At some point in their lives, most people aspire to be homeowners. Buying a house is one of the most significant financial decisions that people make in their lifetime, so of course it’s important to think things through and plan ahead. You probably wouldn’t be reading this if you could afford to buy a house outright in cash – so when it comes time to purchase a home, you’ll need a mortgage.
What is a Mortgage?
Mortgages can seem intimidating for first time homebuyers or people who aren’t especially well versed in finance, but don’t worry. We’ll cover all of the mortgage basics, terminology, tips, and common questions that you’ll need to know to get started on your journey to home ownership.
A mortgage is a purchase agreement between a borrower and lender to repay the value of a home plus interest in agreed upon installments, using the home as collateral.
Mortgages are a lot like most loans at a high level. They include interest rates, terms, down payments, approvals, and other loan essentials. With the home being considered collateral in mortgage loans, you run the risk of losing your home if you fail to repay your loan as agreed upon in your mortgage contract. This process is similar to repossession in things like car loans, but in home ownership this process is called foreclosure.
Pros and Cons of Mortgages
Getting a mortgage is a huge commitment that shouldn’t be taken lightly. You need to make sure that you’re financially prepared to take on the responsibility of home ownership. There are many advantages of mortgages, however, for some there may be other housing options such as renting a home or apartment that make more sense for the time being.
Advantages of a Mortgage
Home ownership is a huge life milestone. It allows you to build equity in your property in hopes to sell in the future or pass it on with a far higher value than when you bought it. In this sense, the cost of a mortgage is an investment. Making a good home purchase can make building equity and your next move far easier and less stressful.
Unlike an apartment, where any modifications will be wiped clean when you leave, a mortgage allows you to build something that is your own and allows more freedom with renovations and modifications.
Drawbacks of a Mortgage
Of course there is a flipside to the positive side of mortgages. There are more associated costs on top of your mortgage payment such as property taxes and homeowners insurance, which can often make it more expensive than renting.
There are also more responsibilities that having a landlord allows people to avoid. Any damages or needed home repairs and property upkeep is all on the homeowner when you decide to purchase.
Permanence could be considered a con depending on your point of view. It’s more difficult to pack up and leave on short-notice when you own your home. The tradeoff for this permanence is of course the ownership and opportunity to build something that is truly yours, so it depends on your perspective and future goals.
How are Mortgages Paid Off?
Mortgage payments are split into four categories throughout the life of your loan. A common acronym for these mortgage payment categories is PITI, which stands for principal, interest, taxes, and insurance.
- Principal: The amount borrowed from the lender to satisfy the purchase price of your home
- Interest: Additional cost that is paid to the lender at an agreed upon rate, which is an annualized percentage (APR) of the loan amount
- Taxes: Of course, there are various taxes that accompany mortgages
- Insurance: There are several types of mortgage insurance that you can have and may be required in certain cases
Mortgage payments follow an amortization schedule, which breaks down each payment to show which categories you will be paying to over time. When a mortgage is first taken out, interest makes up a larger portion of monthly payments. As borrowers progress through their loan term, this percentage decreases and more of each monthly payment goes toward the principle.
Sometimes there may be options available to pay more of your interest upfront, so monthly payments chip away at your mortgage’s principal more aggressively.
Types of Mortgages
There are several different types of mortgages, each holding their unique pros and cons. Ultimately, it is dependent on the borrower’s unique situation as to which mortgage type is best suited for them.
Factors that make up different types of mortgages include the type of rate, the term or length of the loan, whether or not the loan is backed by the United States government, and the size of the loan amount.
There are two common rate types that are used in mortgages: fixed and adjustable (ARM). Fixed-rate mortgages are more common, but often come with a slightly higher interest rate than ARMs at the time of signing.
A fixed-rate mortgage is a loan in which the interest is set, or “locked” upon signing and will not change over the life of the loan.
Adjustable-Rate Mortgages (ARM)
An adjustable rate mortgage (ARM) is a loan in which the interest rate can change throughout the duration of your mortgage. These are often referred to as variable-rate mortgages as well.
