How Mortgages Work: The Ins and Outs of Home Loans
A mortgage is an agreement that allows a borrower to use property as collateral to secure a loan. The term refers to a home loan in most cases. You sign an agreement with your lender when you borrow to buy your house, giving the lender the right to take action if you don’t make your required payments.
The bank can take the property in foreclosure if you default on payments, forcing you to move out so they can sell the home. The sales proceeds will then be used to pay off any debt you still owe on the property.
The terms “mortgage” and "home loan" are often used interchangeably. Technically, a mortgage is the agreement that makes your home loan possible.
Why Consumers Need Mortgages
Real estate is expensive. Most people don’t have enough available cash on hand to buy a home, so they make a down payment, ideally in the neighborhood of 20% or so, and they borrow the balance. That balance can be hundreds of thousands of dollars in many markets.
Lenders are only willing to give you that much money if they have a way to reduce their risk. They protect themselves by requiring you to use the property you're buying as collateral. You "pledge" the property, and that pledge is your mortgage.
The bank takes permission to place a lien against your home in the fine print of your agreement, and this lien is what allows them to foreclose if necessary.
Mortgages are often used by individuals and families, but businesses and other organizations can also purchase property with mortgages.
Types of Mortgages
Several types of mortgages are available, and understanding the terminology can help you pick the right loan for your situation.
Fixed-rate mortgages are the simplest type of loan. You’ll make the same payment every month for the entire term of the loan. Fixed rate mortgages typically last for either 15 or 30 or 15, although other terms are available.
The math on these loans is pretty simple. Your lender calculates a fixed monthly payment based on the loan amount, the interest rate, and the number of years require to pay off the loan. A longer term loan leads to higher interest costs over the life of the loan, effectively making the home more expensive.
The interest rates on adjustable-rate mortgages can change at some point. Your monthly payment correspondingly changes when this happens, for better or for worse. Your payment will increase if interest rates go up, but you might see lower required monthly payments if rates fall.
Rates are typically fixed for a number of years in the beginning, then they can be adjusted annually. There are some limits as to how much they can increase or decrease.
These loans can be risky because you don't know what your monthly payment will be in 10 years and whether you'll be able to afford it.
Home Equity Loans
Second mortgages, also known as home equity loans, are a means of borrowing against a property you already own. You might do this to cover other expenses, such as debt consolidation or your child's education expenses.
You’ll add another mortgage to the property, or put a new first mortgage on the home if it's paid off. The second mortgage lender is typically in second position. They only receive payment if there’s money left over after the first mortgage holder gets paid in the event of foreclosure.
Reverse mortgages can provide income to homeowners over the age of 62 who have built up equity in their homes—their properties' values are significantly more than the remaining mortgage balances against them, if any.
Retirees sometimes use a reverse mortgage to supplement income or to get lump sums of cash. The lender pays you, but interest accrues over the life of the loan until that balance is paid off.
Although you don't pay the lender with a reverse mortgage, at least not until you die or otherwise vacate the property for 12 months or longer, the mortgage must be paid off when that time comes. This could require you or your heirs having to sell the property or refinance the reverse mortgage into a traditional loan.
Interest-only loans allow you to pay just the interest costs on your loan each month, or very small monthly payments that are sometimes less than the monthly interest amount. You’ll have a smaller monthly payment as a result because you’re not repaying any of your loan principal.
The drawbacks are that you’re not building any equity in your home, and you’ll have to repay your principal balance eventually.
These loans can make sense in certain short-term situations, but they’re not the best option for most homeowners hoping to build wealth.
Balloon loans require that you pay off the loan entirely with a large "balloon" payment to eliminate the debt after a set term. You might have no payments until that time, or just small payments.
These loans might work for temporary financing, but it’s risky to assume that you’ll have access to the funds you'll need when the balloon payment comes due.
Refinance loans allow you to swap out one mortgage for another if you find a better deal. You get a new mortgage that pays off the old loan. This process can be expensive because of closing costs, but it can pay off over the long term if you get the numbers to line up correctly.
The two loans don’t have to be the same type. You can get a fixed-rate loan to pay off an adjustable-rate mortgage.
How to Get a Home Loan
Home loans require much more documentation than other types of loans, so be prepared for a lengthy, detailed process. Several factors come into play.
Your Credit and Income
As with most loans, your credit and income are the primary factors that determine whether you’ll be approved. Check your credit to see if there are any issues that might cause problems before you apply, and fix them if they’re just errors.
Late payments, judgments, and other issues can result in denial, or you’ll end up with a higher interest rate, so you’ll pay more over the life of your loan.
Documentation and Ratios
Lenders are required to verify that you have enough income to repay any loans they approve, so you'll have to provide proof of income. Make sure your Form W-2, your most recent tax return, and other documents are on hand so you can submit them to your lender.
- Lenders will look at your existing debts to make sure you have sufficient income to pay off all of your loans—including the new one you’re applying for. They'll calculate your debt-to-income ratio, which tells them how much of your monthly income gets eaten up by monthly loan payments.
- It’s possible to buy with a small down payment, but your chances of getting approved are better when you make a larger one. Lenders calculate a loan-to value-ratio which shows how much you’re borrowing compared to how much the property is worth.
The less you borrow, the lower the risk for your lender because they can quickly sell the property and recover all or most of their money. And a larger down payment gives you more of a personal stake in the property and more of an incentive to avoid foreclosure.
