What is a Mortgage?
A mortgage is an agreement that allows people to borrow money to buy property, which the lender can seize if borrowers fail to pay.
With the median price of homes sold in the US totaling $324,500 in the fourth quarter of 2019, most American families can’t afford to buy a house entirely in cash. Banks and other financial institutions issue mortgages, a type of secured loan, to help borrowers buy property. Borrowers typically have to supply a down payment worth a percentage of the loan amount and must repay the loan through regular payments over a set period of time. Mortgages come with an interest rate that can be fixed or adjustable (variable). If the borrower defaults on the loan, the lender can seize the house.
Imagine Darrell and Sue have found their dream home. It comes with a price tag of $250,000, which they can’t afford out of pocket. Darrell and Sue apply for a mortgage at their local bank. After reviewing the couple’s assets, employment, credit history, and other factors, the bank offers them a home loan. The couple agrees to contribute a down payment of $50,000, which is 20 percent of the purchase price of the home. The bank issues a loan of $200,000 to cover the other 80 percent. The couple will pay back the loan with interest in monthly increments over 30 years.
Having a mortgage is kind of like renting your own house…
Even though you own the home, you did it with borrowed money. If you stop paying, the bank can seize the house. So for a certain number of years, you’re basically paying rent to the bank. As you repay the loan (with interest), you truly own more and more of the house.
Taking out a mortgage can be a confusing process. Here are the steps involved:
Your credit score is an important factor in determining whether you can get a mortgage and the interest rate you receive. The higher your credit score, the lower the interest rate you’re likely to get. If your score is on the lower side, you may want to spend some time boosting it before trying to get a mortgage. Generally, a good score is anything above 700, while an excellent one is anything above 800. Most people have a credit score between 600 and 750.
Often lenders are willing to offer a loan for a more expensive house than you can actually afford. It’s your job to ensure you can make the monthly payment that comes with your mortgage. When you’re figuring out what fits in your budget, you may want to consider the cost of home insurance, property taxes, utilities, maintenance, and other expenses that come with owning a home.
You’ll almost always need to have a down payment when buying a home. Most people try to save a down payment worth 20 percent of the home price. That’s because many lenders require borrowers who put down less to take out private mortgage insurance (PMI). The borrower is the one who pays for PMI, but it’s there to protect the lender in case you default on your loan. However, some lenders these days don’t require PMI even with lower down payments.
When you’re shopping for a house, you’ll typically want to get pre-approved for a mortgage through your lender. Sellers usually prefer to accept an offer from someone with a pre-approval, since it shows the bank has promised to loan you money. When you get pre-approved, your lender will tell you how much they are willing to loan you for a house and the interest rate they’re willing to extend. Most banks offer pre-approvals valid for a certain number of days.
Before getting pre-approved, you might want to get quotes from a few different lenders. You can do this by getting pre-qualified, which is when a lender gives you a tentative quote using limited information. Once you choose a lender and go to get pre-approved, they’ll require all of your financial documents and information to lock in a rate.
Once you’ve gotten pre-approved and made an offer on your house, there are a few other steps that take place, including a house inspection and appraisal. When you close the deal, you’ll sign a promissory note that outlines all of the loan details, including the interest rate, loan amount, loan term, and payment schedule. You’ll also sign a mortgage document, which gives your lender the right to take your house if you stop paying them back.
Once the deal closes, it’s your job to make timely mortgage payments to keep your loan in good standing.
Many people use the terms “home loan” and “mortgage” interchangeably, but there’s a slight difference. The home loan refers to the actual money you borrow from your lender, whereas the mortgage refers to the contractual agreement you make with the lender. The mortgage makes the loan possible and allows the lender to seize the house if you fail to repay it.
One of the most important factors in qualifying for a mortgage is your credit score. This can determine whether a lender will give you a mortgage and what interest rate you’ll get.
There’s no fixed cutoff for qualifying for a mortgage. The credit score you need depends on the lender and the type of mortgage you’re applying for. In general, you’ll need a credit score of at least 620 to qualify for a conventional mortgage. Other loan programs, such as Federal Housing Administration loans, help people with lower credit scores qualify for home loans. Larger mortgages may require a credit score of at least 700.
Keep in mind that in most cases, there will be a correlation between your credit score and your interest rate. The higher your credit score, the lower the interest rate you can usually get. Those with a lower score can work on saving a higher down payment, paying down debts, or finding a cosigner with excellent credit.
Not all mortgages are created equal. Here are some of the different types:
A fixed-rate mortgage is one in which the interest rate doesn’t change for the entire term of the loan. This type of mortgage provides consistency — You know exactly what your monthly payment will be and can rest assured that you won’t be hit with a higher interest rate later. The trade-off is that you often start with a higher interest rate than you would with an adjustable-rate mortgage (ARM).
An ARM comes with a variable interest rate. It often starts with a low introductory rate, but that can change over time based on fluctuations in market interest rates. Your mortgage agreement will typically stipulate how much the rate can increase the first time it adjusts, each time after that, and over the entire life of the loan (the cap is often 5 percent).
