Nobody likes the idea of debt.
However, when it comes to big expenses like secondary education or buying a home, debt is sometimes necessary.
For most people, buying a real estate property is one of the biggest purchases they will make in their lifetime. There’s a lot of money involved, and the truth is that many people can’t afford the purchase upfront.
That’s where the option of taking on debt in the form of a mortgage comes in.
What is a mortgage?
A mortgage is a long-term loan given by a lender to finance a real estate property. The property is used as collateral in exchange for the money that is borrowed.
A lot of lenders utilize digital mortgage closing software to automate the mortgage process. Digital closing tools offer virtual borrower applications and electronic signings so streamlining the process and keeping all documentation organized is easier than ever.
A mortgage works similarly to other loans. When you take out a mortgage, you’re agreeing to pay back the money you borrowed plus interest over a set period of time. In exchange, the lender (usually a bank) pays the upfront cost of the property. The home or building is used as collateral to protect the lender in the scenario that the borrower stops making mortgage payments.
Elements of a mortgage
There are several different parts of a mortgage. Most of the loan will be paid over a period of time, but there is also the upfront cost that comes with buying a property called a down payment. Usually, the down payment is about 20 percent of the overall cost of the property. The other 80 percent is paid off with the loan.
Following an initial down payment, the borrower is responsible for paying for a percentage of the mortgage each month. Here are the five components that make up a mortgage.
A mortgage principal is a term used to refer to the amount of money that someone has borrowed from a lender as they prepare to purchase a home. The higher the principal, the more you owe. Depending on the type of mortgage, this amount may change over time.
The amortization schedule is the frequency with which the borrower must make payments toward the mortgage loan. These payments will include both the principal and any accrued interest.
In exchange for the loan, the lender charges a certain interest rate. This amount is included in a monthly mortgage payment in addition to the principal. Interest is the profit the bank makes by giving you the loan.
Taxes and insurance
Most lenders will require the borrower to open an escrow account for property taxes and insurance. This way, the property owner sets that money aside and doesn’t have to worry about it. The lender is responsible for paying these fees on the borrower’s behalf.
Types of mortgages
Different people are in different financial situations. For this reason, there are different types of mortgages to accommodate the unique needs and circumstances of each borrower.
Next, we’ll go over the most common types of mortgages:
A fixed rate mortgage has the same interest rate throughout the entire term of the loan. Since the interest rate is locked in, this is a popular choice for homebuyers. It offers stability because the rate doesn’t run the risk of increasing as time goes on. Fixed-rate mortgages often start at a higher interest rate than the other options.
An adjustable-rate mortgage (ARM) has an interest rate that can change throughout the loan’s lifetime. Since the interest rate is variable, the monthly mortgage payments will also fluctuate. Although this option is riskier for buyers, most ARMs come with caps that prevent the interest rate and monthly payments from shifting too dramatically. Additionally, this type of mortgage often starts at a lower interest rate than others.
Government-backed home loans are regulated by the U.S Department of Housing and Urban Development. They help in-need real estate buyers by offering benefits such as lower interest rates and down payments.
There are three main types of government-backed loans:
- FHA loans are backed by the Federal Housing Administration. They offer lower down payments and are available to borrowers with low credit scores. While these loans are popular among first-time and low-income buyers, they are not restricted to these groups. Anyone who meets the qualifications can apply.
- VA loans are administered by the Department of Veteran Affairs and are available to veterans of the United States Armed Forces.
- USDA loans serve people who live in rural areas. They’re backed and administered by the United States Department of Agriculture.
With an interest-only mortgage, buyers don’t have to pay the principal until a certain time. This is a desirable option for homebuyers who are concerned about making monthly payments that include principal and interest. There's an inherent risk in delaying principal, especially because this kind of loan encourages people to buy properties they can’t immediately afford. That being said, it’s still a popular option for many.
The mortgage process
Once you've learned what makes up a mortgage, you may be wondering how to get started. There are 6 steps in the process of acquiring a mortgage.
Before you can start looking for the place of your dreams, you need to know what your budget is. The pre-approval process is when a lender evaluates the finances of a potential borrower to determine whether they qualify for a loan and, if so, how much they would be able to borrow. Lenders will usually collect information like employment history, debt-to-income ratio, gross monthly income, credit score, and more.
2. House hunting
Once you know exactly how much money you've been approved for, you can begin the fun part: the search. A lot of sellers will use multiple listing service (MLS) software to advertise their listings. Consider looking within those MLS tools to find a place that meets your criteria. With your pre-approval set, you can also make offers with confidence.
3. Mortgage application
So you've made an offer, and it was accepted. What now? Even though you got pre-approved, you basically still have to get post-approved. This means formally applying to actually receive that loan that you were approved for from the beginning.
4. Inspection and appraisal
Your lender won't just hand over a bunch of money willy-nilly. Most loan lenders will send an appraiser to inspect the property and ensure that it is worth the amount the borrower is applying for.
5. Processing and underwriting
Underwriting is the last major hurdle in acquiring that mortgage loan. Underwriters are those who assess the risks of the lender, evaluate your finances and documentation, and give the final stamp of approval on whether or not they think you will be able to pay back the loan efficiently. Once they complete their analysis, they will prepare the loan package that outlines all the loan terms, interest rates, amortization schedule, and more.
Once closing day has approached, the loan has been approved, and the borrower is ready to move in. After signing a large (and I mean large) stack of paperwork, paying closing costs, and reading the fine print, the borrower can take ownership of their new property and begin making loan payments on the agreed-upon schedule.
Buying a property is a big deal, and choosing the right way to finance it is equally as important. Every homebuyer has unique financial circumstances, so it’s important to know the basics of a home loan before jumping into it.
Once you've got your place, you'll want to start imagining the layout. Check out some free floor plan software that can help you build a strong foundation.
This article was originally published in 2019. The content has been updated with new information.