Before you go out and search for your dream home, it’s important to have an understanding of how mortgages work since you may have one for years to come. Though there are different types of mortgages and programs to choose from, they’re not as complex as they may seem. 

Keep reading to learn more about how mortgages work, what’s included in the monthly payment, and the different types of mortgage loans and programs. You’ll also discover key terms you’ll want to know when shopping for the perfect mortgage to purchase your new home or refinance your existing loan. 

How Mortgages Work

Mortgages are legal documents that are executed between the lender and buyer for home purchases or refinancing. And if the purchaser fails to uphold their end of the bargain by defaulting on the loan payments, the lender has the right to recoup the balance to minimize their losses through foreclosure. 

Once the mortgage documents are signed by both parties, they’ll be recorded with the county to secure the lender’s legal rights to the home, or lien, if the borrower breaches the contract. 

You can use a mortgage to: 

  • Purchase a home that you wish to finance instead of paying in full using cash
  • Refinance your current loan to secure more competitive financing terms

Components of a Mortgage Payment

When you borrow money to purchase your home or refinance an existing loan, you’ll be responsible for making monthly payments until your outstanding debt obligation is satisfied. The primary components of a mortgage payment are: 

Principal

The principal of a mortgage is the amount you borrowed, minus any applicable interest, fees, insurance, or taxes. So, if your new home was $325,000 and you put 5 percent down, the principal balance would be $308,750 assuming you don’t roll any other costs into the loan. 

Keep in mind that each time you make a payment, a portion of it will also be applied to the interest. So it could take several years to start seeing a major reduction in the principal. 

Interest 

As mentioned earlier, the interest rate is another component of your mortgage payment. It is typically determined by the loan type and borrower’s credit score and can have a major impact on your monthly payment.

To illustrate, a 30-year fixed-rate mortgage of $350,000 with an interest rate of 6 percent will have a monthly payment (principal and interest only) of $2,098, and you’ll pay $405,434 in interest over the life of the loan. But if the rate was 5 percent, the monthly payment would only be $1,879 and you’d pay $326,395 in interest over the life of the loan. 

Property Taxes

Although property taxes are only due once a year, you can elect to have them rolled into your payment. That way, the lender will withdraw the funds from your escrow account to take care of the bill when it’s due so you won’t have to come out of pocket for a large wad of cash all at once. 

Homeowners Insurance

Along with property taxes, you can also remit payment monthly for homeowners insurance and your lender will take care of the rest by placing it in your escrow account and remitting paying premiums when they are due. 

Mortgage Insurance

Did you put less than 20 percent down? You may be required by the lender to purchase private mortgage insurance (PMI), which protects them in the event you default on the loan. In most instances, you can drop PMI once you reach 20 percent in equity. The exception to the rule applies to FHA loans which mandate that you carry PMI coverage for the life of the loan if you put less than 10 percent down. 

Types of Mortgage Loans 

There are various types of mortgage programs to choose from. More on that shortly. But before you do so, you’ll need to decide if you prefer a fixed or adjustable-rate mortgage. Both have many similarities but the key difference lies in how the interest is calculated and assessed. 

Fixed-Rate Mortgages

The interest rate and corresponding loan payment remain the same for the duration of the loan. So, if you start with $1,100 per month, you’ll end with $1,100 per month unless the last payment is a partial one. 

Adjustable-Rate Mortgages

Also known as ARMs, adjustable-rate mortgages are accompanied by a fluctuating interest rate, which means your mortgage payment could increase or decrease drastically over time. The rate on ARMs is determined by the index and the margin, which correlates with the current market conditions. 

Mortgage Programs 

The primary mortgage programs are: 

Conventional mortgages 

Most conventional mortgage programs require down payments as little as 3 percent, but the buyer must meet Fannie Mae or Freddie Mac’s qualification criteria. They’re also a little less flexible for credit-challenged borrowers as a FICO Score of 620 across the board at all three credit bureaus is mandatory. 

Government-backed loans

These include: 

  • Federal Housing Administration (FHA) Loans: generally require a down payment of 3.5 percent and a minimum credit score of 580. You can get approved with a credit score of 500 percent, but expect a substantially higher interest rate, and you’ll have to put 10 percent down. 
  • USDA Loans: available to residents in rural areas that are in lower income brackets and do not qualify for conventional financing. 
  • Veterans Affairs (VA) Loans: caters to eligible veterans and their relatives, and doesn’t require a down payment since 100 percent financing is available. 

Government-loans are ideal for buyers with little saved for a down payment or those with past credit challenges as they tend to be more lenient with qualification criteria. And you may have more flexibility with debt to income ratios then you would with a conventional mortgage product. 

Terms You Should You Know 

Closing Costs

Before you can move into your new home or finalize your new loan for a refinance, you’ll go through what’s called the closing process. It’s a meeting where you’ll sign legally binding documents to finalize the transaction. But scheduling it at a time isn’t all you have to worry about. There are also costs that you’ll incur that are not to be overshadowed as they can place a dent in your wallet if you’re not prepared. In most instances, closing costs range from two to five percent of the purchase price, and the lender or seller may offer to pay a portion on your behalf to seal the deal.  

Debt to Income Ratio

Your debt to income (DTI) ratio is the percentage of your monthly debt obligations including your new monthly payment compared to your gross income. (Quick Note: if you’re self-employed, your lender will use your net income). Lenders like to see this percentage at 28 percent or lower, but some will go as high as 45 percent before they turn you away. 

To illustrate, if you earn $6,000 before taxes, have monthly debt obligations of $1,000, and are pursuing a mortgage with a monthly payment of $1,500, your DTI ratio would be close to 42 percent. Because each loan program and lender has there own set of criteria with regards to DTI ratios, it’s best to inquire before applying. 

Down Payment  

Most consumers put anywhere from 3 to 20 percent down, and this amount is used to reduce how much you need to borrow. But there are select programs, like USDA mortgages, that allow lenders to secure mortgages with no money down. 

Pre-Qualification Letter

Also known as a mortgage loan pre-approval, the prequalification letter is a document from the lender stating how big of a loan you qualify for. It’s usually used by borrowers when submitting an offer on a new home. 

Promissory Note 

During the closing process, you’ll sign a promissory note. This document states your intent to pay your loan in full, which includes any applicable interest and fees. It’s legally binding and can be used against you in court should you choose to bail on your commitment with the lender later on down the line. 

The Bottom Line

Once you know the ins and outs of mortgages, you’ll be well equipped to find a lender that can best serve you. And upon being pre-approved for the perfect mortgage product, you can shop for your new home with a peace of mind. But be sure to keep current rates in mind to ensure you’re getting the best bang for your buck when it’s time to close on the loan.

Author

Allison Martin is a syndicated financial writer, author, and Certified Financial Education Instructor (CFEI). She has written about personal finance for almost ten years and holds a master's degree in Accounting from the University of South Florida. Allison's work has been featured on The Wall Street Journal, ABC, MSN Money, Yahoo! Finance, Fox Business, Credit.com, MoneyTalksNews, Investopedia, The Simple Dollar, and a host of other reputable publications. She also travels around the nation facilitating financial literacy and business workshops to individuals from all walks of life. In her spare time, Allison enjoys traveling, cuddling up with a good book, and spending time with family. She lives in Florida with her husband and two young sons.

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