How Does a Mortgage Work?

How Does a Mortgage Work?
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Unless you have enough cash to pay the full purchase price for a home, there's a good chance you'll take out a mortgage for at least part of the amount. This is a type of secured loan where you typically make payments for ​15 to 30 years​ to the lender, and they use your property as the collateral in case you don't pay.

While most often used to purchase a property, a mortgage can also be used for refinancing an existing home loan or even borrowing cash from the equity your current home has built up. Here's a guide to understanding how mortgages work along with the types of mortgages available and what you need to know to get one.

Learning the Basics of Mortgages

When you take out a mortgage to buy a property, the lender offers you the loan by charging interest and expecting that you'll make timely payments for the agreed-upon term of usually ​15 to 30 years​, but this can go up to 50years​. You only have the full claim on the property once you've completed all your payments and been released from the lender. Until that takes place, the lender has the legal right to take the property away if you stop making those payments. However, there are usually opportunities to get help through your lender as well as catch up on missed payments before a foreclosure would take place.

Each month, you'll make a mortgage payment that includes the loan principal, interest, any mortgage insurance required, homeowners insurance and property taxes, with the latter two items known as "escrow." Especially early in your loan term, a lot of your payment will go toward interest rather than your mortgage principal, but as your principal balance goes down, this will change. Your lender also closely watches the balance for your escrow to ensure enough money is being collected to pay your taxes and insurance, and adjustments can occur annually to account for changes in these items.

While it's most common use to use a mortgage for buying a property, you can also find other mortgage loans to refinance a previous loan, often for better terms or a lower payment, as well as second mortgages that provide funds using your home's equity, which is the appraised value minus the current loan. Both of these involve paying monthly mortgage payments.

On the other hand, there are reverse mortgages that can allow you to get monthly payments from a lender based on your home's equity. Keep in mind that these other types of mortgages are also tied to your home and can lead to losing the property for non-payment.

Exploring Some Important Mortgage Terminology

When looking at types of mortgages for buying or refinancing, you'll find both conforming and non-conforming options. Conforming mortgages are affiliated with either Freddie Mac or Fannie Mae, and these entities set their own limits and requirements. So, there tends to be more strictness for qualifying as well as a larger down payment needed.

Non-conforming mortgages aren't connected to these entities. Instead, they may have government backing or are loans for an amount beyond the limit of conforming ones. Such loans may work for borrowers who need to buy more expensive properties, have smaller down payments on hand or have special credit situations.

On the other hand, you'll also find mortgages that give you a fixed interest rate or an adjustable rate. Fixed-rate mortgages are most common since they provide more stability to borrowers who don't want surprises.

An adjustable-rate mortgage can appeal to borrowers who like the idea of starting with a lower payment and possibly taking advantage of lower rates in the future. However, borrowers also need to accept the risk that rates will likely rise for adjustable rate mortgages and prepare accordingly for a larger monthly payment.

Looking at Types of Mortgages

Take a look at these common mortgage types and what makes them useful to certain types of borrowers:

  • Conventional​: You can obtain this type of conforming loan through private lenders and get the most flexibility when it comes to choosing a property you'd like to finance. This type of mortgage usually has the strictest qualifications and requires at least a down payment of ​3 percent,​ though anything down under ​20 percent​ will come with private mortgage insurance. As long as you meet the stricter credit requirements and can show an acceptable debt-to-income ratio, you can benefit from low interest rates for this type of mortgage. However, there's a loan amount limit that varies by location and is often ​around $548,000​.
  • Jumbo​: This non-conforming loan helps borrowers buy properties of a significant value that exceeds the conventional loan limit. Depending on the lender and your location, you could use this kind of mortgage loan to get a property as expensive as ​$2 million​. Expect to have a hefty down payment and meet very stringent requirements to qualify.
  • Federal Housing Administration (FHA)​: Good for those with lower credit scores and higher existing debt loads, an FHA loan is backed by the government and allows down payments ​between 3.5 and 10 percent​, depending on your credit score. This type of loan tends to come with lower mortgage insurance than conventional loans on a monthly basis, but this usually adds up more over the loan term due to upfront and ongoing costs. You can also only use this for a primary home that meets certain standards, and loan limits are usually lower than with conventional loans.
  • Department of Veterans Affairs (VA)​: Also backed by the government like FHA loans, a VA loan allows certain past or present service members – and sometimes their spouses – to get a mortgage loan without a down payment and with more credit leniency. Borrowers with lower credit scores can qualify as long as they can show sufficient income and choose a property that meets the VA's housing standards.
  • United States Department of Agriculture (USDA)​: This government-backed mortgage program has location requirements where you need to buy a primary residence in an approved area, often in a rural place. However, you can avoid a down payment and pay less in mortgage insurance than you would with a conventional loan. This program has income requirements that vary by location.

