A mortgage may seem like a pretty simple undertaking. And at its core, that’s certainly true. It’s simply financing used to either acquire a home or refinance existing financing.
But as the saying goes, the devil’s in the details, and when it comes to mortgages there is an incredible number of details.
If you’ve taken a mortgage in the recent past, you may be familiar with some of those details. But if you’ve never taken one, or haven’t in a number of years, there’s plenty you’ll need to know before you apply.
Mortgage Loan Guide
In this guide, we’re going to present everything from the basics of mortgage financing to many of the technical details. Click any of the links below to quickly navigate this article or continue reading below:
- The Basics of Mortgage Loans
- Types of Mortgages
- How to Qualify
- What is PMI?
- How a Mortgage Will Affect Your Credit
- How to Apply
- Where to Get a Mortgage
By the time you’re done reading, you should be well prepared for whatever your future mortgage lender throws your way.
Mortgage Financing – The Basics
A mortgage is a debt like any other, with the most distinguishing feature being that it’s secured by real estate.
That can be a residential home, an apartment building, a commercial building, a farm, or even raw land.
But in this article, we’re going to focus the discussion on residential real estate, since each of the other mortgage types are a topic all their own.
In the case of a purchase money mortgage, the financing is being used to buy a house.
A refinance is where you take a new mortgage to pay off an old one, or even to consolidate non-housing debts.
It’s sometimes said with a refinance that you’re buying the house back from yourself, mainly because the process is virtually identical to a purchase money mortgage except for the absence of a sales contract.
When purchasing a home, you’ll typically make a small down payment, which can be anywhere from 0% to 20% or more of the purchase price. The mortgage will then comprise the great majority of the purchase price.
Because houses are so expensive, financing terms generally range from 10 years to 30, with 30-year mortgages being the most popular. This is due to the obvious fact that the longer the term, the lower the monthly payment.
The Imbalance Between Principal and Interest
Your monthly payment is comprised of both interest and principal. But because of the long-term nature of a mortgage, the majority of the early payments go to interest, not principal.
For example, if you take a 30-year, $200,000 mortgage at 4%, your monthly payment will be $954.83. Of that total, $666.67 will go to interest, and only $288.16 will be applied to principal.
First-time homebuyers are often shocked at that arrangement. But if you break it out mathematically, it makes perfect sense. On a brand-new $200,000 mortgage at 4%, the interest will be $8,000 per year. When divided by 12, that comes to exactly $666.67 per month.
But as the years pass, and the principal balance is gradually paid down, the split between interest and principal on the payment shifts.
Sometime during the 13th year of the loan, the principal portion of the payment begins to exceed the interest portion. And by the time you make the 360th and final payment, only $3.17 of the payment goes to interest – and the rest of principal.
It’s kind of shocking when you first see this, but it’s the way mortgages work.
Types of Mortgages
You’re probably at least remotely aware that there are different mortgage products.
The most common are the following:
Fixed Rate Mortgages
This is a loan in which all the terms are fixed throughout the life of the loan. That includes the interest rate and the monthly payments. Each will be the same in year 30 as they are in year one. It’s the safest type of mortgage to take if you prefer complete predictability.
Adjustable Rate Mortgages (ARMs)
As the name implies, this type of mortgage includes variable terms. They start out with a fixed term, which can be three, five, seven or 10 years, during which the interest rate and payment remain constant.
But after that, the loan converts to a one-year adjustable, in which both your interest rate and monthly payment will change annually.
ARMs come with what are known as “caps” on rate increases. A common arrangement is:
- A maximum 2% increase in the rate at the first adjustment,
- A maximum 2% on any subsequent adjustment, and
- A maximum lifetime cap of 5%.
As an example, let’s say you take a five-year ARM (referred to as a “5/1” ARM) at 4%. You’ll have that rate for five years, after which the maximum rate will be 6%.
The next rate increase will be limited to 8%, and the most you can pay after multiple increases will be 9% – the original 4% rate, plus the 5% lifetime cap.
ARM loans are best for those who don’t plan to be in a home for more than the initial term of the loan, or if you believe interest rates are heading lower.