The Loan Preapproval Process
It’s best to know how much you can borrow before you start shopping for houses. One way to do this is to get preapproved by a lender.
This is a preliminary process in which lenders evaluate your credit information and your income. They can tell you a maximum loan amount that they’re likely to approve you for. This doesn’t necessarily mean that you'll ultimately be approved, but it's helpful information. Lenders will take a closer look at everything and issue an official approval—or rejection—when you're under contract.
Getting a preapproval letter from a lender can help strengthen your offer when you make one.
How Much to Borrow
Lenders always tell you how much you can borrow, but they don’t discuss how much you should borrow. It's up to you to decide how much you want to spend, what type of loan to use, and how large of a down payment you can make.
All these factors determine how much you’ll pay each month and how much interest you’ll pay over the life of the loan. It’s risky to borrow the maximum amount available, especially if you want to have some cushion in your monthly budget.
Where to Borrow
Home loans are available from several different sources. Get quotes from at least three different lenders, and pick the one that works best for you. You have a few options.
Mortgage brokers have access to loans from multiple banks and other sources of financing, and they can help you select a lender based on the interest rate and other features. They typically charge an origination fee in exchange for this service. You might have to pay the fee, or it might be paid by the lender. Sometimes it's a combination of both.
Ask your real estate agent or other people you trust for a recommendation if you don't know of any mortgage brokers.
Banks and Credit Unions
Money that customers have placed in checking and savings accounts is effectively invested by banks and credit units when they lend it out. These institutions also earn revenue from origination fees, interest, and other closing costs.
Online lenders can fund loans themselves—such as by using investor money—or they can function as mortgage brokers. These services are convenient because you can handle everything virtually, and you can often get quotes more or less instantly.
Each lender should provide you with a loan estimate. This will help you compare the cost of borrowing from different lenders. Read through these documents carefully, and ask questions until you understand everything you see.
Available Loan Programs
It's sometimes possible to get help with your loan through programs offered by government and local organizations. These programs make it easier to get approved, and some offer creative incentives to make homeownership more affordable and attractive.
It might be possible for you to refinance with these programs as well, even if you owe more than your home is worth.
Government loan programs are among the most generous. In most cases, a private lender provides the money, and the federal government promises to repay the loan if you fail to do so. There are a variety of such programs, including:
- FHA loans are insured by the Federal Housing Administration. They're popular for homebuyers who want to make small down payments. It’s possible to buy with as little as 3.5% down with these loans, and they’re relatively easy to qualify for even if you have less-than-perfect credit.
- Veterans, servicemembers, and eligible spouses can buy a home with a loan guaranteed by the Department of Veterans Affairs (VA). These VA loans don't require mortgage insurance, even with no down payment in some cases. You can borrow with less-than-perfect credit, closing costs are limited, and the loan might be assumable—it can be transferred to someone else who would then be liable to make the payments.
- First-time homebuyer programs can make it easy to own your first home, but they usually come with strings attached. These programs are often developed by local governments and nonprofit organizations to help with down payments, approval, interest rates, and more. They're hard to find and to qualify for, however. They might limit how much you can profit when you sell.
Ways to Save Money
Home loans are expensive, so cutting even a few costs can lead to hundreds or thousands of dollars in savings.
- The larger and longer your loan is, the more your interest rate matters. You'll be paying interest on your loan balance year after year, and this can add up to tens of thousands of dollars over the life of the loan. Sometimes it makes sense to pay more upfront—even buying “points” on your loan—if it lets you lock in a low rate for the long term. You can pay mortgage or discounts point fees to the lender at closing in exchange for a lesser interest rate.
- You’ll most likely have to pay mortgage insurance if you make a down payment of less than 20%. This insurance protects the lender in case you stop making payments—the insurer will pay off your balance in the event of default. Try to find a way to come up with 20%.
You can’t really get rid of the cost of mortgage insurance unless you refinance with some loans, such as FHA loans, but you can often get the requirement removed when you build up at least 20% in equity.
- You’ll have to pay numerous expenses when you get a home loan. There are application fees, credit check fees, origination fees, and appraisal costs.
Be wary of “no closing cost” loans unless you’re sure you’ll only be in the home for a short period of time because they can end up costing you more over the life of the loan.
Debt.org. "30 Year Fixed Mortgage." Accessed May 7, 2020.
Alliant Credit Union. "10/1 ARM vs. 30-Year Fixed: Which Mortgage Is Right for You?" Accessed May 7, 2020.
Franklin Trust Federal Credit Union. "Home Equity Loans." Accessed May 7, 2020.
Federal Trade Commission. "Reverse Mortgages." Accessed May 7, 2020.
FDIC. "Interest-Only Mortgage Payments and Payment-Option ARMs—Are They for You?" Page 2. Accessed May 7, 2020.
Consumer Financial Protection Bureau. "What Is a Balloon Payment? When Is One Allowed?" Accessed May 7, 2020.
Debt.org. "Mortgage Re-Fi." Accessed May 7, 2020.
HUD.GOV. "Let FHA Loans Help You." Accessed May 7, 2020.
U.S. Department of Veterans Affairs. "VA Home Loan Types." Accessed May 7, 2020.
Bank of America. "What Are Mortgage Points?" Accessed May 13, 2020.