How Does a Mortgage Work?

admin // November 21 // 0 Comments

Most of us start our credit journey with credit cards or car loans before attempting to climb the Mt. Everest of loans, a home mortgage. Mortgage rates tend to be lower than the interest rates for other types of loans but with most mortgages being 30-year loans, the interest costs can be impressive over time.

The stakes are high because your family home becomes collateral for the loan, so it’s important to understand how a mortgage works and how you can plan ahead to ensure you avoid common pitfalls.

Types of mortgages

While the 30-year fixed-rate conventional mortgage has been a popular choice for decades, there are several other types of mortgages, some of which require special qualifications and some of which can have less predictable payments.

Fixed-Rate: A fixed-rate mortgage, as its name suggests, has an interest rate that does not change over time. This doesn’t mean your mortgage payment won’t change; real estate taxes and home insurance premiums are typically rolled into a mortgage payment and both of these expenses tend to grow over time. The interest rate on the loan for the house itself doesn’t change, which makes a fixed-rate mortgage loan more predictable in regard to payments and increases due to higher taxes or insurance costs tend to move the payments in manageable increments.

Adjustable-Rate: Adjustable-rate mortgages (ARMs) aren’t locked in at a certain rate, which means your mortgage payment can fluctuate with rising (or falling) interest rates. The interest portion of your loan is often based on the Prime rate, LIBOR, or a similar interest index an can change uncontrollably. ARMs may make sense for buyers who believe they’ll be selling their home again within a few years because adjustable-rate mortgages typically have a lower initial interest rate than conventional mortgages. Rates may not stay low forever, however, and this type of loan is generally regarded as being riskier than conventional fixed-rate mortgage loans.

Government Insured Mortgages (FHA, VA, USDA/RHS Loans): Depending on your credit score, a government-insured mortgage, such as a loan insured by the Federal Housing Administration, can make a mortgage loan available with a lower down payment, sometimes as low as 10% or even as low as 3.5% with a qualifying credit score. An FHA loan, the most common type of government-insured mortgage, isn’t free insurance on your loan; upfront costs of up to nearly 2% of the loan amount are due at closing and an insurance premium is rolled into your mortgage payment to insure the loan.

Saving enough to qualify for a conventional mortgage or even putting down more than the 20% required for a conventional mortgage is generally considered to be a much safer strategy than utilizing low-down-payment mortgages. A low down payment can lead to negative equity and can cause a loan to be more expensive in the long run because a higher balance is being financed in addition to mortgage insurance costs.

FHA loans are growing in popularity and can provide some additional benefits, such as making extra cash available for homes that are in need of repair, like fixer-uppers.

Balloon Mortgage: A balloon mortgage differs from other types of mortgage loans in that you’ll have a fixed payment for a term ranging from 1 year up to 7 years, after which the remaining balance is due in one lump sum payment. This type of loan isn’t a good fit for most home buyers because of the large and looming balloon payment, but it can be useful if you intend to sell the home before the balloon payment is due, such as might be the case with real estate investing.

Reverse Mortgage: A reverse mortgage can be an option for homeowners over 62 years of age and who have a qualifying amount of equity in their home. Instead of borrowing to buy a new home, a reverse mortgage is a way to access the equity in your home to help pay living expenses, pay for needed repairs, or to get caught up on debt payments. Even though you are accessing your own equity, a reverse mortgage is still a loan and if it isn’t paid back, the lender will eventually own all or part of your home.

Conventional Mortgage Loan: Conventional loans are fixed-rate mortgages with a fixed mortgage term ranging from 15 years up to 30 years. Common conventional mortgage terms include:

  • 15-year mortgage
  • 20-year mortgage
  • 30-year mortgage

This article generally focuses on conventional fixed-rate mortgages because these are the most common type of mortgage loans and they often pose the least risk to buyers because payments for conventional fixed-rate loans are comparatively predictable.

Your home as collateral for the loan

When you have a mortgage, your home is collateral for the loan, which means that your lender can repossess the home if you fail to make timely loan payments and the loan goes into default. This process of lender repossession is called foreclosure, and it can be costly in a number of ways including having an extremely adverse effect on your credit score.

Additionally, the lender can pursue you for the difference between the outstanding loan amount and the amount they are actually able to recover by reselling the foreclosed home.

The risk of foreclosure and its lingering effects, as well as the risk of losing a safe place to stay, are strong reasons for choosing a loan you can afford and for avoiding riskier types of loans.

Home insurance is often a wise investment but is almost always required when borrowing money to finance your home. Lenders may also require flood insurance if your home is in a high-risk flood zone. In many cases, your lender will include your home insurance premiums with your mortgage and will pay the insurer directly to be sure that the policy is in force.

Foreclosure is still a risk

Foreclosures are down considerably since their peak of about 4% during the housing crisis. However, abstract concepts like average foreclosure rates are meaningless to a household that is struggling to meet its financial obligations and falling behind on payments. A mortgage is a long-term obligation and one that can be affected by a number of unpredictable expenses, such as unexpected healthcare costs, changes in income, or the loss of a job.

