As if buying a home itself wasn’t daunting enough, especially if you’re a first time home buyer. The jargon that’s thrown around in the real estate industry can make things incredibly confusing, especially when it comes to a home mortgage loan. You’re often left with a lot more questions instead of leaving with the answers you were searching for.
In order to make an educated decision about something as important as buying a home and applying for a home mortgage, it’s easier to get comfortable with the mortgage process first and understand the basics as best you can.
We’ll cover the fundamental basics of what exactly a home mortgage loan is, understanding how much house you can afford, the different types of mortgages, and how to eventually pay back your loan. Let’s see if we can shed some light on all of it.
First things first.
What Exactly Is A Mortgage?
By definition, a mortgage is a loan that is secured by property or real estate. In exchange for receiving the funds to buy a property or a home, the lender is promised that you (buyer) will pay back these funds within a certain time frame for a certain cost (the interest). This promise, the mortgage, is a legally binding contract and secures the note by giving the lender the right to have a legal claim against the borrower’s home if the borrower defaults on the terms of that note.
Essentially, you (the borrower) has possession of the property or the home, but the lender is the one who owns it until the loan is completely paid off.
Borrower – is the individual or individuals extended a loan and mortgage for the purchase of a house and/or property. The borrower is responsible for making all payments and fees associated with the loan over the life of the loan.
Lender – the finance company or bank that directly awards home loan or mortgage money to a borrower or home buyer.
Loan – money lent from a financial institution to a creditworthy borrower over a specified period and at a particular interest rate.
This is a home mortgage loan at its most fundamental level.
How Much House Can You Afford?
Before the house hunting process ever begins, knowing exactly how much house you can afford is always a good idea. You’ll save a lot of time in the long run by planning ahead and not looking at houses that you cannot afford, bidding on properties you can’t obtain or applying for loans that you’ll be denied on.
There are a lot of factors that lenders use to calculate and figure out how much of a mortgage payment you can afford.
- Front-end ratio
- Back-end ratio
- Credit Score
- Credit Report
- Down payments
- Available Funds
- Interest Rates
- The Lender
Canadian, eh? If you happen to find this page, check out this page on Canadian mortgage requirements.
Front-end Ratio & Back-end Ratio
There are two ratios that lenders consider when qualifying and determining how much any person can borrow for a mortgage. The first factor or ratio is called the front-end ratio. This ratio is the percentage of the yearly gross income that is dedicated to making the mortgage (principal, interest, taxes, insurance) each month compared to the total income for each month. The back-end ratio, often known as the debt-to-income ratio calculates and determines what percentage of your income is needed to cover your payments and debts. The mortgage is included in these debts as well as car payments, student loans, child support, credit cards, and other loans.
Credit Score & Credit Report
Your credit score and credit report can play a significant role in determining how much house you can afford. This allows the lender to make a more informed decision about your home mortgage loan prequalification.
Your FICO score represents data within the credit report and includes the history of bill payments and the number of outstanding debts in comparison to your income. The higher your credit score, the better of a chance it’ll be to obtain a loan or to pre-qualify for the home mortgage you’re applying for. While on the other hand, a lower score may cause the lender to reject the mortgage application, require a larger down payment, or may result in higher interest rates.
It’s incredibly important to keep up with your credit report and verify it’s accuracy. Unfortunately, identity theft is a huge problem and may cause issues on your credit report. You can get a copy of your credit report from each major credit bureaus for free at www.AnnualCreditReport.com
In the unfortunate event that there are any errors or issues, you can dispute them using this free guide from the Federal Trade Commission (FTC).
You can check out our nifty mortgage calculator to give you an idea of what kind of mortgage you can afford.
In addition, it’s also a good idea to consider your personal financial lifestyle when buying a home. Although you may be approved for a particular mortgage amount, it doesn’t necessarily mean you can actually afford the payment. There’s a lot of personal factors to consider and plenty of questions to ask yourself.
- Are two incomes required to make ends meet and pay the bills?
- How stable is your current job?
- Do you have “champagne” taste?
- Are you willing to make a lifestyle change to afford your new home?
- Will you be making another “big” purchase anytime soon (e.g., a new car)?