These loans aren’t nearly as common as they were a dozen years ago. Basically, your loan is set up like a fixed rate mortgage. You’ll have a fixed interest rate, and monthly payments will be based on a 30-year payout. But the loan will require a one-time rate reset after five, seven, or 10 years, at the then prevailing rates for 30-year financing.
Like balloon mortgages, these are not nearly as common as they were a dozen years ago. They’re usually set up as 30-year fixed rate loans (though they can be ARMs), but have an introductory term during which you pay interest only.
For example, a particular mortgage may have a 30-year term, with a five-year interest only period at the beginning. At the beginning of the sixth year, your payment will be adjusted to include principal payments. However, the payments will be larger than they would be for a straight 30-year fixed rate loan, because the principal balance must be amortized over the remaining 25 years.
In addition to the various mortgage products, there are also different mortgage types. The five most common are:
These are mortgage loans issued by the Federal National Mortgage Association (FNMA), more commonly known as “Fannie Mae”, and the Federal Home Loan Mortgage Corporation (FHLMC), better known as “Freddie Mac”.
Both are federally chartered mortgage funding agencies that were once publicly traded corporations (but both are now held in receivership by the federal government).
These loans are generally available to borrowers with stronger credit and income profiles. And unlike FHA and VA mortgages, they can be used to purchase second homes and even small investment properties.
These are loans insured by the Federal Housing Authority (FHA), which is a US government agency as part of Housing and Urban Development (HUD).
FHA loans are primarily available for those with weaker credit and income profiles, and only for owner-occupied properties.
VA mortgages are insured by the US Department of Veterans Affairs, and issued exclusively to current and former members of the US military and their families.
Like FHA mortgages, they are available only for owner-occupied properties. But the main distinguishing feature is the 0% down payment requirement. If you qualify for a VA mortgage, you can literally get 100% financing on either a purchase or refinance.
Conventional, FHA and VA mortgages are subject to maximum loan amounts. For 2019, it’s $484,350 for single-family homes in most areas, but as much as $726,525 in areas designated as high cost. Even higher limits apply for two-, three- and four-family properties.
If you’re looking to purchase or refinance a property that will require a higher loan amount, you can use what is known as a “Jumbo” mortgage. Jumbo mortgages are typically issued by banks and other institutions, in amounts exceeding $1 million.
However, qualification for Jumbo mortgages is more strict. You’ll generally need stronger credit and higher income, as well as a larger down payment or equity, to qualify.
Interest rates are usually slightly higher than those on conventional loans, due to the higher level of risk on larger loan amounts.
This is a term that refers to any type of loan secured by real estate that’s in a subordinate position to a new or existing first mortgage.
They generally come in two types, home equity loans and home equity lines of credit, commonly known as “HELOCs”. Either can be used in conjunction with a purchase or as a new loan on a property you already own.
Home equity loans usually have fixed interest and payment terms, while HELOC’s may come with a low introductory offer (often interest-only), then convert to a variable rate loan.
Once they do, the rate will usually be based on the Prime Rate plus a specific margin. For example, if the Prime Rate is 5%, and the bank’s margin is 2%, your rate will go to 7%. Each time the Prime Rate changes, your HELOC rate will adjust up or down.
In most cases, the term of either a home equity loan or HELOC will be somewhere between 10 and 20 years. They are available at banks and credit unions.
How to Qualify for a Mortgage
There are all kinds of specifics based on your own personal financial profile, so we’re going to keep this discussion general.
Mortgage lenders typically consider income in the form of debt ratios. Usually, there are two ratios, your housing ratio, and your total debt ratio.
The housing ratio is your proposed new house payment, divided by your stable monthly income. The new house payment includes principal and interest on the new mortgage, and monthly allocations for real estate taxes, homeowner’s insurance, private mortgage insurance (“PMI”) if required, and any homeowner’s association dues imposed by your neighborhood.
The total debt ratio, usually referred to as the “DTI” (debt-to-income ratio), adds your fixed monthly obligations to your house payment. That includes student loans, auto loans, credit cards, child support, and other fixed payments.
For example, if your stable monthly income is $5,000, and your proposed house payment is $1,200, your housing ratio is 24% ($1,200 divided by $5,000). If you also have $600 in recurring non-housing debt, your DTI is 36% ($1,200 + $600, divided by $5,000).