ARM rates are determined by an index of international interest rates and can fluctuate with the economy and actions of the Federal Reserve.
Mortgage Rate Style Pros and Cons
|Fixed-Rate||Stability and certainty throughout your loan. Your expectations are set for required interest payments.||You may miss out on an opportunity to capitalize on falling rates.
Often starts at a higher interest rate.
|Adjustable Rate (ARM)||Provides the opportunity to lower your interest payments if rates decline.|
Often starts at a lower interest rate.
|Unpredictability and the inherent risk of facing rising interest rates.|
Mortgage Term Length
Another factor of different mortgage types is the term of the loan. This is a measure of how long the borrower has to pay off the loan amount. The longer your loan term, the lower your principal payment is each month, however, there are of course drawbacks to this as well.
The most common mortgage terms are 15-year, 20-year, and 30-year. However, there are many different options that vary by mortgage company that can be higher or lower than this range and may even have more customizable options to fit the borrower’s budget.
Mortgage Term Pros and Cons
|Shorter Term Loans||Balance is paid off faster|
You’ll pay far less in interest
|Monthly payments are much higher|
|Longer Term Loans||More manageable monthly payments||Takes far longer to pay off
A significant portion of the payments will go to interest charges
If you can swing the larger payments, we definitely recommend choosing a shorter mortgage term. It’s important that you don’t put yourself in a bad spot or stretch your finances too thin, but choosing a 15-year mortgage over a 30-year could save you upwards of $100,000 over the life of an average sized home loan.
A common home loan through a mortgage company, bank, or credit union is considered a “conventional” loan. This is a standard agreement between borrower and lender, with the home as collateral, and relies on the rates and terms set at the time of signing.
There are also several other types of home loans that are backed by the government. These mortgages often have more lenient approval criteria, lower costs, or both.
FHA loans are a special type of mortgage that is government backed by the Federal Housing Administration (FHA), which is an agency of the Department of Housing and Urban Development (HUD).
These mortgages are geared to help those with existing debt or a lower credit score obtain a mortgage by having more lenient financial requirements in comparison to conventional loans. This can be accomplished by offering borrowers a lower down payment requirement, financing the closing costs as part of the loan, or lowering the credit requirements.
There are certain requirements that the borrower and home must meet to be approved for an FHA loan.
USDA stands for the United States Department of Agriculture, which provides specialized loans for qualified borrowers in rural areas. Typically USDA loans have no down payment or mortgage insurance requirements, but have an additional upfront fee.
Military families may qualify for a VA loan, which is backed by the U.S Department of Veterans Affairs. Much like USDA loans, VA mortgages usually have no down payment or mortgage insurance required, but have a funding fee upon signing.
The amount that the loan is for can also help determine the type of mortgage. Usually a loan will be either categorized as a conforming or jumbo loan – jumbo of course being the larger of the two.
What is considered a conforming mortgage varies slightly by location due to some areas being higher cost than others. The limit for being considered a conforming loan is $484,350 for most single-family homes in the United States, with the exception of the District of Columbia, Alaska, Hawaii, Puerto Rico, and some other U.S. Territories being $726,525 due to a much higher cost of living. 
Non-conforming loans are often referred to as jumbo loans, which exceed the limits above. These loans are put into a separate category due to the amount of risk that is involved for a lender to allow that much money to be borrowed. With that being said, jumbo loans typically have more strict requirements.
Mortgage Qualification Requirements
Depending on the type of mortgage you are taking out, there are different requirements that borrowers must meet. These mortgage approval requirements are primarily based on a few key factors.
Conventional loans require a credit score of at least 620, however there are some options for those with lower credit scores like government-backed FHA loans, which can be approved for borrowers with credit scores as low as 580. 
Better credit scores will increase your chances of an easy approval and help secure better terms for your mortgage.
