Home Mortgages Explained

So, you think you’re ready to buy a home but don’t know where to start. No worries, you’re in luck. This article covers the basics of mortgages to help you get into your dream home.

What is a Mortgage?

Closing on a home mortgage and getting the keys you your home.

Mortgages help bridge the gap between the total price of a home and your downpayment. With home prices on the rise, many Americans are looking to mortgages as the standard of homeownership. Depending on your financial situation and credit, lenders help fund a large portion if not the entire price of a home.

Mortgage Requirements

Your house may be the largest asset that you will ever own.

Income

Since home prices vary, lenders don’t set a specific minimum income threshold for each borrower. Qualifying for most home loans requires you to have at least two years of reportable income. Lenders take a look at the average of your two most recent tax returns as the basis for their decision. Lenders use this calculation to minimize their risk and ensure repayment of the funds lent.

Debt

“Not all debt is good debt”, and lenders keep this in mind when analyzing your financial situation. Lenders look to see if you are not overextending yourself, therefore increasing your risk in their eyes as a borrower. Types of good debt include debts incurred towards acquiring income-generating assets or higher education. Types of bad debt include consumer, auto and payday loans that require monthly debt payments.

Debt-to-Income Ratio

Your debt-to-income ratio plays a big part in determining your ability to obtain a mortgage. Although 30% is the sweet spot, most lenders prefer ratios much lower than 30%. Your ratio can be calculated by dividing your current minimum monthly debt payments by your monthly gross income.

For example, if your total minimum debt payments total $1,250 and your monthly gross pay is $5,000, then your debt-to-income ratio is 25%.

Credit

Your credit score ultimately determines the price you pay for your mortgage. Therefore higher scores lead to lower interest rates and as a result, a lower monthly payment. Arming yourself with a stellar credit score increases your odds of obtaining a favorable rate during the pre-approval process.

It’s a good idea to know where you stand before your application process begins. Credit monitoring services like Credit Karma can help you determine the general range of your credit score.

Reserve Assets

Even if your income meets the minimum requirements, lenders also look at your reserve assets before determining loan eligibility. All lenders are unique but in this situation the more assets that you own the better your chances of approval. A good mix of savings, investments, and an emergency fund of 3-6 months of monthly expenses should be a good starting point. Remember that the assets in your reserve should be counted separately from the funds going towards your downpayment.

Downpayment

Although there are some low/no downpayment mortgage options, most lenders recommend some form of downpayment at closing. A downpayment shows lenders that you have some skin in the game and helps lower your monthly payments. Downpayment’s help build instant equity in your home and can eliminate frivolous PMI and interest rate fees. A higher downpayment could potentially save you thousands of dollars during the life of the loan.

Banks and Mortgage Brokers

Real estate. House on stack of coins. Flat design business concept illustration.

Banks & Other Lenders

The funding needed to acquire the properties comes from banks and other non-traditional lenders. Lenders perform buyer and property due diligence, set the terms of the mortgage based on qualifications, and eventually service or sell the loan after closing. The “homeowner” does not actually own the home until the last payment is met and all principal and interest have been paid. As the rightful owner of the home, the lender has the right to foreclose on a property if the buyer does not uphold the mortgage agreement.

Mortgage Brokers

Home mortgage brokers specialize in sourcing financing for potential homeowners. Brokers work as a liaison between buyers and home lenders to find the lowest rates and most favorable terms depending on qualifications. Brokers provide several options to buyers allowing them to choose between multiple competing offers. While more options are preferable to only one, brokers do charge a premium for their services.

Interest Rates

Fixed-Rate

Rates never change during the life of a loan unless the homeowner decides to refinance the remaining balance. Therefore providing stability for homeowners who want a set mortgage payment every month. Homeowners don’t worry about paying more when rates go up, but miss out on the savings when rates go lower.

  • Best time to buy: Low-Interest Rate Environment

Variable Rate

Variable mortgages typically start out at a lower introductory rate in comparison with fixed-rate mortgages. The homeowner may deal with a monthly mortgage payment that’s never the same month over month. When interest rates increase, so does the overall mortgage payment, which leads to an over-budget overwhelming burden.

  • Best time to buy: High-Interest Rate Environment when the Fed signals cuts in interest rates are imminent

Home Loan Length

30 Yr Home Mortgages

30-year loans are the most popular option, and what the majority of home buyers opt for. 30-year loans spread payments out over the course 30 years, for a total of 360 payments. These types of loans generally charge lower interest rates and have lower monthly payments due to the longer time horizon. The lower payments associated with 30-year loans enables price-sensitive buyers a great option to obtain homes.

