Ultimate Guide to Mortgages

What Is a Mortgage?

A mortgage is a type of loan typically issued by a bank, credit union, or online lender to purchase a property — you are essentially lent money by a financial institution. You then repay the loan, typically in monthly installments. Each installment includes the principal (outstanding loan balance) and the interest (the price you pay the lender for borrowing money) of the mortgage.

A mortgage is a contract between you and the lender that you will make your payments plus interest on time. You are charged interest by the lender for providing you with the loan.

It’s important to note the difference between your interest rate and the annual percentage rate (APR) on your mortgage. Where interest is the cost of borrowing the money each year, the APR is a broader overview of the cost of borrowing, which takes not only the interest rate into account but also any points, mortgage broker fees, and other charges you must pay in order to get the loan. Not surprisingly, the APR is typically higher than the interest rate.

When buying a home, a down payment is usually required in order to obtain a mortgage. This is a percentage of the cost of the house, ranging from at least 3 to as much as 20 percent, according to Consumer Finance, that you provide up front.

The size of your down payment opens up more mortgage options to you, as lenders typically look at your down payment in increments of 5 percent when calculating your interest rate and other loan costs.

Essentially, the more you pay up front as a down payment toward your home, the lower your monthly payments will be. Conversely, the less money you put down, the higher your monthly payments.

Important note: While most mortgages are structured with monthly payments, biweekly payments do exist. There are companies that will structure biweekly for you for a fee, but you can also do this yourself. The big advantage of paying half the amount of your monthly mortgage every two weeks (as opposed to the full amount once each month) is that you’ll make 26 of these during the year — so in essence, you’ll be paying an extra monthly payment each year.

This goes totally to the reduction of principal, and will typically pay off a 30-year mortgage in about 22 years if done from the start. It can also reduce years from a 15-year mortgage.

Biweekly payments could make sense for people who want flexibility to take a 30-year mortgage and make payments on a 15-year schedule. Then, if they need to, they can make the lower scheduled payments. This can be a good strategy for people with variable income or for those with low-security jobs.

How Does a Mortgage Work?

Like most loans, the borrower receives a lump sum from the lender, called the principal. The borrower agrees to pay it back over a set period of time, typically 15 or 30 years. The money you borrow accrues interest, and each monthly payment repays both the principal, the interest on your mortgage, and may include taxes or insurance.

An interesting tidbit: With most types of mortgage, most of your early monthly payments go toward paying interest. As time goes on, you pay less in interest payments and more toward the principal, until you pay off both in full and own your home.

The typical process of a mortgage begins with the prospective home buyer comparing lenders — we will cover how to identify the lender that best suits your needs later. Once you have identified your lender, the process looks something like this:

• Find out for how much of a loan you prequalify: This initial, optional step gives you a very rough idea of how much you might expect to be approved for based on the preliminary information you supply to the lender — it is not a guarantee. It does, however, save you from wasting time looking at properties out of your range and gives the seller increased confidence in your ability to close.
• Get pre-approved by your lender: This step comes next, also optional but a good idea to complete; information such as your credit history, proof of employment and income, and proof of any assets is verified by your lending institution. It is contingent on a qualifying property and that your information still meets the standards set out by the lender. Once pre-approved, a conditional letter for the mortgage amount is issued. You can use this to help you secure the house you want.
  • Remember that while a pre-qualification or pre-approval are helpful to give you an idea of whether you will be approved, neither is a guarantee.
• Make an offer on the property: Through your real estate agent or in the form of a letter, you make an official offer for the house you have chosen. The seller can accept, reject, or counter your offer. You can, in turn, accept, reject, or counter — negotiations may go on until such a time as both parties are satisfied. There is always the chance someone outbids you, so the sooner you can get your home into contract the better.
• Go to contract: The contract on the property is drawn up through the real estate agent, broker, lawyer, or sometimes the seller themselves, and signed by both parties confirming the offer that was accepted by both parties in the previous step. The contract is typically a form with add-ons, specifying a time to close and subject to mortgage approval.
• Paying earnest money: Once the contract is signed, the buyer may have to put down “earnest money,” at least 1 to 2 percent of the mortgage amount to show you make the offer in good faith, which will be held in escrow. This varies widely from state to state — it is customary in some states, and may just be a personal check for a couple of thousand dollars in others.
• Get ready for the home inspection: A run-through of the physical property, an inspection is required by the lender, is next. The inspection lists any issues with the property big or small — ranging from termite damage to a cracked windowpane. Both the lender and the buyer should be aware of any potential property issues. Often the buyer will insist on major defects being fixed before a sale, or they will deduct the cost of fixing any major items from the selling price (the seller must agree).
• Title or deed search: This determines who currently owns the home, and thereby who has the right to sell the home. The search looks for the documents that hold this information, such as the property title, the deed, and any liens taken out on the home. For example, though a married couple might live in a home together and decide to sell, if the deed is in the wife’s name, she is the only one who can legally sell the property.
• Ensure you are protected: That being said, many first-time home buyers might feel intimidated by the process. You can insist on contingencies and disclosure alerts to make sure you are protected, within reason.
  • Your contingency must be legitimate: A hole in the roof is a major concern, but putting in a contingency that your mother-in-law needs to approve the color of the exterior when she flies in next month is probably a deal breaker. Proceed with caution or you may lose out on the property.
  • Disclosures are also common. For example, many homes in New York City must disclose if they have lead-based paint, or you may ask the seller to disclose the results of a termite inspection. In most areas of the country it is normal to have contingencies for mortgage approval and property inspection. Do your research and know what is within your right to ask for.
• Complete the full mortgage loan application if you haven’t already done so: Though some documentation was done in the pre-approval stage, the lender will require updated and more in-depth information from you now. It’s not uncommon to need to provide pay stubs, two years’ worth of tax returns, details of any other debts you are paying (such as student or auto loans), and proof of any other sources of income. The lender is required to provide you with a Loan Estimate within three business days that details both the monthly and long-term costs of your mortgage.
• The mortgage process and underwriting begins: Usually the longest wait for the buyer, now the loan processor, appraiser, and underwriter work together to cross-check, double-check, nitpick, and verify all the information you provided about your finances; the property will also be scrutinized with an appraisal.
• An appraisal is essential to protect both you and the lender to pay for what the property is worth, not an inflated value. Professional appraisers don’t just type your address in Zillow — they look closely at the home, recent home sales in the area, factors such as local crime statistics and school quality, then provide a number or a range for your property value.
  • Keep in mind the underwriter will be looking at a number of factors when evaluating your loan worthiness including: verifying all information you provided about your employment, assets, and liabilities; evaluating your credit history to determine your risk to the lender before loaning you money; and considering your debt-to-income (DTI) ratio to ensure that you can repay all your debt without drowning. This can be a nerve-racking time for any buyer. Be honest about your finances and respond to any document requests from the underwriter in a timely manner so you don’t slow down the process.
• Close, assuming you are approved for your mortgage on your new home: Documents are drawn up, such as the promissory note (which states your intent to repay the mortgage), the deed of trust, and the deed to the property itself. You’ll also receive a Closing Disclosure at least three days before closing that should closely match the Loan Estimate mentioned above. At the closing, you are also required to pay the down payment and any closing costs, such as private mortgage insurance.

There may also be an opportunity to pay points to help offset costs. Also referred to as discount points, points are a type of prepaid interest paid up front to the lender in order to lower the overall interest rate of your mortgage. One point costs the same as 1 percent of the amount financed. You’re basically paying a little more up front for a lower lifetime interest rate.

“If a buyer is planning on staying in a home for at least five years, they may consider paying points to reduce the mortgage rate,” says certified financial planner Tony Matheson. “With rates at historical lows, it may be advisable to lock in the lowest fixed rate possible for the next 30 years.”

