How Mortgage Loans Work
How Mortgage Loans Work: A Detailed Explanation
Homeownership is among the largest investments that a single individual can make. For many, this ambition becomes a reality because of mortgage loans. This type of financing makes the purchase of a house or land possible and allows the borrower to reimburse the lender over a specified duration, typically within 15 to 30 years. The question that arises is, how does a mortgage loan work and what needs to be done by an individual to be able to apply for one?
In this ultimate guide, we will discuss how mortgage loans work, their types, how to apply for it, and other pertinent details that a borrower needs to know regarding a loan for a home.
1. Describe a Mortgage Loan:
A mortgage loan is a secured debt against a specified asset, in this case, commercial or residential real estate. When an individual wishes to borrow a large sum of money, they take out a mortgage where the bank or mortgage company acts as the lender. The borrower must repay the loan amount plus interest over a period of time. This type of loan is secured against the property, which means that in case of default, the lender can take possession of the property.
Such loans are normally repaid in monthly installments over a few years, typically 15, 20, or 30 years.
Mortgages can have either fixed or adjustable interest rates, and have a variety of features and requirements for down payments.
2. The Basics of Mortgage Loans
In a typical mortgage loan, the borrower is expected to pay back the **principal** amount with an added **interest**.
Principal: In simple words, it refers to the amount borrowed from a lender. If for example, a borrower buys a home that costs $300,000 and pays $60,000 as a down payment, then the principal comes out to be $240,000.
Interest: Refers to the additional cost incurred on the principal amount. The lenders charge an interest to the borrower to make a profit on the loan, which is primarily charged to the borrower in an annual percentage rate, also referred to as the APR.
You will make monthly payments for a set period, commonly known as the term of the loan. Each payment includes a portion of both the principal and the interest, and the sum of those amounts is what you send in every month. The payment authority to whom you will pay the money and the amount that you will pay is determined by the terms of the loan set with the lending institution, that includes the interest rate that has been set as well as the repayment term, amongst other things.
3. Types of Mortgage Loans
There are varying types of mortgage loans available to which the features and requirements of each may differ. Being aware of the type that meets your financial criteria can greatly help you in making the right decision when it comes to getting a mortgage from a lender.
a) Fixed-Rate Mortgage
Has an interest rate that does not change over the duration of the loan.
Such level repayment makes budgeting easier as there is less volatility to worry about considering such payments are uniform across the board and consistent throughout the duration of repayment.
Advantages:
- There are no surprises when having to pay bills on a monthly basis.
- These loans are immune to changes in the economy, as the payments will remain the same regardless.
Disadvantages:
- When compared to adjustable-rate mortgages, the interest rates on these mortgages are much higher.
- Losing out on adjustable rate mortgages can be detrimental and a disadvantage if the economic climate becomes more favorable.
b) Adjustable-Rate Mortgage (ARM)
An adjustable-rate mortgage (ARM) is a type of loan where the initial interest is set lower than average. This is beneficial as it allows the borrower to make smaller payments earlier in life. However, following the initial period, the interest rate becomes higher and is susceptible to market fluctuations.
Advantages:
- Smaller payments at the beginning.
- If the economy decides to do well, the borrower has a lot of room to save.
Disadvantages:
- Regardless of how adjustable-rate mortgages benefit the borrower, if the economic climate becomes unfavorable, the adjustable-rate mortgages will have the same detrimental impact on the borrower.
- After the initial fixed period, there will be a changed that will affect both parties, resulting in the previously ‘comfortable’ economy feeling much tighter.
c) Interest Only Mortgage
For a designated period of time, borrowers are required to only pay the interest. Once the period ends, the borrower is mandated to pay both the principal and interest while also paying the previously set payments, resulting in extremely high repayments.
Advantages:
- Ideal for those who have recently started making an income.
- Provides easy flexibility in the formative years.
Disadvantages:
- The loan balance is maintained throughout the interest-only period without any reduction.
- Payments increase dramatically at the end of the interest-only period.
d) FHA Loan
FHA loans are government subsidized loans available to moderate to low-income borrowers. They have reduced down payment limits usually within 3.5% and are more favorable to individuals with poor credit.
Pros:
- Reduced down payment limits.
- More relaxed credit score restrictions.
Cons:
- Increased monthly installments due to mandatory insurance.
- Borrowing limits are set according to the property location.
e) VA Loan
VA loans are available without a down payment or private insurance to active duty soldiers, veterans, and some spouses. These loans have backing from the department of veterans affairs.
Pros:
- No down payment needed.
- Lower interest rates and no insurance.
Cons:
- Limitations on eligibility for veterans and soldiers.
- Possible additional funding fees.
A mortgage type categorized as jumbo, exceeds selling limits set by government affiliations like Fanny May or Freddie Mac.