- Will there be a new addition to the family soon?
Income, Down Payments, & Available Funds
Lenders like to see steady sources of income. Avoid changing jobs or quitting before submitting a mortgage application and finishing the home buying process.
The more money you can afford to pay up front, the more likely you’ll be approved and it’ll also make for a lower loan. Of course, if you have an excellent credit history, you’re likely to be approved regardless of how much money you can afford to put down. For those with less than perfect credit, the amount of a down payment could make or break the difference between approval or rejection of the home loan. Along with a good down payment (although not necessary), it’s a good idea to have funds set aside and readily available to cover any closing costs if applicable or if something should arise. You’ll also want to avoid making any major purchases that can deplete any available funds before purchasing your new home.
Although loans aren’t actually approved or denied based on interest rates, they do make a difference when determining what your monthly payments will be. It’s also possible for interest rates to change during the loan application process.
Due diligence is an asset, and every lending institution is different. Learning the reputation and history of the lender, finding out how many mortgage applications they approve, as well as how many they deny can prove to be valuable. If the lender denies twenty percent of borrowers who apply, it’s definitely not a good sign.
Different Types of Mortgages
There are several different types of mortgages available and understanding the pros and cons between them can be helpful before you go mortgage shopping.
Conventional Mortgage Loans: Fixed-Rate Mortgages
A conventional mortgage loan is best suited for those who have good or excellent credit and usually follow fairly conservative guidelines when it comes to a borrower’s credit score, minimum down payments, and debt-to-income ratios. Consequently, you’ll need to have awesome credit to qualify for some of the best interest rates.
The most popular and representing over 75% of all home loans, fixed-rate mortgages is when interest rates remain the same throughout the life of the loan. Fixed-rate mortgages usually come in 30, 15, or 10-year terms with the 30-year term being the most popular, although, a smaller term would build equity faster. What’s the main difference between these different terms? Basically, the longer the term the lower your monthly payment will be, but you’ll be paying more interest in the long run and vice versa.
Probably the biggest advantage of having a fixed rate mortgage is that you’ll always know the exact interest and principal payments for the entire life of the loan. If you lock into a fixed rate mortgage while interest rates are high, you can always refinance later when rates decrease.
Considered a tad bit riskier because payments can change significantly, an adjustable-rate mortgage or ARM is a mortgage loan in which interest rates change based on a specific schedule after a “fixed period”. In exchange for the added risk associated with an ARM, you’re rewarded with an interest rate lower than that of a 30-year fixed rate.
One-Year Adjustable-Rate Mortgages
When acquiring a one-year adjustable-rate mortgage, you essentially have a 30-year loan where the rates change every year on the anniversary of the loan. Obtaining a one-year ARM can possibly allow you to qualify for a home loan that is higher and acquire a home that is more valuable. Many homeowners with extremely large mortgages can get the one-year ARM and refinance them each year. The lower rate allows them to buy a more expensive home, and they pay a lower mortgage payment so long as interest rates do not rise.
Adjustable-rate mortgage loans are considered to be rather risky because the payment can change from year to year in significant amounts.
10/1, 5/5, 5/1, 3/3, and 3/1 Adjustable-Rate Mortgages
10/1, 5/5, 5/1, 3/3, and 3/1 ARMs are mortgages where the monthly payment and interest rate remain the same for “X/” amount of years for the first part of the mortgage and then changes every “/X” amount of years after. For example, in a 5/5 ARM the interest rate is fixed for the first 5 years and then at the beginning of the 6th year, interest rates are adjusted every 5 years.
Sometimes called a “30 due in 5”, a 5/25 mortgage is when monthly payments and interest rates do not change for 5 years and at the beginning of the 6th year, the interest rate is adjusted with the current interest rate for the remaining life of the loan.
2-Step Mortgages & Balloon Mortgages
A 2-step mortgage is an adjustable-rate mortgage that has the same interest rate for part of the mortgage and a different rate for the rest of the mortgage based on the current market rate. Those who chose to take the 2-step mortgage usually have plans of refinancing or moving out of the home before the period ends.