There is a prepayment penalty with some mortgages, which means if you sell your home within a certain time period, you must pay a fee. These fees can be no more than 2 percent of your loan balance in the first two years and 1 percent of your loan balance in the third year, and cannot be charged after that, thanks to the Dodd-Frank Act.

Note: Any lending institution that offers you a mortgage with a prepayment penalty must also offer you a similar mortgage without one. There may be additional state restrictions.

What Are the Costs Associated With a Mortgage?

If it were only as simple as settling on the advertised price. There are also a number of costs associated with a mortgage on top of the home’s value.

Usually referred to entirely as closing costs, there are some up-front costs such as the aforementioned down payment relevant in almost all mortgages. There are also costs to close the loan, such as:

• Application fees
• Lender fees
• Appraisal and home inspection fees
• Credit check fees
• Title service fees and insurance (for legal claim to the home you’re buying), usually 0.5 percent of the home’s purchase price, according to the American Land Title Association, a trade association for real estate finance professionals
• Origination fees
• Prepaid interest points
• Attorney fees (if applicable)
• Escrow fees
• Flood certification (required by lenders in some states and localities)

And then there are the actual closing costs. Taxes and government fees such as property tax or recording fees — which makes your ownership of the property public. The home buyer or seller may also be expected to pay a transfer tax, which is a fee or tax for transferring property ownership.

Private Mortgage Insurance (PMI) may also be required depending on the lender. This insurance lowers the risk that the lender undertakes when lending to you, but not all types of mortgages require it. Typically, if your down payment on the property is less than 20 percent of the property cost, you will need PMI.

Closing costs are typically between 2 and 5 percent of the cost of the home. The average single-family home mortgage totaled $5,749 in closing costs in 2019, according to a report by ClosingCorp, a mortgage data solutions company. So if your home cost $200,000, and you paid $5,749 in closing fees, that’s almost 2.9 percent of the overall cost of your home.

Closing fees vary from state to state, and can be negotiable. Some home sellers may be willing to take on certain costs as an incentive to the buyer, and you may be able to obtain more competitive rates on the legal fees associated with buying a home if required.

All fees are laid out in the Closing Disclosure you will receive at least three days before closing. You’ll also receive an estimate of all closing costs when submitting your loan application for a mortgage.

While the onus is normally on the home buyer to cover the cost of closing fees, the seller may also owe real estate commissions, escrow fees, and other costs.

And sometimes, the fees don’t stop at closing. Depending on the mortgage, your lender may charge a prepayment penalty if you pay all or part of your mortgage off early. If your mortgage is subject to this fee, it must be outlined in your closing disclosures. In general, this fee applies only if you pay off your entire mortgage within the first three to five years, but check with your lender beforehand to ensure there are no surprises if you want to pay it off early, or sell.

How Much House Can I Afford?

There are a multitude of calculators available online to figure out how much of a mortgage you (and your spouse, if applicable) can afford. Sometimes, you may qualify for more than you can actually afford. Before doing the nitty-gritty math, ask yourself how much you can reasonably afford to pay each month. Only you know what your short-, immediate-, and long-term plans are and what money they will require.

“The most important thing is to think about what fits best into your overall financial plan,” says Matheson.

“Be careful not to fall [too far] into the trap of looking for ‘how much you can afford’. Weigh your home purchase in the context of all of your other financial goals like retirement, cash flow, and college savings [if applicable],” Matheson adds.

Once that is done, you’ll be in a better position to tackle the actuality of your situation. As with any loan, next comes a credit check. Make sure you’re aware of the state of your and your spouse’s credit before beginning your search for a lender.

“Your credit score absolutely impacts your interest rate,” says Matheson. “I recommend aggressively looking at strategies to improve your credit score when you are shopping for a mortgage. If you carry a balance on your credit cards, the fastest way to improve your score is to pay off the balance. A higher credit score can save you thousands of dollars in interest over the life of the loan.”

Next, determine how much you have for the down payment. Remember, down payments can be as low as 3 percent of the overall cost of the home, but some lenders require up to 20 percent. While a larger down payment will leave you more out-of-pocket now, it will save you thousands in the future on interest.

