borrower’s credit score: A higher credit score lowers the mortgage interest rate.

• Borrower’s debt-to-income ratio: The homebuyer’s monthly debt payments divided by their gross monthly income determine the ability to manage the monthly mortgage payments and repay the loan. The Consumer Financial Protection Bureau (CFPB) recommends a ratio of no more than 43%.

• Borrower’s down payment: Putting down more money for a mortgage typically lowers the monthly payments.

• Borrower’s savings: Assets that can be easily converted to cash to make mortgage payments if needed, such as money in checking, savings, or money market accounts, are important.

• Property type: The lender wants to ensure the home can be resold if needed because it is used to secure the mortgage.

• Occupancy plans: Whether the home would be a primary, secondary, or rental property impacts the ability to secure a mortgage.

Steps to take before applying for a mortgage include:

1. Knowing your credit score: Your credit score impacts the odds of approval and influences the interest rate. These tips help borrowers check and improve their credit score:

• Request a free credit report from annualcreditreport.com.

• Dispute any errors.

• Pay bills on time.

• Pay off credit cards or keep low balances.

2. Determining how much home you can afford: Use an online affordability calculator to estimate your potential monthly payments and maximum home cost. Remember that in addition to principal and interest, your monthly payments might include homeowners’ insurance, property taxes, and private mortgage insurance. Other considerations should include:

• Utilities

• Maintenance costs

• Homeowner’s association dues

• Appliances

• Furniture

• Additional mortgage reserves for financial emergencies

3.       Shopping for the best value: Consider each lender’s interest rate and fees. Collect loan estimates from at least three lenders.

Common Mortgage Terms

Understand these terms before signing mortgage documents:

Annual percentage rate: The annual percentage rate (APR) typically is higher than the note rate because it reflects the cost of borrowing money based on the interest, fees, and loan term, expressed as a yearly rate. The APR makes it easier to compare loans with different interest rates and costs. The higher the difference between the note rate and APR, the more a borrower pays in closing costs.

Deed of trust: Some states allow a trustee to be added to a mortgage, providing the trustee the authority to take control of a home on the lender’s behalf if the payments cease.

Discount points: Also called mortgage points, discount points are the money paid to the lender in exchange for a lower interest rate.

Mortgage: A mortgage gives the lender the right to take ownership of and sell the home if the payments are not made according to the terms of the promissory note.

Mortgage closing costs: Closing costs are expenses charged by a lender to make or originate a loan, typically 2-6% of the loan amount. These expenses include origination fees, discount points, and fees related to underwriting, processing, document preparation, and loan funding. The total closing costs include appraisal and title fees, title insurance, surveys, and recording fees.

Mortgage insurance: Mortgage insurance protects a lender against losses incurred if they have to foreclose on a home because the payments cease.  

Note rate: The note rate is the actual interest rate paid each year based on the amount borrowed, expressed as a percentage rate. This rate does not reflect the costs or charges for the mortgage and should not be confused with the annual percentage rate.

Promissory note: The promissory note outlines the loan repayment details, including:

• Interest rate

• Total loan amount

• Loan term  

• Monthly principal and interest payment

• When the loan is considered late

*This information is for educational purposes only.