What Are Mortgages?
A mortgage is a loan to purchase a home in which the home acts as collateral for the loan. Most mortgages will lend a percentage of the purchase price, with the remainder coming from the home buyer in the form of a down payment. You can expect to put down anywhere from 3.5% to 20% of the home’s price in cash, depending on the source of the mortgage. The first thing to understand about mortgages is amortization.
When you finance the purchase of a home with a mortgage, you arrange to make fixed payments for a set number of months, i.e., the term. You then write a monthly check to the mortgage holder that pays interest and reduce mortgages principal (i.e., builds your equity in the home). A lender allocates most of your payments to interest in the early years of the mortgage. Interest contributes to the lender’s profits, so it’s not surprising that lenders like to collect it first. As the years pass, the split begins to favor principal. Your last mortgage payment is practically all principal repayment.
For example, suppose you purchase a home and take out a $250,000, 30-year mortgage carrying a 5% interest rate. If the interest rate were zero, the monthly payment would be $250,000 divided by 360 months, or $694.44. Thanks to the interest, your fixed payment is $1,342.05. In your first payment, $1,041.67 goes to interest and $300.39 pays down principal. Your new principal for month two is $249,699.61. Thus, the lender applies 77.6% of your first payment to interest. Over time, the split between interest and principal repayment shift such that most of your payment is allocated to principal reduction.
There are many mortgage offerings available to you, but they all share a common core of characteristics:
- Loan amount: determined by the value of the home, your down payment, any loan guarantees, your income and your creditworthiness
- Down payment: cash you bring to the purchase transaction to fill the gap between the home’s price and the loan amount. In some cases, you can use money from friends or relatives for the down payment
- Term: the amount of time you must pay off your loan, usually in monthly installments. Most mortgages have
- Interest rate: how much the lender charges for the mortgage balance. Usually presented as a standardized annual percentage rate (APR) that includes fees and other charges
- Interest rate type: mortgages can have fixed or variable-rate interest. Fixed-rate interest doesn’t change over the life of the mortgage, so you know your exact cost up front. A variable-rate mortgage will periodically reset the interest rate based upon prevailing conditions. In most cases, a variable rate mortgage specifies a balloon payment to collect the remaining loan balance all at once after a set period, such as 3, 5 or 7 years
- Prepayment penalty: some mortgages charge you a penalty if you prepay principal ahead of schedule. It’s best to avoid this type of mortgage
- Loan guarantee: some mortgages are insured against default by a federal agency such as the Federal Housing Administration (FHA). The guarantor sets minimum standards for these loans, such as minimum down payment and maximum interest rate.
Types of Mortgages
Before choosing a mortgage provider, be aware of the different types of mortgages available to you:
- Conventional mortgages: these are Uninsured mortgages offered by banks, credit unions and other loan providers that conform to standards set by federal government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac. As of 2019, a conventional mortgage cannot exceed $484,350, although some high-cost areas such as Hawaii have a higher limit of $726,525
- Jumbo mortgages: these are non-conforming, uninsured loans in amounts that exceed those of conventional mortgages
- FHA mortgages: mortgages issued by conventional mortgage lenders and insured by the federal government, with less stringent credit requirements. You can obtain an FHA-insured primary mortgage with as little as 3.5% down if your credit score is at least 580, your debt-to-income ratio is below 43%, and you meet satisfy certain other criteria
- VA mortgages: issued by the Veterans Affairs Department and requiring no down payment for qualified applicants
- USDA mortgages: issued by the U.S. Department of Agriculture to rural home buyers. These require no down payment but have other fees and restrictions
Choosing a Mortgage
When it comes to actually choosing a mortgage to finance your home purchase, consider the following factors:
- Amount you can borrow: a lender will specify a maximum monthly mortgage payment that includes insurance costs and property taxes, both of which are usually included in the monthly payment. The lender will evaluate data such as payment as a percentage of income (typical maximum: 28%), and total monthly debt as a percentage of income (typically up to 36%). Your credit score and previous credit history can impact the lender’s offer. Generally, a FICO score above 620 is required, although your lender might require a substantially higher score
- Amount you must put down: while certain FHA-insured loans require only 3.5% down, most lenders mandate a higher amount, and require you get private mortgage insurance for down payments below 20%. The insurance premium is figured into you monthly payment
- Closing costs: lenders charge various fees at closing, such as origination fees, title insurance premium, deed recording fees, appraisal costs and so forth. When shopping for mortgages, you can save money by comparing closing costs, not just APRs
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A mortgage might be the largest debt you’ll ever assume. When making such a large commitment, it makes sense to understand your obligations and options, shop around for your best deal, and be realistic about how much mortgage you can afford.