Debt-to-Income (DTI) Ratio
One key factor that lenders look at when taking out any loan is your debt-to-income ratio, or DTI. This measurement helps gauge your ability to pay back the loan by comparing your income to existing debt.
Debt to Income Ratio = Total debt / income
(most often monthly)
Lenders prefer low debt to income ratios, usually no more than 45% for most mortgages.
Some types of mortgages may not require a down payment, and those that do vary in amount depending on the individual borrower’s financial situation and the home they’re looking to purchase.
Down payments are cash paid upfront when taking out a loan. This cuts down on the amount borrowed, often putting borrowers in range of the amount of risk a lender is willing to take.
For conventional mortgages with down payments less than 20%, PMI (private mortgage insurance) is required. To avoid this extra cost, many home buyers aim to save up for a 20% down payment before buying a home.
Choosing the Right Mortgage Lender
There are many different lenders that you can compare rates for when choosing the right one to finance your mortgage. It’s important that you not only compare rates, but any terms or eligibility requirements as well.
Many major banks and credit unions offer mortgage loans as well as several non-bank mortgage companies.
Non-bank mortgage providers offer many of the same financing capabilities and competitive rates that banks do, but these companies specialize in loans and typically do not offer banking services as well.
These companies create loan programs using a variety of funding services like national banks, but they are still the ones funding the loan unlike mortgage brokers. By specializing in mortgages, these companies can sometimes be quicker to close or provide additional services or technology to help you along the way with your mortgage that most banks won’t.
Banks and Credit Unions
You can also try to finance your mortgage directly through your bank or credit union. Sometimes you may find better mortgage rates, so it’s important to consider.
Your bank may not have the expertise of a mortgage company or be able to move quite as quickly. Be sure to check in on both bank and mortgage company options when shopping around.
Common Mortgage Terms
Throughout the process of getting a mortgage, you may encounter terms that you haven’t heard before. It’s important to get familiar with some of these terms and what they mean so there’s no confusion or misunderstanding when working through the mortgage process.
|Amortize||To gradually lower the value of a loan over a set term or period of time. An amortization schedule will show how debt payments to the principal and interest of the loan will be handled over time.|
|Appraisal||An assessment of something's value. Appraisals are completed by home value experts to determine a home's worth.|
|APR / Rates||Annual Percentage Yield - the annual cost of interest and fees for a loan, expressed as a percentage. APR includes more than simply the interest rate and is more accurate in terms of actual cost to the borrower.|
|Balloon Loan||A mortgage that uses an adjusted amortization system, having a large lump sum payment at the end of the loan term to pay off the remaining balance.|
|Broker||A middle-person who does not independently originate mortgage loans, but connects lenders and borrowers and aids in the mortgage process.|
|Closing Costs||Expenses beyond the purchase price of the home to finalize a mortgage and "close" on the house. These costs are often part of negotiation between the buyer and seller.|
|Closing Disclosure||A form that outlines the terms, payment schedule, fees, and other details of a mortgage upon finalizing the loan.|
|Co-borrower/co-signer||A secondary person whose name is on the loan in an effort to increase the primary borrower's chance of approval, often due to credit score and will be financially responsible in the case of default from the primary borrower. A co-borrower typically has shared ownership of what is being financed whereas a co-signer is strictly for qualification purposes.|
|Conforming||A conforming mortgage is one that's borrowed amount does not exceed a set number within the mortgage industry. Loans that exceed this breakpoint are considered jumbo loans.|
|Contingency||A clause written into a mortgage agreement that outlines certain criteria, which if aren't met, will void the sale. This is often used to protect both parties in a mortgage agreement under certain scenarios.|
|Conventional||A standard mortgage that is not government backed through programs such as USDA, FHA, or VA loans.|
|Deed||A legal document outlining the ownership of a property.|
|Department of Veterans Affairs (VA)||A government administration which provides programs for U.S Veterans and military families to purchase homes with more lenient terms or costs.|