How high these ratios can be will depend on the type of loan – conventional, FHA, VA, or Jumbo:
- Conventional – generally the DTI should be 36% or less, but can go as high as 50% for stronger financial profiles.
- FHA – generally 32% for the housing ratio, and 43% for DTI. But like conventional, the DTI can be as high as 50% for stronger financial profiles.
- VA – generally 41% on the DTI. But the VA also uses a complicated qualification process based on residual income (remaining income available after housing, debts, and necessary living expenses have been accounted for) so the ratio is no better than a loose guideline.
- Jumbo – they generally mirror those of conventional loans, and may go higher for particularly strong financial profiles.
While your loan amount will be qualified based on your income, mortgage lenders also carefully evaluate your employment. What they’re most interested in is the stability of that employment.
As a general rule, they’ll look for a minimum two-year work history. They’ll want to see that you’re either at the same employer, or at two or more during that time at the same or a higher pay level. Exceptions will be made if you are a new college graduate or recently discharged from the military.
If you’re self-employed, you’ll usually need a minimum two-year history – verified with complete tax returns – though less may be accepted for an otherwise strong financial profile.
When applying for a mortgage, credit is determined mainly by two factors, your credit score and the occurrence of any major derogatory events.
Your credit score indicates your overall credit worthiness. For conventional loans, the minimum credit score is 620. With FHA, the minimum is 580, though many lenders will not approve an FHA loan with a score below 620. VA loans have no stated credit score minimum, but lenders typically impose one at 620 or 580.
Since Jumbo loans involve much larger loan amounts, minimum credit scores are higher. They may be between 680 and 720, and even higher on certain loan types and loan amounts.
Major derogatory events include bankruptcy and foreclosures. You’ll typically need to wait at least two years after either event to apply for a mortgage. And of course, that will also be dependent on your credit performance since the event. If you filed for bankruptcy more than two years ago, but you have several late payments and a couple of collections since, your application may be declined.
With Jumbo mortgages, the requirements for major credit events are stricter. Since the loans are issued by different banks, they can set their own guidelines. One lender may require a minimum of five years, while another may decline any loan involving a borrower with a major credit event.
The minimum down payment requirements vary by loan type:
- Conventional – generally 5%, but can be as low as 3% for first-time homebuyers and low income households.
- FHA – typically 3.5%.
- VA – 0%.
- Jumbo – once again, the minimum will be determined by the lending bank. You should generally expect 20%, but some banks may go lower with certain programs.
Private Mortgage Insurance
Commonly known as “PMI”, this is probably the most complicated mortgage related topic. It’s sometimes confused with mortgage life insurance, which is a policy that pays off your mortgage upon your death. It’s even confused with homeowner’s insurance, which pays claims for damage to your property.
What is PMI?
Private Mortgage Insurance actually insures the lender, not the borrower, in the event of loan default. For example, your mortgage may include a mortgage insurance requirement of 25%, which means the insurance company will pay 25% of the outstanding mortgage balance if you default on the loan. (Presumably the other 75% is covered by the foreclosure value of the home.)
Even though the policy covers the lender, the premiums will generally be paid by you as the borrower.
Each loan type has its own mortgage insurance requirement and rates:
- Conventional – PMI will be required when you either make a down payment of less than 20% of the value of the property, or your equity in a refinanced property is less than 20%. The insurance will be charged on a monthly basis, and included with your mortgage payment.
- FHA – mortgage insurance will be required on any loan, regardless of the down payment or equity. The premium requirements are the most costly of the major mortgage types, since there is both an up front premium (generally 1.75% of the new loan amount, plus a monthly premium added to your mortgage payment.
- VA – requires only an upfront premium, known as the funding fee. It will be 2.15% of the loan amount for most borrowers, but there are variations. The funding fee is added on top of your loan amount, and financed over the term of the loan.
- Jumbo – mortgage insurance requirements vary by lender and loan type, but may not be required based on high down payment levels.
As much as we’d like to present specific examples of monthly mortgage insurance premiums, there are too many variables involved. The amount you’ll pay will generally depend on the size of your down payment, your credit score, and the type of loan. You’ll need to check with your lender to determine what your specific monthly premium will be.