If you find yourself lacking the cash on hand to make a substantial down payment, it’s worth considering whether you can wait a few years before beginning your homeownership journey. Considering your mortgage’s interest amount, in the context of how much you’ll have to pay up front, can help in determining whether it’s better to buy now or delay your purchase.

Beyond using a financial calculator to obtain a rough estimate, Consumer Finance has a simple method for calculating how much you can afford.

The general rule for the maximum you can receive from lenders is the 28/36 rule. This states that no more than 28 percent of your household income should go toward mortgage payments, while your DTI ratio should be no more than 36 percent.

That said, the less debt you have, the better, overall. And this 36 percent includes the “new” debt of your mortgage. Generally, you will qualify for more mortgage than you can prudently afford, though; as the buyer, you need to qualify yourself for what fits into your financial plan. Hint: What you can afford to pay is typically less than what the lender is willing to loan you.

Each situation is different, so this may not work for everyone, but it is a good starting point. As we will see, some types of loans allow your DTI to be much higher, depending on other variables such as your credit score and assets.

What Types of Mortgages Are There?

Mortgage loans are structured in three ways: fixed rate, adjustable rate, or interest only. Within these three structures, there are many different types of mortgage loans for prospective home buyers (and refinancers), and their features often overlap with one another.

Here, we’re going to look at these three structures of mortgages, and the most popular choices within them: conventional mortgages, jumbo mortgages, government-insured mortgages, and online mortgages.

Each has its own advantages and disadvantages, so it’s important you weigh them all to find the best fit for your financial situation.

Mortgage Structures

Fixed-Rate Mortgages

As the name suggests, fixed-rate mortgages keep the same interest rate over the entire period of the loan, meaning monthly payments are always the same. A fixed-rate mortgage term is usually 15 or 30 years, and the term you choose affects your monthly principal, interest, and interest rate. Therefore, it also impacts how much interest you will pay in total over the entire period of the loan.

Most mortgage types we will see can be fixed rate or adjustable rate.

Pros of Fixed-Rate Mortgages

• Predictability: Monthly payments and rates are always the same.
• It may be easier to budget since the monthly amount is known.
• With a shorter, 15-year loan, you pay lower interest rates and a lower cost overall.
• With a longer, 30-year loan, you have lower monthly payments.

Cons of Fixed-Rate Mortgages

• Usually have higher initial interest rates than adjustable-rate loans.
• You are locked in if you get your mortgage during a period of relatively higher rates — you will not get any relief if rates decline.

Adjustable-Rate Mortgages

The antithesis to fixed-rate loans, adjustable-rate mortgages (ARMs) begin similarly to fixed-rate mortgages. During the initial period, you have a set interest rate that lasts a few years. This beginning period usually has lower interest rates, making initial payments lower and therefore more enticing.

The interest rate can reset after this period. Again, this interest rate is set for a period of time, and then can reset again, and so on.

For example, with a 5/2 ARM, the interest rate may reset after five years, then every two years after that. This reset is based on an index (often an average for a short period in the market or a specific date before the reset, such as the prior month’s close). Similarly, a 7/2 ARM has a seven-year initial period followed by resets at two-year intervals.

There is a cap on how much each reset can be and a cap on the maximum that the rate can go to. For example, you might be able to go up as much as 2 percent every two years, but not more than 7 percent over the life of the loan. It could also come back down.

ARMs are also usually over a 15- or 30-year period.

Pros of Adjustable-Rate Mortgages

• Low initial payments in the initial period.
• There is a specified maximum rate, so you can avoid paying more than you can reasonably afford.
• Payments could decrease.

Cons of Adjustable-Rate Mortgages 

• Payments could increase.
• ARMs tend to be riskier and complex than other mortgages, as if you use an ARM to buy more house than you could afford with a fixed-rate loan, you could get into trouble. They are better suited for the more experienced borrower.