Finally, hybrid mortgages combine features of fixed-rate and adjustable-rate mortgages. They have a fixed rate for a specified period of time (often three, five, or 10 years), then switch to an adjustable rate for the rest of the life of the loan.
When taking out a mortgage, you’ll have the choice of different repayment terms. Two of the most common types are 15-year and 30-year mortgages. A 15-year mortgage has a much higher monthly payment, since you’re paying off your loan twice as fast. However, it also often has lower interest rates, and the interest doesn’t have as many years to grow.
Many people choose 30-year mortgages, because they give you more years to pay off your loan, which results in a lower monthly payment. However, you’ll usually have a higher interest rate, and you’ll end up paying a lot more in interest in total than you would with a 15-year mortgage.
A conforming loan is one that meets guidelines allowing it to be purchased by Fannie Mae and Freddie Mac. Conforming loans must fall under a limit set by the Federal Housing Finance Agency (FHFA). The limit as of 2020 is $510,400 for one-unit properties, or $765,600 in high-cost areas.
Loans that exceed the limit set by FHFA are jumbo loans. Lenders will still write these mortgages, but they put more risk on the lender because they’re harder to sell. Jumbo loans are usually harder to get — You’ll probably need a higher credit score than you would for a conventional mortgage.
Federal Housing Administration (FHA) loans allow those with low credit scores and small down payments to qualify for a mortgage. The FHA approves certain lenders to originate these loans and then insures them to reduce risk for the lender. Borrowers with a credit score of 580 or higher might qualify with a down payment as low as 3.5 percent of the purchase price. Those with a credit score under 580 can still qualify with a 10 percent down payment. Borrowers without an extensive credit history or with a bankruptcy or foreclosure on their record may also be eligible.
The Department of Veterans Affairs issues home loans to veterans, surviving military spouses, and current members of the US armed forces with no down payment or private mortgage insurance. Similar to the FHA loans, the Department of Veterans Affairs doesn’t actually lend the money, but rather insures a portion of the loan with lenders who participate in the VA program.
While mortgages can offer a great opportunity to borrowers, they have downsides as well.
Mortgages make homeownership a reality for people who can’t afford to drop hundreds of thousands of dollars in cash upfront for a house. Because you’re spreading that cost over several decades, buying a home becomes much more affordable.
Mortgages can also be pretty cost-effective in some parts of the country. For example, the average monthly cost of rent in Baltimore is $1,286. The average monthly mortgage payment is $978. That’s $300 per month in savings — And this number accounts for the cost of property taxes and home insurance. Mortgage rates have also been historically low over the past decade, making it a more affordable time to buy a home.
There’s also the fact that, when you’re renting a home, you’re giving your money to someone else. When you move out at the end of your lease, you don’t recover any of it. When you have a mortgage, those monthly payments go toward your equity in the house, meaning it’s money you can potentially get back when you sell.
Mortgages also come with potential tax benefits. You may be able to deduct all or a portion of your mortgage interest payments or private mortgage insurance on your annual tax returns. These deductions can lower your taxable income, and therefore your tax bill.
First of all, mortgages are expensive. Even though they tend to have lower interest rates than most other types of debt, and interest rates are at historic lows, you still end up paying a considerable amount in interest over the life of the mortgage.
Let’s say you borrow $200,000 through a 30-year fixed-rate mortgage with an interest rate of 4.5 percent. Assuming you take the entire 30 years to pay back the loan, you will pay over $160,000 in interest. When you’re considering a home purchase, you may want to use an amortization calculator to figure out how much you’ll be paying in interest over the life of your loan.
Adjustable-rate mortgages come with their own disadvantages. If interest rates increase, your monthly payment could get a lot higher and potentially become unaffordable. Some ARMs have penalties for prepayment, so you can’t avoid the interest rate increases by selling or paying off your mortgage early without paying a price.
It’s also a reality that you could lose money on your home. Real estate tends to hold or increase in value over longer periods of time, but that doesn’t make it impossible that your home could lose value while you own it. The housing market fluctuates — You could buy a house at the peak of the market and have to sell it when the market is down.
Another downside that comes with a mortgage is that you’ve made a commitment to your lender to make your monthly payment for decades. If there ever comes a time where you can’t, that could result in foreclosure. This event lowers your credit score and could make it harder to get a loan in the future.
Banks and lending institutions often sell mortgage notes (promissory notes) to get their money back and free up cash flow. Investor groups who buy those mortgage notes, sometimes at a discount, take over collecting principal and interest payments from the borrower.
Most buyers of these notes aren’t individual investors — They are hedge funds and other banks. Part of the reason for this is that banks typically sell mortgages notes in bulk. However, investors might be able to buy a single mortgage note through a broker.
Two types of mortgage notes an investor might purchase are:
When an entity purchases a mortgage note, it takes over all of the rights of the bank or financial institution that originated the loan. That includes the right to foreclose on the property. So if you buy a non-performing note, you could try to help the borrower get back on track with payments. But you could also foreclose on the loan and take control of the property.
Investing in mortgage notes is a whole different ball game than investing in the stock market. As with any other investment opportunity, there are risks involved. You may want to do your research on the front end to know what you’re getting yourself into.
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