The material presented here is for educational purposes only, and is not intended to be used as financial, investment, or legal advice.
What is a Mortgage?
Are you wondering, "what is a mortgage and how exactly does it work?" Short answer: It’s a large loan that enables you to purchase or refinance a home without paying cash up-front for the entire purchase. Mortgage types and terms vary, and the choices can get confusing if you’re not familiar with how they work! Whether you already have a mortgage or you’re thinking about purchasing a home for the first time, get ready to learn all about mortgages and how they work.
If you’re in the market for a new home, you’ll also need to shop for a mortgage, or a loan that will enable you to purchase your home. There are several kinds of mortgages, term lengths and other important factors to consider before you commit to this long-term loan.
Below, we’ve compiled a guide to help simplify the complex homebuying process. You'll learn what a mortgage is and how it works, all about your monthly payment, different mortgage types and terms and how to choose from the many options.
What is a Mortgage and How Does it Work?
A mortgage, or a home loan, is a loan from a financial institution enabling a borrower to purchase a home. The collateral for the mortgage is the home itself, which means the lender can take possession of the home if the borrower misses their monthly payments for an extended time and defaults on the loan. In exchange for lending the borrower such a large sum of money, the lender collects monthly interest from the borrower.
Unpacking a Monthly Mortgage Payment
A monthly mortgage payment comprises several costs, which generally include the following:
- Principal. Part of your monthly payment will go toward paying down the mortgage principal, or the actual amount of money you borrowed to purchase the home. This may appear on your monthly mortgage statement as “remaining principal balance,” which just means the amount of money you still owe on your loan.
- Interest. This refers to the money you pay your lender for the privilege of borrowing money. As time progresses, you will begin to see more of your monthly payments going toward principal and less toward interest through a process called amortization.
- Taxes. Many lenders will collect property taxes due on the home as part of the monthly mortgage payment. The money for these taxes will be held in an escrow account until your property taxes are due. At this time, the lender will pay the taxes on your behalf.
- Homeowners insurance. This provides coverage in case your home is damaged from fires, storms, accidents or other disasters. Here, too, the lender will keep these funds in escrow and pay your insurance provider on your behalf when the policy premiums are due.
- Mortgage insurance. If you’ve made a down payment that is less than 20% of your home’s value, most home loans will require you to pay private mortgage insurance, or PMI, until you own 20% of your home. These payments are often bundled together with your monthly mortgage payment.
Types of Mortgages
Now, let’s look at the home loan itself and how it works. Ready to take out a mortgage? First, you’ll need to decide what kind of mortgage best fits your needs.
These are some options:
- Conventional mortgages are the most common. These home loans typically require a minimum credit score of 620 or higher and a down payment of at least 3% but have fewer fees attached.
- FHA loans are insured by the Federal Housing Administration (FHA). Credit scores must be 580 or higher and down payments must be 3.5%, at minimum.
- VA loans are insured by the Department of Veterans Affairs and require little to no money down. They are only available to qualified U.S. veterans, active-duty military personnel and eligible surviving spouses.
- USDA loans, guaranteed by the U.S. Department of Agriculture, also require no money down. These loans are only available to homebuyers who meet income requirements in designated rural and suburban areas of the country.
- Jumbo loans are mortgages that exceed the limits on loan amounts as set by the Fair Housing Finance Agency (FHFA). These limits are adjusted annually, vary by county and are higher when housing is expensive.
Types of Mortgage Terms
Once you’ve chosen your mortgage type, you’ll need to decide on a mortgage term. This is the amount of time you’ll be paying on your loan. Most mortgages today have 30-year terms, which means it will take 30 years to completely pay the loan off in full (if you pay exactly the monthly amounts specified by your lender). Other popular terms include 15 years, 20 years or 25 years.
Next, you’ll need to choose the flexibility of the mortgage.
The majority of home loans are fixed-rate mortgages, or mortgages with an interest rate that does not change throughout the loan term. Fixed-rate mortgages can be an excellent choice in a rising-rate environment. They are also, generally, the preferred term for borrowers who prefer the stability and budgeting advantages of a fixed monthly payment. You’ll typically pay the same amount every month for the life of the loan.
An adjustable-rate mortgage (ARM), on the other hand, will have an interest rate that fluctuates at predetermined intervals throughout the loan term. In a 5/1 ARM, for example, the interest rate will remain fixed for five years, and then be subject to adjustments once a year after the five-year period is over. An ARM can be a great choice when interest rates are especially low. During the adjustable period of the mortgage, the interest rate change will be based on a standard financial index, such as the key index rate set by the Federal Reserve.
Shopping for a Mortgage
When choosing a mortgage lender, it’s crucial to do your research. Ask these questions about every lender you are considering:
- What is the average interest rate for this lender?
- What kind of down payment will you need to make if you take out a mortgage through this lender?
- What is the lender’s minimum credit score requirement for this mortgage?
- What is the maximum debt-to-income ratio, or the total monthly debt payments (including mortgage) divided by the borrower’s gross monthly income, that the lender considers acceptable?
- What kind of customer service, attention and efficiency can you expect from this lender?
- Will your loan be serviced locally, or will you always need to call or email to get any questions answered?
- What are the approximate closing costs and other fees you will need to pay if you use this lender?
You can also ask for references of recent borrowers and check what the internet has to say about this lender.
A home is likely the biggest purchase you’ll ever make, so you want to make sure you understand every aspect of your loan. Now that you know what a mortgage is, you will be better prepared to choose the right loan and best lender for your specific situation and needs. Once you’ve made your decision and apply for your mortgage loan, you can start thinking about the best part of buying a home — filling it with beautiful new memories!
Mortgage loans are offered by Define Mortgage Solutions, LLC, NMLS ID #1761612, a subsidiary of Desert Financial Credit Union. BK#0949053