Interest-Only Mortgages

It may sound strange, but some mortgage loans allow you to pay just the interest for a period of time, not the principal balance. This means the overall balance owed on your mortgage loan does not go down in the interest-only payment period, which is often the first 10 years.

For those who wish for more cash flow in the beginning of their mortgage, interest-only payments are typically lower than principal plus interest payments, making this an attractive option. Once the principal payments kick back in, however, the payments are usually high.

For aspiring homeowners who don’t anticipate staying long in their new property, this mortgage option may also make sense. Borrowers for this loan usually must have substantial assets or high income to qualify — this is not typically a great option for most aspiring homeowners.

Pros of Interest-Only Mortgages

• Lower monthly payment.
• Usually structured as adjustable-rate and so have lower initial interest rates.

Cons of Interest-Only Mortgages

• You don’t build equity by reducing the mortgage balance on your property.
• You may lose equity provided by your down payment if the market declines.
• When the interest-only period ends, your payments will increase.

Mortgage Types

Conventional Mortgage

The most common type, conventional mortgages are not insured or guaranteed by a government agency, yet certain kinds of conventional mortgages follow limits set by government-sponsored enterprises (GSEs) like Fannie Mae or Freddie Mac. These are called conforming mortgage loans, and are limited to lending a maximum of $484,350 in most counties.

Conversely, conventional loans that do not meet the limits set out by these GSEs are referred to as non-conforming loans. These mortgage loans can extend into the millions.

Pros of Conventional Mortgages

• Overall borrowing costs are typically lower.
• Can be used on primary, secondary, and investment properties.
• When you reach 20 percent in home equity, you can request to cancel your PMI (if you had one).
• With non-conforming loans, there is no limit to the amount that can be borrowed.

Cons of Conventional Mortgages

• The lower your credit score, the higher your interest rate.
• Higher down payment requirements.
• Stricter qualifying guidelines, such as a credit score requirement of at least 620.
• PMI required if down payment is less than 20 percent.

Jumbo Mortgages

Another type of conventional mortgage, jumbo mortgages are the most common example of a non-conforming loan as they go above the federal dollar limit mentioned previously. As the amount is higher, usually credit requirements are also higher, and paperwork becomes more in depth.

Where conforming loans end and jumbo loans begin depends on county; there are exceptions to the standard to allow for higher real estate costs in some counties, and they put a higher limit on conforming loans, so jumbo starts above a higher base. They are most common in more expensive areas and for the more affluent buyer.

Pros of Jumbo Mortgages

• More funds available to borrow for more expensive properties.
• Interest rates are comparable to other loan types.
• Higher down payment means more equity in your home faster.

Cons of Jumbo Mortgages

• Usually a higher down payment is needed to qualify, often 10 to 20 percent.
• High credit score requirements, usually above 700 though exceptions can be made
• Available only in certain localities.
• Must have a low DTI ratio.

Government-Insured Mortgages

These mortgage loans are backed or guaranteed by the federal government. Three main government agencies provide such loans: the U.S. Department of Agriculture (USDA), the Federal Housing Administration (FHA), and the Department of Veterans Affairs (VA).

The purpose is to help those with lower income who may not have enough cash on hand to make a sizable down payment, or have a higher DTI ratio, to become homeowners. Sometimes applying for a government loan is as easy as filling out an online application, but in other cases, you must go to an approved lender to access a government-insured loan. Each lender then has its own application process.

• USDA loans usually don’t require a down payment, but you must purchase a home in an eligible area, usually rural and suburban. They also typically have low interest rates but borrowers must meet a certain income requirement, which varies state to state.
• FHA loans require down payments of as low as 3.5 percent, and accept borrowers with credit scores as low as 500. FHA loans require mortgage insurance premium payments.
• VA loans are available to military service members, veterans, and their families, at low interest rates. No down payment or PMI is required, and closing costs are capped.

Pros of Government-Insured Mortgages

• Generally low or in some cases no down payment.
• May provide financing if you don’t qualify for conventional loans.
• Lower credit requirements.
• Lower fees (in some cases).

