How do mortgages work?

Mortgage 101
With the right approach, obtaining a mortgage can a be a smooth and painless process. This article will walk you through all of the basics.
Published on
March 27, 2023
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Buying a home is a lengthy process that involves many different moving pieces. While you don't necessarily need to understand the intricate details of each moving piece, there are some terms that you should be familiar with. One such term is "mortgage", which is essentially a loan that you'll receive to help you pay for a home.

Even though a mortgage might sound simple and straightforward, obtaining a mortgage takes numerous steps. With the right approach, you may be able to find a mortgage that has a low interest rate. The following guide offers a comprehensive look at how mortgages work and what it takes to be approved for one.

What Are Mortgages?

A mortgage is a common loan that you can use to purchase a home or similar type of real estate. A lender will provide you with this loan by making an agreement with you that requires you to make monthly payments. When you make these payments on time, you will slowly repay the money that you've obtained from a lender. Keep in mind that lenders can be anything from national banks to credit unions.

The monthly payments that you make after obtaining a loan are divided into interest and principal. The principal of the loan is the total amount of money that you initially agreed to repay. If you received a loan worth $160,000, the principal of the loan will be the entire $160,000. The loan interest is the price you pay the lender in order to borrow their money, which helps to reduce the risk that the lender takes on.

In the first few years after you've obtained a mortgage loan, the majority of the payment you make every month will be comprised of interest. Over time, more and more of the monthly payment will go towards paying off the principal. The property that you're acquiring with the loan will be used as collateral to secure the loan, which means that failing to make your payments could result in the lender seizing your home.

Step-By-Step Process for Obtaining a Mortgage

The mortgage loan process involves five distinct steps that you should be aware of, which include:

The underwriting and closing process typically takes around 30-60 days to complete. During this period of time, an inspection and appraisal will occur to make sure that the home you're buying is in good condition while also identifying the current value of the property.

Obtaining an Initial Approval

The first step in the process of obtaining a mortgage involves applying for and receiving an initial approval, which will simplify the process of finding a home and making an offer. This process involves identifying how much money a lender will give you in a loan. The lender you're thinking of obtaining a mortgage from will look at your assets, credit history, and income to arrive at an amount that they believe you can afford. You'll also find out what your interest rate will be at this stage of the process.

When you first send in an application for preapproval, you will be asked several questions about your assets, the type of home you'd like to buy, your income, and yourself. The lending institution you apply to will take a look at your credit score and history to gain a better understanding of how much you can afford. Once you know how much you can afford, your search for a home will be much more straightforward. If you're approved for anything under $350,000, you won't waste time searching for homes that cost $400,000 or more.

Prequalified vs. Preapproval

Before you send in a preapproval application, it's important to understand the difference between prequalification and preapproval. A prequalification is less formal and less accurate in comparison to a preapproval since asset verification isn't necessary. While a prequalification can give you a somewhat accurate estimate of what you should be able to afford when buying a home, a preapproval is much more accurate and will guide you through the process of searching for a home.

Making an Offer

Once you've found your dream home with the help of a real estate agent, the next step in the mortgage process involves making an offer on the home. When the market is competitive, your real estate agent might suggest making an offer that's higher than the asking price, after which you may need to wait a few days to find out if your offer is accepted or rejected.

It's possible for negotiations to occur at this stage of the process between you and the seller. For instance, you might want to ask the buyer to cover some of your closing costs. In the event that your offer is accepted, you'll be able to enter the final stages of the mortgage process.