In most cases, a property will be acceptable for mortgage financing as long as it meets local zoning ordinances, as well as standards of safety and livability. That doesn’t mean the house has to be in mint condition, but it must meet minimum standards for human occupation.
For residential mortgages, the property must be one-to-four family. More units will require specialized mortgages.
Whether you are purchasing a house or refinancing, the lender will generally require an appraisal be performed. The appraiser will determine the market value of the home, based on sales of comparable properties in the local market within the past year.
The appraised value may be either higher or lower than the agreed-upon sale price. However, the lender will use the lower of the sale price or the appraised value in determining your mortgage amount.
How a Mortgage Will Affect Your Credit
This is a double-edged sword. On one hand, a good mortgage payment history is generally the strongest credit component on your credit report. That’s because it’s a secured loan, and generally your largest debt.
But the other side of that sword is that your credit will affect both your ability to be approved for your mortgage, as well as the interest rate you’ll pay.
As you can see from the myFICO Loan Savings Calculator below, a credit score higher than 760 can get you an interest rate of 3.443%, while a score of 620 will result in a rate of 5.032%. The difference between the two payments on the same loan amount is almost $200 per month.
The moral of the story: It pays to do everything possible to improve your credit score before applying for a mortgage. Due to the high cost of low credit, it will be well worth it to you to take several months to work on repairing your credit before applying.
The Mortgage Application Process
You’ll be required to complete a loan application as well as other documents to begin the process. This can either be done online, at the lender’s office, or even at your home, place of business, or other mutually agreeable location, between you and the lender’s representative.
You’ll also need to supply supporting documentation for your employment, income, and savings.
The list can include, but is not limited to the following:
- Name, address, phone number and contact parties for your employer.
- Copies of recent pay stubs, as well as W-2s for the past year or two.
- Two year’s complete income tax returns if you’re self-employed, commissioned, have significant investment income, or own rental property.
- 1099s, award letters or bank statements supporting receipt of Social Security or pension income.
- Copies of leases on rental properties.
- Copies of the last two monthly statements from any savings or investment accounts you will be drawing down payment and closing costs funds from.
- A copy of the sales contract on a purchase, or the deed for a refinance.
- Written explanations – and any relevant documentation – to explain any past credit issues.
- A copy of your divorce decree or court order if you are either receiving or paying alimony or child support.
You should be prepared to provide any of the above documentation that applies in your situation. But keep in mind the lender may request additional documentation based on your particular circumstances.
Mortgage Closing Costs
There will be certain fees involved in the mortgage process. These will include an origination fee (typically 1% of the loan amount, paid to the lender), and appraisal fee, credit report fee, attorney or title company fee, title insurance, and real estate and mortgage transfer taxes, among other fees. You can generally assume total closing costs will come to between 2% and 4% of your mortgage amount.
You can pay the closing costs out-of-pocket, which when added to your down payment can significantly increase your total investment. But in many markets, it’s also possible to have the closing costs paid by the property seller. Sellers will do this as an inducement for you to buy their home.
You can also have the closing costs paid by the lender, by what’s referred to as lender paid closing costs. The lender will pay your closing costs in exchange for a slightly higher interest rate on the loan. For example, the lender may pay 2% of the loan amount toward closing costs, in exchange for a rate increase of 0.25%. If funds are tight, this will be a good trade-off.
Where to Get a Mortgage
If you have good credit, the search for a mortgage should start with your personal bank or credit union. But it should never end there either. Check with other banks, as well as mortgage companies lending in your area.
Also, investigate online lenders. Online mortgage lending has become much more popular in recent years, and you can often find better rates and terms. Examples of popular online lenders include (in no particular order):
- Rocket Mortgage
- Quicken Loans
- Lending Tree (provides access to multiple lenders)
- J.G. Wentworth
- Veterans United
Also, be aware that many large banks provide mortgage loans on a nationwide basis through their online platforms. This includes Bank of America, Chase, Citi and a large number of regional banks.
Equipped with the information provided in this article, you should be already to make an application and get your mortgage approved at the lowest possible rate.