Lasting for a much shorter term and working a lot like a fixed-rate mortgage, balloon mortgages tend to have lower monthly payments because of a large payment (the balloon) at the end of the loan and because you’re primarily paying the interest for that month. Balloon mortgages are great for responsible borrowers with the intentions of selling the home before the due date of the balloon payment and are often used by investors. However, homeowners can run into big trouble if they can’t afford the balloon payment, especially if they’re required to refinance the balloon payment through the original loan lender.
Before Signing The Dotted Line
Before agreeing to any particular loan, we highly recommend you get in touch with a professional mortgage broker who can help make sense of everything. Make sure you shop around to find the best possible rate for you, as a small difference in interest rates can lead to thousands of dollars in savings over the life of the loan.
Need a reference? We’ll point you in the right direction. And if you’re interested in seeking more information on ARMs, check out this free Consumer Handbook on Adjustable-Rate Mortgages.
Federal Housing Administration Home Mortgage Loans
Federal Housing Administration mortgage loans or FHA loans, usually has more flexible guidelines and standards that benefit those whose housing payments will be a pretty big chunk of their take-home pay, have a lower credit score, and home buyers with small down payments. In comparison to conventional mortgage guidelines that tend to cap debt-to-income ratios at around 45% and sometimes less, the FHA allows you up to 57% of their income on your monthly debt obligations, such as the home mortgage, HOA fees, your credit cards, and any student or car loans.
FHA loans require a minimum down payment of 3.5% and two mortgage premiums. The first is an upfront premium of 1.75% for the loan amount and is to be paid at the time of closing. The second is an annual premium varying from 0.45% on the low end and up to 0.85% on the high end, rolling into the monthly mortgage payment for the entire life of the loan. Premiums aside, you can qualify for an FHA loan with a credit score of 580 or even lower and they’re often the only option for home buyers with a high debt-to-income ratio and a less than awesome credit score.
Fun fact: the Federal Housing Administration doesn’t actually loan any money, they insure the mortgage.
Veterans Affairs Home Mortgage Loans
VA loans are available for the majority of active-duty military, veterans, National Guard, and for those in the Reserves. VA loans are also available for the spouses of military members who died during active duty or because of a service-connected disability. If you do qualify for a VA loan, you’re not required to place a down payment, however, the VA does charge an upfront funding fee of 1.25% – 3.3% depending on the loan amount which may be paid by the seller or rolled into the mortgage loan. And just like FHA loans, the VA doesn’t loan any money but guarantees the loans made by private lenders.
Fast forward a bit and now we need to know how we actually pay back this home loan.
Repaying A Home Mortgage Loan
Usually, your home mortgage loan is paid back in monthly installments and consists of the principal, interest, taxes, and insurance.
The principal is the repayment of the initial balance borrowed. For example, if you borrowed $250,000 to buy your home, your initial principal balance would be $250,000 and after every payment, the principal balance decreases. While the interest is the cost you pay for being allowed to borrow the money for the past month.
There are two types of insurance payments when it comes to owning a house. First, a private mortgage insurance or PMI protects the lender from any loss if their investment in case the borrower defaults, whereas hazard insurance is exactly that, protecting both the borrower and the lender from property loss from any hazard. Typically, a private mortgage insurance isn’t required if you put 20% or more as a down payment on your home. And as long as you’re not behind payments, the private mortgage insurance payments are usually automatically terminated when the loan-to-value (LTV) reaches 78% or when you reach the midway point of your loan.
And as always, Uncle Sam needs his cut – a percentage of the value of the property is paid as taxes and can vary depending on where the borrower lives and are often reassessed annually.
Before Signing The Dotted Line
Before agreeing to any particular loan, we highly recommend you get in touch with a professional mortgage broker who can help make sense of everything. You’ll also want to make sure you do some shopping around first to find the best rate possible, as a small difference in interest rates can end up being thousands of dollars in savings over the life of the loan.
Need a reference? Ask and we’ll point you in the right direction.
Looking to buy a home? We can help in that department. Get in touch with us and we’ll work out the details together.
Questions? Let us know in the comments and we’ll do our best to answer them.
We’re not your typical Orlando Realtor. We’re a real estate team consisting of different talents, strengths, and backgrounds. Coming together to achieve a common goal. Helping you.