What is home equity?

Your equity in your home is the difference between the market value of your home and the balance you still owe on a mortgage or any other type of home loan. If the market value of your home is $250,000 and you still owe $150,000, then you have 40% equity, or $100,000.

Equity is important to understand because it measures how much of your home you have paid off, and by extension, how close you are to becoming debt free.

It’s also possible to have negative equity, which means you owe more than your home is worth. Some types of loans can more easily lead to a negative equity position, such as loans with a low down payment. Housing prices can change rapidly and localized sales activity, like short sales or foreclosures, can change the value of your home. One below-market transaction might not move the needle much, but a few in your neighborhood can affect the value of other homes in the neighborhood. If you are close to zero equity, market changes can push you into a negative equity position.

What’s required to get a mortgage?

Mortgage lenders may have different internal underwriting requirements and different types of loans can have unique qualifications as well, but mortgage underwriting is much more standardized now than in the period leading up to the housing crisis. In general, for a 30-year fixed rate loan, you can expect the following criteria to be considered as part of your application:

  • Down payment: Some lenders will allow as little as 3% down but Private Mortgage Insurance (PMI) will be required. You can avoid the extra expense of PMI — as well as reduce the risk of negative equity — by putting down 20% or more.
  • Credit score: Most lenders require a credit score of 620 to 640 to qualify for a mortgage. FHA insured loans have more lenient credit score requirements. Generally, you can expect a lower interest rate as easier approval with a higher credit score.
  • Employment: Your lender will require proof of a steady income and income sufficient to meet the obligations of the loan. For some government-insured loans, you may need to prove two years of employment within the same industry.
  • Debt-to-income ratio: For conventional loans, lenders consider how much you have to make in debt payments (including the mortgage) when compared to your income. This is called debt to income ratio and banks watch this number closely. Typically, this number shouldn’t exceed 43% for most lenders but some lenders are more flexible. A higher debt-to-income ratio could indicate that the mortgage combined with your other obligations doesn’t leave any room for error.

Choosing a mortgage lender

How are mortgage payments calculated?

Your mortgage payment is calculated using a complex algebraic equation:

P = L[c(1 + c)n]/[(1 + c)n – 1]

“P” represents your payment, “L” represents the loan amount, “n” represents the number of payments and “c” represent the interest, if you were curious.

More important than understanding the complex mathematical formula is understanding which expenses go into your mortgage payment and where you can make a difference.

Your mortgage payment has some fixed expenses. These include:

  • Real estate taxes
  • Home insurance
  • Flood insurance (if applicable)

These “fixed” expenses still can go up or down — but most likely up. However, these elements within your mortgage payments are not affected by extra payments and don’t change because your mortgage balance goes down.

If your mortgage loan has PMI, the monthly expense for PMI is also unaffected by payments — until you reach 20% equity based on the original appraisal price, at which time you can cancel your PMI. Most lenders will automatically cancel PMI when you reach 22% equity.

Your mortgage also has some numbers that do change as you make payments. If you haven’t guessed already, these are the principal on the loan and the interest.

With the way most mortgage loans are structured, instead of your monthly mortgage amount changing when you make extra payments, the effective term of the loan will be reduced because you’re paying down the principal, which in turn reduces the interest that you pay over time.

How much a mortgage really costs over time

The real cost of your mortgage is based on three factors: the remaining principal, the interest rate, and the amount of time remaining on your mortgage.

A mortgage balance of $240,000 with a fixed rate conventional loan at 5% interest, will cost nearly $224,000 in interest expense over the life of the 30-year loan.

If you’re able to make biweekly payments, meaning payments every two weeks instead of once per month, you can save over $40,000 in interest over the course of the loan and shave nearly five years off the length of your mortgage. Because your extra payments are applied to the principal, less interest can accrue, which lowers your overall cost for the mortgage loan.

Choosing the right amount of home for your family

Over the past hundred years, average home sizes have grown by nearly 75%. Predictably, this increase in home size comes with an increase in price and associated costs, like property taxes and home insurance. Consider the needs of your family and consider approaching home buying from a standpoint of home much home you need instead of how much homes you can afford.

Homeownership and life, in general, is filled with surprises, some of which cost money. By buying beneath your budget, you leave room for life’s surprises and for routine maintenance your home will require. A roof might cost $8,000 to $10,000. Replacing a heater or central air conditioner can cost a similar amount. Leave enough room in your housing budget to cover these and other items that aren’t built to last as long as your home itself.

Compare loan offers with an online calculator, including interest rates, points (if applicable), and other upfront costs. Some closing costs can be rolled into the loan but this means you’ll be paying for them for the length of your mortgage. If you have the cash available, it’s better to pay for most of these expenses at closing or to find a lender whose loan has fewer fees or surprise costs.

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