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 buying a house and how it all works.
This article breaks down what a mortgage is, how they work, and explains the mortgage terminology in plain English.
What is a Mortgage
A mortgage is a loan that is used to purchase or refinance a house. A mortgage loan is secured by the home. If a borrower cannot make their monthly mortgage payments, the lender will foreclose on the property.
How a Mortgage Works
When you buy a home, you will need to get a mortgage loan unless you have the cash to buy it outright. Your mortgage could have a fixed-rate or an adjustable-rate; fixed-rate mortgages are the most common. You’re interest rate, and monthly mortgage payment will be the same for the life of the loan.
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. You will need a loan from a mortgage lender for the remaining 90% ($180,000).
The maximum amount you can get a loan for will depend on your Debt-to-Income Ratio (DTI ratio). Your DTI ratio is the amount of your income that goes towards your monthly debt obligations. Use our home affordability calculator to see how much you qualify for.
The amortization schedule shows how much of your monthly payment goes towards interest versus the amount that goes towards interest. In the beginning years of a mortgage, the majority of your payment goes towards interest. In the later years, the majority of your payment goes towards the principal balance.
When you get a mortgage, the lender will usually not finance 100% of the purchase price. You will be responsible for the down payment, which is a portion of the sales price that is due upfront. How much you will need as a down payment will depend on the type of mortgage loan you get.
The down payment must come from your own funds or be a gift from a family member or friend. You cannot get a loan for the down payment. Lenders will look at your last 2-3 months of bank statements to ensure the funds are your own.
Your mortgage payment includes more than just the principal and interest payments. Your property taxes, mortgage insurance, and homeowners insurance is also included in your payment and goes into an escrow account your loan servicer sets up for you.
The interest rate is the amount you will pay annually for borrowing the money from the lender. The amount of risk you present determines your rate. Your credit score is the biggest factor. The higher your score, the lower your interest rate will be. Rates also vary by lender, which is why it’s important you compare loan offers and rates with at least 3-4 mortgage lenders before deciding to ensure your getting a competitive rate.
Annual Percentage Rate (APR)
The annual percentage rate is the loan’s total cost, including the mortgage rate, closing costs, and any other lender fees. The APR is a quick and easy way to compare different loan offers to find the loan’s real cost and determine which loan will save you the most money.
The lender you get your mortgage through will usually sell your loan to a loan servicer. The loan servicer will send you a notice that your loan has been sold to them and provide information on how to send your monthly payments to them.
Types of Mortgage Loans
FHA loans are guaranteed by the Federal Housing Administraton and require just a 580 credit score with a 3.5% down payment making them easier to qualify for than traditional mortgage loans.
Conventional 97 Loans
The Conventional 97 loan program is a type of conventional mortgage that requires just a 3% down payment with a 680 credit score.
HomeReady / Home Possible Loans
A conventional mortgage is not backed by the Government and meets the requirements of Fannie Mae and Freddie Mac. You need a 620 credit score and a 5%-20% down payment to be eligible.
Veterans of the military are eligible for a VA loan, which requires no down payment or mortgage insurance.
USDA loans are for low-to-median income homebuyers in rural parts of the country. They don't require a down payment and have the lowest mortgage insurance rate of any home loan.
What’s Included in Your Monthly 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 and Interest
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 principal; as the loan goes on, a larger percentage goes to the principal balance.
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.
Private mortgage insurance (PMI) is insurance on the loan itself. If 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.
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.
A fixed-rate mortgage loan has a fixed interest rate and monthly payment that stay the same throughout the life of the loan. The most common loan term is a 30-year fixed-rate mortgage. 15-year fixed-rate mortgages are also a popular option for those who want a lower interest rate and pay off their home earlier. A 15-year term will have a higher monthly payment, but you’ll save tens of thousands of dollars in interest over the course of the loan.
An adjustable-rate mortgage (ARM) is a loan with a low initial interest rate for a period of time, usually five years, that will adjust up or down according to market rates. The most common is a 5/1 ARM, where the first five years of the loan you have a low-interest rate, then 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.
How to Qualify for 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 with different requirements, but here are the basics you can qualify for a loan.
1. You Need Steady Income
Your income needs to be sufficient to afford the loan. Lenders will accept not all types of income; income must be consistent and reliable. If you are a 1099 employee 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. The maximum DTI ratio for a mortgage is typically 43%. However, some home loans allow for a DTI ratio of up to 50%.
2. Down Payment of 3%-20%
The amount you need to have down will depend on the type of mortgage you get. There are two types of mortgage loans that require no money down, VA and USDA loans.
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.
3.5% - 10%
No down payment
No down payment
5% - 20%
Conventional 97 Loan
Home Possible Loan
10% - 20%
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. If your score is below 580, you should improve your score before applying for a mortgage. Check out our tips for raising your credit score fast.
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?