Main Content

How Do Mortgages Work?

If you’re thinking about buying a home, it’s a good idea to bring yourself up to speed on various parts of the transaction. How mortgages work is certainly an important topic, and because most people don’t buy a home very often, it’s good to refresh your memory. So, whether this is your first or fifth home purchase, this guide will give you the latest information you need to know about mortgages.

About Mortgages

In very simple terms, a mortgage is the loan you get when you need to finance the purchase of a home. A mortgage is probably the biggest loan you’ll get in your life, and it may have the longest term. As you know, no one finances a car purchase for 10, 20, or 30 years. Unless you plan to pay cash for your home, you’ll need a mortgage.

How Mortgages Work: Elements of a Mortgage

You’ll understand a lot more about how mortgages work once you learn about the different elements you’ll run across.

Secured Loan

Your loan is secured by your home, meaning that your lender holds the title to your home until you pay off what you owe. If you don’t make payments as agreed to in the mortgage documents, the lender can repossess the house. In that regard, it works just like a car loan.

Down Payment

Almost all mortgage loans require a minimum down payment. You can always put down more than the minimum if that makes sense for you financially.

You’ll want to know the minimum down payment requirements for any loan you consider. One common myth about mortgages is that you need a down payment of 20 percent of the cost of the home in order to qualify. In today’s market, you’ll see a variety of requirements ranging from nothing down in some rare cases, all the way up to 20 percent.

In some cases, you can put down less than the minimum required, and the lender will add an additional charge to your monthly payment amount.

Loan Amount

The loan amount is what you will owe after your down payment. So, if your home cost $350,000 and you put 10 percent down, your loan amount would be $315,000. You would pay off that amount over time at a specified interest rate.

Loan Term

You will pay the loan off over a specified period, which is your loan term. Common loan terms are 30 and 15 years.

Interest Rate

Your interest rate will be either fixed or adjustable. If you get a fixed-rate mortgage, the interest rate will be the same for the life of the loan. If you get an adjustable rate mortgage (ARM), you’ll agree to changes in the interest rate based on a pre-defined formula.

Monthly Payment Amount

You pay off your loan with monthly payments, but it’s important you know how that payment is calculated. When you talk to a lender, they may discuss a dollar figure that consists of paying off the principal and the interest.

But, you also need to know your total monthly payment amount that is sometimes called PITI. The acronym PITI stands for Principal, Interest, Taxes, and Insurance. Typically, the lender is responsible for collecting amounts for your property taxes and your home insurance, and then sending those amounts to the appropriate party.

Your real estate agent can help you determine what you might reasonably expect to pay in property taxes and home insurance if you don’t have a specific home in mind when you talk to your lender.

If a lender allows you to make a down payment that is less than the minimum, they will typically charge you a monthly fee for Private Mortgage Insurance (PMI). You’ll need to add that amount to the PITI amount in order to see what you’ll be paying each month.

Types of Mortgages

Mortgages come in a variety of types. You’ll need to find the right lender and the right type of mortgage to meet your needs the best. Your real estate agent can provide advice about selecting lenders in your area. Here are some of the options you’ll see.

Conventional vs Government-Backed

The government backs some mortgage loans, including FHA, VA, and USDA. There are pros and cons that you need to review before making a final decision. For example, FHA loans offer lower down payment minimums, but they always require a mortgage insurance policy.

The government doesn’t back conventional loans. These loans usually require larger down payments, but the monthly payment is often lower than government-backed loans.

Fixed vs Adjustable Rate

The interest rate on a fixed-rate mortgage is established when you obtain the loan and it stays at that rate throughout the life of the loan.

If you get an adjustable-rate mortgage (ARM), the interest rate is set when you obtain the loan and stays at that rate for a predefined period. Afterward, your interest rate will change according to changes in the interest rates reflected in an index of international interest rates.

For example, if you got a 5/1 ARM at 3% interest, you’d pay three percent interest for the first five years. The interest rate would adjust once a year after that, indicated by the “1” in the name. ARMS typically also have a cap on how much the interest rate can change. So, if your ARM was capped at 2%, your interest rate couldn’t adjust any more than that, even if the interest rates went up or down by 4%.

The advantage to an ARM is that the initial interest rate is typically lower than you would get on a conventional mortgage. You need to weigh that benefit against the fact that you won’t know what will happen to your mortgage payment during the adjustable period.

Short vs Long Term

A 30-year loan is the most common, which means you will pay the loan off in 30 years. However, there are also shorter-term loans of 10 or 15 years. Interest rates on 30-year mortgages are higher than a shorter-term loan, but the monthly payment would be lower.

Conforming vs Jumbo Loans

A conforming loan meets the maximum loan limit established by organizations like Fannie Mae and Freddie Mac, which are government-sponsored organizations that buy and sell mortgage-backed securities. If you need to finance an amount that is more than the maximum, you’ll need a nonconforming loan, also known as a jumbo loan. Jumbo loans typically require larger down payments and excellent credit ratings because of the risk such a large loan presents to the lender.

Other Considerations

It’s always a good idea to get pre-approved for a mortgage before you make any formal offers. The pre-approval will let you know how much you can spend on a home. It also puts you in a good negotiating position because sellers know there probably won’t be a problem with your financing.

Another factor to keep in mind is that when you close on a house, you’ll need funds to cover both your down payment and the seller’s closing costs. Your agent and your lender can give you a rough idea of the closing costs in your area.

If you’re ready to get serious about buying a home, you can use LemonBrew to find the perfect local real estate agent. That agent can give you the insight you need to expand on your knowledge of how mortgages work, along with all the other things that will make your home buying experience a success.