A mortgage provides the means for many Americans to finance homeownership, so it’s important to understand how they work. Learn everything you need to know about mortgages — the types available, what’s included in your payment, consequences of missed payments, what happens once you pay off your mortgage, how to get approved, and where to apply.
What’s the Definition of a Mortgage?
Let’s begin with the basics. What is a mortgage? A mortgage is a loan used to purchase a home or property. As the borrower, you sign an agreement to repay the loan by making a set number of monthly payments, plus interest, usually over many years.
How Does a Mortgage Work?
A mortgage loan definition is a good starting point, but you may still be asking, “how does a mortgage work, exactly?” Let’s dig a bit deeper, so you understand from the lender’s perspective. There are a wide variety of lenders, including commercial banks, credit unions, and mortgage loan companies.
Since the lender is taking a risk by giving you a loan, the home itself is used as collateral. Collateral is an asset that a lender accepts as security. That means if you stop repaying your mortgage, the lender may repossess and sell the house in a process called foreclosure.
The interest rate is another way the lender protects against risk. When they evaluate your mortgage application, they’re trying to figure out how likely you are to repay based on your credit score, debt-to-income ratio, and other factors. We’ll talk about that in a bit. The higher the risk, the higher the interest rate. And vice versa.
Types of Mortgage Loans
To meet the varied financial needs of potential homebuyers, there are several types of mortgage loans.
Conventional mortgage loans are backed by the private lender. That means if you don’t make your payments, the lender loses money on the loan. For this reason, it can be more difficult to qualify. You’ll need a good credit score and not be carrying too much debt relative to your income. But you’ll benefit from a lower interest rate than other mortgage types.
Jumbo mortgages are even more stringent than conventional mortgages because homeowners are borrowing more (roughly half a million depending on the area). Plus, if the borrower defaults, the lender can’t sell the loan to Fannie Mae or Freddie Mac, two entities formed by the government to boost the housing market. Interest rates are either in line with conventional mortgages or slightly higher.
Government-insured mortgages are less risky to the private lender because the government guarantees all or part of the loan if the homeowner is unable to pay. Examples include the FHA, VA, and USDA programs. These types of mortgages often have more flexibility regarding credit score and down payment, making it easier for first-time homebuyers to qualify.
Fixed-rate mortgages have the same interest rate for the entire life of the loan. Once you sign the agreement, the lender cannot alter your rate regardless of market changes.
In an adjustable-rate mortgage (ARM), the interest rate varies throughout the life of the loan. There’s often a low “teaser” rate for up to ten years, followed by periodic rate adjustments based on an index that reflects the borrowing cost to the lender on the credit markets.
What Makes Up a Mortgage Payment?
A mortgage payment has four parts: principal, interest, taxes, and insurance. This is sometimes shortened to PITI. It may also include private mortgage insurance if you made a down payment of less than 20%. Let’s define exactly what makes up a mortgage payment.
The principal is the original loan amount. A portion of your payment each month will reduce this balance. This is called amortization, meaning that the mortgage debt is gradually reduced over the term of the loan, taking interest into account.
Interest is the cost of borrowing money from your lender. The amount is determined by your interest rate and loan balance. Bear in mind that only a small percentage of your payment goes toward the principal in the first few years of your loan. Most of your payment goes toward interest. This is a way for lenders to protect against losses.
Taxes are the property assessments collected by your local government. Almost all lenders require you to include (or escrow) your property taxes into your monthly payment.
Like property taxes, homeowner’s insurance is typically escrowed into your monthly payment. Since your house is collateral for the loan, the lender wants to ensure coverage in case of an emergency.
Private Mortgage Insurance (PMI)
Private mortgage insurance is often required when the homebuyer puts less than 20% down. It’s a protection for the lender against default. For conventional loans, you typically stop paying after you’ve reached 20% equity. However, some government-backed loans require PMI for the life of the loan.
What Happens If You Stop Paying Your Mortgage?
In most cases, the lender will issue a Notice of Default once you haven’t paid for 90-180 days. You’ll be given a grace period of three calendar months to work out an arrangement with the lender, sell the house, or pay the outstanding balance. If the default isn’t resolved, the lender will sell the home at an auction.
But that doesn’t have to happen. Review the terms and conditions of your mortgage to see how long you have before the loan goes into default (and if there are late fees). Visit FDIC Foreclosure Prevention to access a variety of resources for struggling homeowners. Since there are variations by state, be sure to find out what happens if you stop paying your mortgage from a local source.
What Happens When You Pay Off Your Mortgage?
Even though it might seem like your obligations are complete after you send that last payment, it’s important to understand what happens when you pay off your mortgage. There are a few important steps.
Your lender should send a canceled promissory note showing the loan has been paid in full. They should also provide a certificate of satisfaction, which you can file with your County Registrar to clear the lien on your property title. In other words, officially make you the owner.
Since the lender has been putting a portion of your mortgage payment into an escrow account to pay your property taxes and homeowner’s insurance, you’ll now need to pay each of these separately. Research the property tax laws in your area to determine where and how frequently to submit your payments. Then contact your homeowner’s insurance company to verify that you’re the sole owner and set up a payment method.
How Do I Get a Mortgage?
Lenders consider many factors when deciding if a homebuyer qualifies for a mortgage. As we discussed earlier, they’re seeking to minimize risk by lending to individuals who are most likely to repay the loan. Let’s look at a few of the ways they assess potential borrowers.
Your credit score predicts how likely you are to repay debt. It’s calculated using your payment history, the amount of debt you have, and the length of your credit history. The higher your score, the more likely you’ll receive favorable credit terms, which may translate into lower payments and less interest.
Naturally, your annual income is one of the biggest factors in whether you’ll be approved. Lenders want to know that you have a stable income that’s adequate to cover the mortgage payments.
Lenders also want to be sure that you don’t carry too much debt, as this could affect how much you have leftover for mortgage payments. To calculate your DTI ratio, take your total debt amount and divide it by your gross income (including taxes). For example, if your debt is $4,000 per month and your monthly gross income is $12,000, your DTI is $4,000 ÷ $12,000, or 33 percent. Most lenders want your DTI to be under 36 percent.
A down payment is the cash you pay upfront to get a home loan, typically a percentage of the total sales price of the house. To get a conventional mortgage, you’ll have to pay at least 5%, while government-funded mortgages require less. For example, the VA loan requires no down payment. Also, keep in mind that even if you’re approved, if you make a down payment of less than 20%, most lenders will require private mortgage insurance or PMI. It’s typically .5 to 1% of the loan balance.
Where Do I Get a Mortgage?
You can get a mortgage from a wide variety of lenders, including commercial banks, credit unions, and mortgage loan companies. Some homebuyers engage a mortgage broker, who doesn’t lend you the money but instead finds the best lender for you. You may also want to speak to a real estate agent who may have lenders they can recommend. Regardless, make sure you compare the rates of several mortgage lenders before choosing one.