Cons of Government-Insured Mortgages

• Often come with PMI mandates.
• Heftier documentation to support application.
• Sometimes have restricted areas of purchasing.
• For primary homes only.

Mortgage Source: Online Mortgages

An honorary mention for the latest that technology has brought us. Doing our grocery shopping online isn’t enough anymore. Now, you can apply for a loan to finance a home from the comfort of your sofa. And it’s often faster, too: Online lenders process mortgage applications 20 percent faster than traditional lenders do, according to a study by the Federal Reserve Bank of New York.

These mortgages make shopping around for the best rates easier, as everything can be researched online. Plus, owing to high competition between lenders — and some online lenders not having brick-and-mortar institutions, thereby lowering their overhead costs — this can lead to greater savings for the borrower.

That’s not to say the entire process can be done online; you may still have to mail in documents pertaining to your loan application when the time comes. And as with any online activity, be vigilant and do your research to ensure you’re dealing with a legitimate lender.

Any non-bank entity online is not evaluated by the Consumer Financial Protection Bureau. But “safety and soundness” evaluations of these online lenders are conducted by state mortgage regulators, according to the Federal Deposit Insurance Corporation.

Pros of Online Mortgages

• Faster than traditional mortgages.
• Lower interest rates and fees.
• Fewer forms to fill out (in general).
• Easier approval, as some online lenders do not have the same restrictions as traditional banks and credit unions.

Cons of Online Mortgages

• Increased risk of fraud or scams as you are communicating mostly online rather than dealing with a brick-and-mortar institution.
• Online lenders may accept those with low credit scores, but this could hike up the interest rate.

Shopping Around: What to Look for in a Mortgage

Just like you did with your home, car, and the coffee machine you pined for, shopping around for a mortgage can help you get the best deal. From lender to lender, costs and interest rates differ, so do your research.

Get quotes from banks, credit unions, and online lenders. If you are willing to pay the extra fee, a mortgage broker can do the shopping for you, too. (Make sure you shop around for brokers as well!) With the internet, comparing mortgages has become much easier.

Now that you know all the costs associated with a mortgage, ask for individual information from each financial institution on points, interest rates, down payments, fees (and what each fee includes, as sometimes they are lumped together), and PMI.

Remember: Negotiation is key on everything from the asking price of the home to playing one lender’s offer against another to get the best rate. If you’re unsure how granular you should get, check out this mortgage shopping worksheet from the Federal Trade Commission (FTC).

How to Protect Yourself When Applying for a Mortgage

When taking out a mortgage, you have a multitude of rights. If you feel that you have been exposed to unfair practices, predatory lending, or discrimination based on age, sex, race, religion, or disability, there are steps you can take and organizations you can reach out to for help.

The first step would be to contact the lending institution’s customer service hotline or website to file a complaint and resolve it there. Make sure you have all the documents and receipts on hand that back up your claim. If the lending institution does not help, there are several government agencies that you can go to for resolution, and in some cases you should go through multiple channels.

You can find your local agency for housing counseling services by contacting the U.S. Department of Housing and Urban Development (HUD) or the Legal Aid Society. You can also report the issue to the FTC, the Consumer Financial Protection Bureau (CFPB), or the office of the Attorney General in your state.

To protect yourself further, don’t sign any documents with information you don’t understand or that is incorrect, rush into a loan without doing research, or neglect to research the lender you plan to choose.

Ensure that you understand each fee being charged and each term being used by asking questions. Review all documents or hire a trusted lawyer to do so for you. Be informed, and make decisions based on that information.

Final Thoughts on Mortgages

Now that you have all the information you need, you can make informed and educated decisions about your future home. Whether you’re a first-time buyer or purchasing your second property, making sure you do your research is vital in ensuring your future financial wellness.

Given this is likely one of the biggest purchases and assets of your life, don’t go into it blindly. Be realistic with yourself, do your research, and shop around for the loan that makes the most sense. If you need help in the process, you now know where to find it.