Researching Common Mortgage Qualifications

If you plan to get a mortgage, lenders check that you meet the qualifications for the type of mortgage you seek. While specifics can vary, here are some key qualifying factors to consider:

  • Income​: Lenders want to see that you have a steady income for at least a few years, and they'll ask for proof like tax returns, W-2 forms and bank statements to verify how much and how often you get the money. This not only includes traditional employment income but profits from a small business, Social Security payments, alimony and other regular sources of funds. Your income is used for calculating debt ratios and determining how much of a mortgage you can get. At the same time, for some government loan programs, there is a maximum income to qualify.
  • Credit profile​: While FHA loans can allow credit scores of ​500​ and above, you'll often find that a credit score of ​620​ or higher gets you the most options for mortgage programs. Expect to get the best interest rates when your score exceeds ​700​. If you have a recent bankruptcy on your credit report, keep in mind that you may need to wait a few years or even until the discharge to qualify for a mortgage, so be sure to discuss this with your lender.
  • Debt-to-income ratios​: Lenders take a look at two ratios when determining whether you can afford a mortgage loan, and both consider your income and debts. The first ratio, called the front-end ratio, determines the percentage of your gross income that your mortgage payment (plus related extras like homeowners association fees) takes up each month; this should usually not be more than ​28 percent​. The second ratio, the back-end ratio, determines the percentage of gross income that your total monthly debts take up. This usually shouldn't exceed ​43 percent​, but some mortgage programs allow a higher ratio such as ​50 percent​, especially if you have compensating factors.
  • Down payment​: With VA and USDA loans, this might not be necessary, but other loan programs usually require a down payment that can range from a minimum of ​3 to 10 percent​. Some programs base this on your credit score. In any case, keep in mind that PMI usually comes with a down payment ​under 20 percent​ of your property's price, and you might need to make a higher down payment anyway if you can't qualify for a big enough mortgage loan amount.
  • Other cash reserves​: Lenders want to see extra funds for closing costs, which usually total several percent of the house's price, as well as some reserves that show you can afford to make future mortgage payments. If you have a less stable income, prepare to show several months of mortgage payments in the bank.
  • Property requirements​: Getting a mortgage is dependent on other factors like passing required inspections, having an appraisal with a proper valuation and meeting any other property requirements for the chosen mortgage program.

Buying Property With a Mortgage

When applying for a mortgage, you can expect to go through numerous steps both in preparing the application and providing documents through closing. Usually, you start with getting a pre-approval when you're still looking for homes on the market since this provides a good idea of your home purchasing power and assurance that you'll likely get officially approved during underwriting. This also gives you a chance to research multiple lenders, try to find the lowest interest rate possible and look into special programs that could offer down payment assistance, especially if you're a first-time homebuyer.

Once you've gotten a pre-approval and found a property you'd like to purchase, you can make an offer. If the seller accepts it, you usually put down some earnest money and proceed with getting a home inspection, appraisal, title search and other steps needed to prepare for continuing the mortgage application process. You can complete the full mortgage application and include information and documents about your chosen property, income and cash reserves following your accepted home offer. The underwriters run a credit report, verify income and contact you for any other documents that are needed.

When everything is complete, you'll be ready for closing during which you attend a meeting, finish making your down payment and complete the final paperwork to complete the home purchase. You'll then get the keys to your new place and start to take on the responsibilities of a mortgage borrower.

Handling Your Mortgage Payments

Once you are officially approved for your mortgage, your lender may arrange for you to make automatic monthly mortgage payments using your bank account, or you can add your account information and pay manually each month. Other options include paying with checks and money orders. You should get monthly statements that update you on your account and show the payment due alongside any important notes.

If you struggle to make payments, reach out to your lender quickly to discuss your options and help avoid foreclosure. You could qualify for a short-term deferment of mortgage payments, arrange to make up part of missed payments for several months or get your loan terms modified. A common way to reduce your mortgage payments and possibly lower your interest rate is to pursue a refinance, but beware closing costs and fees can set you back in equity.

While paying your mortgage, keep in mind that making extra payments can help you build equity faster and reduce interest over time. Except for FHA loans that would require refinancing to another type of mortgage for this benefit, PMI can also drop off once you've reached ​20 percent​ or more equity.