What is a Mortgage? Everything You Need to Know

what is a mortgage

I was speaking to my 16-year-old son the other day, and he had some questions. Like.

What is a mortgage? What does your credit score need to be? How do they work?

Many people today are uninformed when it comes to the process of buying a house and how it all works.

In this article, I will be breaking down what a mortgage is and how the process works from start to finish for the novice.

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What is a Mortgage?

A mortgage is a loan used to finance the purchase of a house. When you buy a home in most cases, you will be required to use a down payment, typically between 3.5%-20% of the purchase price you will pay in cash. The remaining amount is borrowed from a mortgage lender; this loan is called a mortgage.

For example, You make an offer of $200,000 on a house, and it is accepted. You have 10% ($20,000) saved up; this will be your down payment. The remaining 90% ($180,000) you will need a loan from a mortgage lender.

Once the sale is complete, you now have a $180,000 mortgage loan that you will make monthly payments to the lender.

What’s Included in Your Mortgage Payment

When you get a mortgage loan, there are more things to pay besides just the principal balance and interest. There are taxes, insurance, and HOA fees to pay. Here is a breakdown of all the costs associated with a home loan.

Principle Payment

The principal balance is the amount of money you borrowed. Each month a portion of your payment will go towards the principal balance. For the first few years, only a small amount of your mortgage payment goes to the principle, as the loan goes on a larger percentage goes to the principal balance.

Interest Payment

Interest is what a lender charges for lending you money. The majority of your monthly loan payment in the first 10-15 years will go towards interest.

Property Taxes

Every state in the U.S. has property taxes that will be due each year. The county will assess the value of your home and charge you based on the county tax rate.

Property taxes are usually included in your monthly payment and placed in an escrow account. The lender will make the tax payment when it becomes due.

Mortgage Insurance

Private mortgage insurance (PMI) is insurance on the loan itself. In the event, a borrower defaults on the loan; the insurance company will reimburse the mortgage lender.

PMI is required on all conventional loans with a loan-to-value ratio higher than 80%. Meaning unless you put down at least 20%, you will be required to carry mortgage insurance.

FHA loans require mortgage insurance regardless of how much money you put down. FHA MIP rates vary based on the amount of your downpayment.

VA loans do not require the borrower to carry mortgage insurance at all.

Closing Costs

Closing costs are fees charged by the mortgage company for funding and processing the loan. You will be charged for items such as your credit report ($20-$35), loan application fee ($200-$400) and a loan origination fee (2%-5% of the sales price)

Closing costs vary from lender to lender, so it’s a good idea to get a loan estimate from at least three lenders. This will ensure you’re getting a competitive interest rate and closing costs.

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Mortgage Term

The most common loan term is a 30-year fixed-rate mortgage. A fixed-rate loan is where you lock in your interest rate for the entire term. 15-year fixed-rate mortgages are also a popular option for those wanting a lower interest rate and to be able to pay off their loan in half the time.

An adjustable-rate mortgage (ARM) is a loan that has a low-interest rate for the first few years, then it increases after the initial period is up.

The most common is a 5/1 ARM, where the first five years of the loan you have a low-interest rate than the rate increases every year. This is a good option for homebuyers who don’t plan on staying in the home for at least five years.

What You Need to Get a Mortgage?

Now that you know what a mortgage is, you probably want to know what you need to qualify for a mortgage.

There are several types of home loan programs that have different requirements, but here are the basics you need to be able to qualify for a loan.

1. You Need Steady Income

Your income needs to be sufficient to afford the loan. Not all types of income will be accepted by lenders; income must be consistent and reliable.

If you are a 1099 employee that is paid commissions or by the job, the lender will need two full years of tax returns. They will take the average income you have made in the last two years to use as your income.

Your debt-to-income ratio, or DTI ratio, is the amount of your monthly income that is going towards debt.

For example, if your monthly income is $5,000 per month, and you have a $200 credit card payment, $400 car payment, and your estimated mortgage payment is $1400. The total debt payments are $2,000, which is 40% of your income.

Lenders like to see a maximum DTI ratio of 36% but may allow up to 45% in some cases.

Use our calculator to see how much house you can afford

2. Down Payment of 3%-20%

A down payment is a percentage of the purchase price a borrower needs to pay in cash at closing. The amount you need to have down will depend on the type of mortgage you get.

FHA loans only require a 3.5% down payment, while a conventional loan will require between 5%-20% down.

There may be first-time homebuyer programs and grants that can help you with the down payment.

Check out our article on low and no downpayment mortgage loans

3. A Decent Credit Score

One of the biggest factors in determining your eligibility for a mortgage is your credit score. For most home loans, you will need a 640 credit score. However, some lenders may be able to accept lower credit scores for an FHA loan.

FHA loans require a 580 credit score with a 3.5% down payment. If you have a credit score of 500-579, you may qualify with a 10% down payment. However, finding a lender that will work with scores under 580 will be difficult.

FHA loan credit requirements

If your score is below 580, you should work on improving your score before applying for a mortgage. Check out our tips for raising your credit score fast.

The Bottom Line

Mortgages don’t have to be complicated. Make sure you work with an experienced real estate agent and loan officer who can walk you through the home buying process from start to finish.

Do you think you’re ready to get a mortgage?

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