Mortgage Basics

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by Advice Chaser
by Advice Chaser
orange and blue concrete painted house

If you own your own home, you probably have a mortgage. And if you’re dreaming of homeownership, you will almost certainly need one. A mortgage is simply a loan used to buy property, which uses the property as collateral for the loan.

A house is a significant investment, which few people can afford to buy in cash. Luckily, mortgages are usually a very safe bet and can help you build wealth. Just be careful not to get trapped into a bad mortgage or one beyond your means.

How They Work

Simply speaking, a bank lends you the money to spend on a home. That amount is called the principal. But unlike a student loan or a credit card loan, there’s collateral the bank can repossess if you don’t pay: your home. While that may seem frightening, it tends to result in lower interest rates for you because the bank’s risk is lower.

In order for the bank’s risk to be low, however, the loan can’t be more than the house is worth. Generally speaking, banks prefer to lend 80% of the home’s cost, while you put 20% down. If you don’t have 20% of the home’s price in cash, you may end up paying private mortgage insurance, or PMI. This is a cost of about $100-200 a month that the bank charges for the extra risk. Once you’ve paid off enough of your mortgage that only 80% of the home’s value is still owed, you can get your PMI removed for a lower monthly payment.

Most mortgages are on a 30-year or 15-year term. What that means is that, after 30 or 15 years of paying your monthly payment, the loan will be paid off and you will own your home debt-free. A 30-year term will give you a lower payment, but a 15-year term will mean you pay less interest over the years and get free of the debt sooner.

The Process

Your first step in getting a mortgage is getting pre-qualified by a bank. You will provide some initial documentation, and they will tell you how large of a loan you can get. That will determine the prices of homes you can consider.

Next, you can get pre-approved by submitting more documentation. The lender should provide a loan estimate which details your estimated interest rate, monthly payments, fees, and loan policies.

After you’ve found the home of your dreams, a closing date will be set. Sign on the dotted line, and the home—as well as the mortgage—will be yours.

Sometimes, the bank that lent you the money will sell your mortgage to another company. In that case, the new company becomes your loan servicer, and you will have to send your monthly payment to them instead.

Types of Mortgages

Not all mortgages are the same. Most people know about conventional mortgages, but different types can unlock new benefits. On the other hand, some types of mortgages are a bigger risk for you than a conventional mortgage.

  • Conventional mortgage: This is a loan from a private lender, conforming to government standards. You will need to either pay 20% down or pay PMI.
  • Government-insured mortgages: These include FHA, USDA, and VA mortgages. If you meet the requirements, you could make a down payment of less than 20% without having to pay PMI.
  • Adjustable-rate mortgages: While most mortgages are fixed-rate, meaning your interest rate stays the same, an adjustable-rate mortgage changes your interest rates as market rates change. That could mean you pay less when interest rates drop—but it could also mean your monthly payment goes up more than you can afford.
  • Balloon mortgages: You pay a normal monthly payment for a certain number of years, and then the entire cost of the home comes due at once. This can be risky if you don’t manage to sell or refinance before that payment comes due.

How to Save on Your Mortgage

There are many ways to reduce the cost of your mortgage:

  • Putting more money down, so you don’t have to pay PMI
  • Improving your credit rating, which will win you a better interest rate
  • Buying when interest rates are low
  • Buying points (also known as “buying down the rate”) can lower your interest rate
  • Bargaining down loan fees, with the help of your real estate agent or a lawyer
  • Refinancing your home if interest rates drop later on

In general, the better financial health you’re in—high credit score, low debt-to-income ratio, more cash on hand—the less you’ll pay. Choose a home that fits your situation: you’ll always do better buying a house you can afford than trying to push the limits of what a bank will lend you.

Help With Your Mortgage

Are you considering buying a home soon and need mortgage advice? Would you like advice on how to refinance to lower your monthly payments? Contact us to reach a financial advisor who can help you make these vital decisions.

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