15 Yr Home Mortgages

15-year loans are the less popular home buying option, but they do have some great benefits. 15-year loans spread payments out over the course 15 years, for a total of 180 payments. Lenders usually charge higher interest rates because the lender needs to benefit from the compressed time frame. Higher monthly payments are the biggest con of 15 years loans, but help owners build equity in their home quicker. The higher payments may seem daunting at first but the cost savings outweigh the upfront burden.

Types of Mortgages

FHA Loans

FHA loans are issued by lenders and insured by the governments Federal Housing Administration. By far the easiest to obtain, FHA loans only require a credit score of 580 or above. Buyers in this credit bracket will be required to put down 3.5% as a downpayment, and are subject to PMI fees. In addition to the credit score requirement, buyers will need to have a debt-to-income ratio of less than 43%. As of 2019, FHA loans are limited to around $315k for single-family homes.

Conventional Loans

While conventional loans are subject to stricter approval requirements, there are many benefits gained from this option. The majority of lenders require at a minimum a 5% downpayment and 620 credit score. Unlike FHA loans, conventional loans only require PMI if the original downpayment is under 20% or until 78% of loan principal remains. Also, a debt-to-income ratio of up to 50% is allowed but requires a higher credit score depending on the lender.

VA Loans

Issued by the VA and tailored for military personnel and their families, VA Loans are known for the no downpayment benefit. Lenders offer favorable terms since a portion of the loan is guaranteed by the Department of Veterans Affairs. VA loans do not require PMI, have a minimum credit score, or have a stated minimum income threshold. In terms of debt-to-income, VA loan lenders usually require a ratio of around 41%.

Investment Loans

Also known as rental property loans, investment loans are used to purchase an investment or owner-occupied multi-family property. These types of loans require a minimum downpayment of 20-25% depending on the lender. Investment loans are great for generating monthly cash flow and building wealth. Lenders factor in the income generated through these loans during the approval process.

Interest-Only Loans

Interest-only loans stand as debatably the riskiest loan option on the market today. Most require interest-only payments for the first 3, 5, or 7 years. At the end of that time frame, a balloon payment of the remaining principal is due. House flippers use these loans to lower their holding costs while procuring and renovating projects. The proceeds from the sale of the renovated home pay the principal balance before payment is due. While this can be a lucrative alternative in hot housing markets, a downturn can leave homeowners holding the bag.

Other Considerations

People are putting more money into their mortgages than ever before.

Property Taxes

Usually baked into your overall monthly payments, property taxes go directly to your local city. Property taxes help fund your cities public works projects, infrastructure, utilities, and school systems. Depending on your area, property taxes fluctuate in overall price and benefit. Property taxes are determined by the city regarding the perceived value of your home. A good rule of thumb, the more affluent the area, the higher the property taxes.

PMI

PMI is private mortgage insurance that buyers pay when they can’t afford a downpayment of at least 20%. This insurance protects the lender in the event of a default on the loan. Some loan options allow you to opt-out after a certain portion of the loan is paid down. Avoid PMI if possible in every circumstance when mortgage shopping.

Homeowners Insurance

Homeowner’s insurance provides support in the event damages, losses, or personal liability claims associated with the property. As an essential piece of the homeownership picture, this form of insurance pays the lion’s share of covered perils. Policies can vary by region and provider, are factored into monthly mortgage payments in addition to principal and interest.

Mortgage Points

Mortgage points provide a discounted interest rate in exchange for upfront payment at closing. Typically set at 1% of the total amount borrowed, each point lowers the monthly payment overall fees of a loan. To take full advantage of buying points, experts recommend staying in the home for a longer time horizon. Although a great long-term benefit, points do not count towards any portion of the loan principal.

Closing Costs

The closing comes after you find the perfect place, agree on a purchase price and lock-in your financing. At closing, you will need to bring your downpayment check, if applicable, and an additional check to cover closing costs. Closing costs generally consist of prorated taxes, relator, title search, title transfer, appraisal, and inspection fees. Depending on the lender, closing costs vary substantially. Prepare for closing by becoming aware of what your lender requires well ahead of your closing date.

Upkeep

Although not a direct piece of your monthly payment, upkeep on your home must be factored into the price of homeownership. Homeowners need to budget for things not covered by homeowners insurance like a leaky faucet or new washer and dryer. Monthly upkeep can add up over time depending on the location, age, and current state of a property.

The Best Mortgage for You

If you’re on your way to becoming financially fit, then homeownership is right around the corner. You should be aware that the total price you pay is never what the home’s listed price states. Becoming pre-approved for a loan that’s within your means will give you the upper hand over other potential buyers. A balanced budget, great credit, and dedicated savings will help you attain the home of your dreams.

If the time is right for you to pursue homeownership, use this calculator to determine how much home you can afford.