They are normally used to secure larger houses, so their eligibility requirements are tougher and their interest rates are higher.
- Pros:
A high value house can be purchased using these loans.
Flexible loan terms.
Cons:
Interest rates are comparably higher.
More stringent credit and income qualifications.
4. The Mortgage Application Process
It is essential to grasp the steps in getting a mortgage defined by each lender in order to ensure you have a pleasant experience while applying for the loan. Below is a list of the ordered steps:
Step 1: Pre-Qualification or Pre-Approval
This one is the most important: applying for a mortgage pre qualification or pre approval. Prequalification includes a small assessment of some financial factors (income, how much debt you have, etc.), but Pre-approval is typically more comprehensive, and requires such documents as income tax returns, bank statements, and credit reports.
Pre-Approval informs you the amount you are eligible to borrow and aids in restricting spending while searching for a new home.
Step 2: House Hunting and Making an Offer
When you have received your pre approval, you can begin your search for houses within your price range. This process can be easily done with the assistance of a realtor. After selecting a property, you will need to make an offer on the house.
If the seller consents to your offer, it is possible to begin the application process for the required mortgage.
After submission, the mortgage lender will process the loan and appraise the borrower’s financial ability. Step 1: Applying for the Loan Covering Step 2 of the mortgage application nourishes the overall analysis to confirmation fraternity. The loan will be set in the underwriting stage where it will either be approved or denied.
Once your mortgage has been authorized, the closing process will begin. This includes working on the additional payments required for the house ownership to legally belong to you along with signing the mortgage papers. You will be obligated to pay back at a preferred rate through the following months.
While If your loan is approved, you’ll move to the closing stage. This involves signing the mortgage agreement, paying closing costs, and officially transferring ownership of the property. You’ll then begin making monthly mortgage payments back.
5. Common Mortgage Loan Terms You Should Know
Mortgage loans come with their own specific terminology. Understanding this vocabulary is very helpful when applying for a mortgage. Here’s a list of commonly used terms relate to mortgages that are helpful:
Private Mortgage Insurance (PMI): Insurance usually enforced when the borrower is unable to deposit at least 20% of the property cost.
Down Payment: The first payment made while purchasing a property which is a fraction of the total cost, usually a percentage.
Amortization: Signifies a gradual repayment strategy where the loan deposit is paid back slowly over an agreed time frame along with monthly payments.
Escrow: is a trust account held by a neutral third party for payment of property taxes, insurance, and related expenses.
Fixed-Rate: is a type of loan interest where the rate does not fluctuate over the life of the loan.
Adjustable-Rate: in this type of loan the interest rate varies at predefined times within the duration of the loan based on the economic conditions.
Second Edition - Questions and Answers section of the book (FAQ)
Q1: What is the minimum credit score that I need to qualify for a mortgage?
620 is the average credit score that most lenders look for in conventional loans. However, such low scores as 580 may be accepted for government sponsored loans like FHA.
Q2: What is the minimum amount of down payment I need to make?
The minimum down payment is determined by the type of loan. Conventional loans often ask for 5% which is the minimum amount needed while FHA loans offer lower rates of 3.5%. There's also some VA and USDA loans that do not require any down payments from eligible borrowers.
Q3: Can I be able to secure a loan with a mortgage and really bad credit?
Yes, and although it is a possibility, it would be a lot tougher. Imbued backed loans like FHA and VA loans do tend to be more lenient towards those with terrible credit. If your credit score is verging lower, expect high interest rates and poor terms.
Q4: Can you explain what PMI is and is it necessary?
Private mortgage insurance (PMI) is an insurance that is compulsory if an individual makes down payment of lower than 20 percent on a conventional loan.
It serves as a safety net for the lender if you cease to pay your mortgage. You can, however, prevent paying PMI by either opting for a higher down payment or applying for a different type of loans that have no PMI, such as VA or USDA loans.
Q5: Is it possible to pay the mortgage off earlier than needed?
The answer is in the affirmative. Generally, mortgages can be paid off prior to its due time without incurring any fines, however it is important to read the rules as some mortgages do come along with restrictions against prepayments.
Q6: What's the meaning of an escrow account?
This account can be understood as an instrument serving as a deposit held by a neutral third party and is used for paying costs related to the property like tax and home insurance. Some lenders may wish for an escrow account to make sure that the borrower’s other obligations are also met.
Conclusion
Mortgage loans are crucial in enabling people in the acquisition of a home. There are a number of considerations that need to be addressed when buying a home which include how mortgages operate, the various forms of mortgages, and the process of getting a loan. In this regard, one has to be sure whether one is buying a house for the first time, or simply refinancing it. With a well laid out plan on the loan, one is able to achieve real estate prosperity.