Understanding Important Mortgage Terms

There are a wide range of mortgage terms that you should be knowledgeable about before you start searching for a home. The most important terms related to a mortgage include:

  • Down payment - The down payment that you make is designed to cover some of the costs associated with buying a home. Most loans require down payments of at least 5% of the purchase price or higher. Keep in mind that making a lower down payment usually means that your interest rate will be higher.
  • PMI - PMI stands for private mortgage insurance, which you may be required to obtain if you apply for a conventional loan. This form of insurance is necessary if your down payment is less than 20%.
  • Earnest money - When you sign a purchase agreement, you can provide the seller with an earnest money deposit, which is a small amount of money that shows how serious you are about going through with the purchase.
  • Appraisal - Once the seller has accepted your offer, an appraisal will occur, which involves a professional looking at the home to determine its true value. This valuation is necessary for the underwriting process of your mortgage.
  • Inspection - A home inspection is a visual examination of the systems of a home as well as the physical structure of the property. The professional who administers the inspection will tell you what areas of the home might need improvement. If the inspector finds that appliance or roof repairs will be needed in the immediate future, you could ask the seller to take care of these issues before you move in or lower the sale price.
  • Title company - A title company is necessary during the home-buying process to ensure that the title of the home is clean and can be provided to you without issue.
Mortgage Types to Consider

There are many different types of mortgages you can consider applying for when purchasing a home. The primary loans available to you include:

  • Conventional loans - These loans aren't backed by the government and are ideal for borrowers who have a great credit score.
  • Jumbo loans - These loans are designed for more expensive properties and are relatively common in high-cost locations like New York City and San Francisco. Since higher loan amounts are riskier, you'll need to provide ample documentation if you want to be approved for a jumbo loan.
  • Government-insured loans - If you're finding it difficult to qualify for a conventional mortgage, consider looking into government-insured loans, which include VA loans, FHA loans, and USDA loans. These loans are backed by the U.S. government and are designed to help more people become homeowners. Regardless of the type of government-insured loan you apply for, you'll find that the down-payment requirements and minimum credit score requirements are lower in comparison to conventional loans.
  • Fixed-rate loans - These mortgages have the same exact interest rate throughout the life of the loan, which means that your monthly payments will be predictable.
  • Fixed vs Adjustable - Adjustable-rate loans are less predictable since interest rates can fluctuate depending on market conditions. Most of these mortgages will have a fixed interest rate for the first seven years of the loan before switching to adjustable rates.

Regardless of the type of mortgage you obtain, the term of your loan could be either 15 years or 30 years. Keep in mind that a 15-year term will invariably come with higher monthly payments. When you're first making an offer, you may be able to lock in an interest rate with your lender, which means that the interest rate won't increase if the closing occurs by a set deadline.

Closing Process

After your initial offer has been accepted, you may need to wait for anywhere from 30-60 days until you can move into your new home. During this period of time, all of the necessary inspections and appraisals will take place. However, most of this time is taken up by the underwriting process, which is performed by the lender to make sure that all documentation is in order and that you have the finances needed to obtain a loan.

The home title will also be verified at this time. Once the underwriting process has been completed, you'll receive a closing disclosure document that provides you with all of the information you need about the details of your loan.

Paying the Down Payment and Closing Costs

Your down payment and any closing costs will need to be paid on closing day, which is the same day that you sign the mortgage papers and take ownership of your home. This money can be paid via a check.

Signing Mortgage Papers

The final thing that you do before taking ownership of your dream home is to sign mortgage papers, which are closing documents designed to transfer ownership to you from the seller. You should also have a valid photo ID on hand as well as the closing disclosure that you received.

What Is an Escrow Account?

An escrow account is a type of bank account that's managed directly by your lender while the closing process is ongoing. The earnest money deposit that you made will be kept in this account until the sale of the home closes. Once ownership of the home transfers to you, it's possible that your lender will establish this account as a place to pay your private mortgage insurance and taxes.

What Is a Loan Servicer?

A loan servicer is a professional who processes the loan payments that you make, manages the escrow account that's been set up for you, and responds to any inquiries that you might have.

Mortgage and Promissory Note

A promissory note is a written agreement between you and the lender that consists of a promise to repay the loan and contains all of the pertinent details about the loan. The mortgage is the actual loan that's secured by your property.

Whether you're buying your very first home or relocating because of a job, finding the right home can take some time. Now that you know about mortgages and all that they entail, you should be able to navigate the mortgage process with ease.

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