|Earnest Money Deposit||Also known as a "good-faith deposit", a payment to the seller that allows for time that the buyer can retain their offer on a home while they secure financing and conduct home inspections and appraisals.|
|Escrow Account||A legal arrangement where a third party collects and holds money while the two sides of a financial transaction complete the purchase process.|
|Fair Market Value||The selling price of a home in the current market.|
|Fannie Mae||The Federal National Mortgage Association (FNMA), a U.S. government sponsored public company that purchases mortgages and offers them through a secondary market, making them guaranteed and more affordable for borrowers with lower incomes.|
|FHA||The Federal Housing Administration (FHA), which provides insured mortgages backed by the U.S. government designed to make mortgages more accessible to lower-income borrowers by having lower down payment more lenient approval requirements.|
|Forbearance||An agreement between a borrower and lender to temporarily postpone mortgage payments.|
|Foreclosure||Repossession of a home by a lender after the borrower has defaulted on their loan and fails to keep up with the terms or payments in a mortgage agreement.|
|Freddie Mac||The Federal Home Loan Mortgage Corporation (FHLMC), a U.S. government sponsored public company that purchases mortgages sells them as mortgage-backed securities, which fund new loans from banks to homebuyers.|
|Home Equity||The value of an asset (home) compared to the amount owed on the lien against it. If the value of a home exceeds its debt, the owner has equity (or "positive equity") and if the debt exceeds the asset's value, the owner has negative equity (commonly referred to as "underwater" or "upside down")|
|Home Inspection||A step in the mortgage process where a home pending sale is reviewed by an expert to identify any safety hazards or needed repairs prior to the sale of the home.|
|Mortgage Points||Commonly referred to as "discount points", are optional payments available upon closing of a mortgage that allows the borrower to pay for a lower interest rate.|
|PITI||Principal, interest, taxes, and insurance (PITI), the components to a mortgage payment which is often used as a more inclusive measure of cost to accurately depict the cost of a home loan.|
|PMI||Private mortgage insurance (PMI), a required insurance for mortgage loans with down payments less than 20%, which covers the lender in the event of default from the borrower.|
|Pre-approval||A preliminary qualification for a mortgage, which allows the borrower to solidify a lending source and provides an estimated interest rate and approval amount.|
|Prequalify||A step within the mortgage process to estimate the amount a borrower would likely be approved for. Unlike a pre-approval, prequalification does not indicate any commitment to any property or lender.|
|Prime Rate||The interest rate that commercial banks charge corporations and most qualified customers, often considered the lowest rate that a loan can be financed with.|
|Principal||The borrowed amount of a loan, equal to the purchase price and does not include any interest or fees.|
|Rate Lock / Lock-in||Solidifying the current interest rate between an offer and closing on a home, allowing the borrower to maintain this interest rate once a mortgage is finalized.|
|Seller Concessions||Closing costs that the seller of a home has agreed to cover. Sometimes in mortgage negotiation, the buyer may ask the seller to pay for closing costs.|
|Short Sale||Also known as a "pre-foreclosure sale", when a home is sold for less than the remaining mortgage balance.|
|Term||The length of time that a mortgage is agreed to be paid off in. The most common mortgage terms are 15, 20, and 30-year.|
|Underwriting||The process used by lenders to determine if an applicant should be approved for a mortgage.|
|USDA||United States Department of Agriculture (USDA), which provides government-backed specialized loans for qualified borrowers in rural areas, typically with zero down.|
|Variable / Floating Interest Rate||A variable interest rate that fluctuates with market index movement, increasing or decreasing throughout the duration of a mortgage.|
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Do you need excellent credit to get a mortgage?
Are mortgage brokers worth it?
Can a mortgage cover renovations?
What happens when a mortgage is paid off?
What happens when you overpay on your mortgage?
What’s the difference between getting prequalified and preapproved for a mortgage?
Can you get a mortgage with no credit check?
When should I consider refinancing my mortgage?
How long does it take to close on a house?
Do I need mortgage insurance?
What is the most common type of mortgage?
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