How Do Mortgages Work? The Ultimate Guide

Whether you’re a first time home buyer or consider yourself experienced in the world of homeownership, knowing how mortgages work is crucial to a healthy financial life.

Obtaining a mortgage is quite an involved process, so you may ask yourself, how do mortgages work?

Read on to learn more about the mortgage process, the various programs available, and how to find the mortgage that’s right for you.

How Do Mortgages Work?

Before you start filling out piles of paperwork, what is a mortgage exactly? Mortgages are loans that hold property (your home) as the collateral for the lender.

Your lender loans you a sizeable amount of money that you must pay back over time, with interest. This mortgage is presented to you over a set amount of time and with specific conditions, also called the mortgage terms.

If you don’t repay your mortgage on time, the bank can repossess or foreclose on its collateral, which is your home. Lenders make money on your mortgage from the fees and interest rates associated with the loan.

Before you get excited and call your bank, it’s important to note that there are several different types of mortgages. The most common terms are a loan over 30 years, giving you stable monthly payments for a predetermined amount of time.

Most mortgages offer a stable or set interest rate, but some may come with an adjustable rate. With an adjustable-rate mortgage, your payments have the potential to skyrocket as rates rise.

There are a few other forms of mortgages available including a 15 and 20-year loan. While rare today, you may also find something called an “interest-only mortgage,” which means you’ll only pay the interest on the loan for a set period.

It’s crucial to understand the differences between these types of mortgages before you commit. Put a budget together and take a close look at your income and expenses to help you determine how much home you can afford.

Where Can You Get a Mortgage?

Most home mortgages are offered by traditional banks, such as your local bank or a nationwide lender. Credit unions also offer their customers mortgages, and they tend to have slightly lower rates than most of the larger lenders.

You can also find mortgages through nationwide lenders like Quicken Loans and other online providers. A company called Loanpal offers to finance for homes and solar power. Make sure you do your homework and compare rates and fees before you choose a lender to work with.

If you don’t have time to shop around, consider a mortgage broker. A broker can do the legwork for you and compare rates and terms to help you get the best deal.

When you apply for a mortgage, you’ll need to provide the lender with specific information. This info tells the lender whether you’re credit-worthy, and it also helps them give you an accurate rate quote.

Here are some items you’ll need to have when applying for a mortgage:

  • The last 2-years of your IRS tax returns
  • Your most recent paystub
  • Last year’s W2 from your employer
  • A signed form authorizing the lender to pull your credit report and obtain your credit score
  • Valid identification, such as a social security card or driver’s license

Once you provide the lender with the pertinent information, they’ll begin to process your loan. If you’re simply asking to be pre-approved to find out how much money you have to buy a home, you won’t need to give them all of this upfront.

What Types of Mortgages Are Available?

When you ask how do mortgages work, it’s important to keep in mind that not all mortgage programs are the same. You can choose from several programs, and each one has its own set of guidelines for the borrower.

An FHA loan is backed by the United States government and it’s more appealing to first time home buyers. Conventional mortgages are usually offered to those with higher scores and those who have more money to put down on the home.

FHA Mortgages

If you’re new to the world of home buying or your credit isn’t what you want it to be, an FHA mortgage might be the best option. Most FHA programs allow you to pay as little as three to 3.5% down.

With an FHA loan, you’ll need to pay something called PMI, or private mortgage insurance. This insurance protects the bank in case you default, and it will be part of your monthly payments for the life of the loan.

Unless you have 20-percent or more to put down on your home, every borrower must pay PMI. Talk to your lender about FHA loans and find out more about the latest guidelines. For those with lower credit scores, the FHA program can be a great way to get you into your first home.

Conventional Mortgages

A conventional mortgage is backed by either Fannie Mae or Freddie Mac, and it’s typically a better option for those with higher credit scores. Conventional mortgages may require you to put 20-percent down, but some programs accept as little as three percent.

Even if you have to pay PMI, you can have it removed once your home’s equity reaches 80-percent or more. With an FHA mortgage, you don’t have this option.

In addition to the option to remove PMI in the future, conventional mortgages tend to have lower rates. There are other fees involved to get these types of mortgages, so speak with your lender to find out more.

Other Mortgage Programs

Aside from the standard FHA and conventional loans, there are a few other programs available if you qualify. VA loans are offered to veterans of the US military and their spouses.

If you live in a rural area, you might qualify for a USDA loan. These loans provide borrowers with low-interest rates, but you must meet their location and income guidelines to be approved.

Jumbo loans are larger mortgages typically backed by private banks and investors. These mortgages are for high-end buyers who need to borrow a larger sum of money than most other programs provide.

What Other Costs Are Involved With Getting a Mortgage?

Once you’ve determined which lender and loan program is right for you, your lender will start to process your application. Part of buying a new home is the upfront costs you’ll need to pay, known as closing costs.

Your closing costs will vary depending on where you live, the size of the loan, and other conditions. In general, closing costs typically account for around two to five percent of your purchase price.

Your lender will give you something called a closing disclosure three days before you close on the mortgage. This disclosure breaks down all of your closing costs and will give you the total amount of money you’ll need to have at the closing table.

Some of your closing costs will include:

  • Appraisal fee to determine the market value of the home
  • Title search fees and title insurance
  • Attorney’s fees (when applicable)
  • Origination fees charged by your lender
  • Various administrative fees
  • Escrow costs like property taxes and homeowner’s insurance

Read your closing disclosure carefully to make sure to understand every item. If you have questions, contact the lender before your closing date.

What’s Involved in a Mortgage Payment?

As you’re thinking, “how do house loans work,” you’re probably wondering where your money is going every month. After you’re approved and close on your loan, you’ll begin making monthly mortgage payments.

A typical mortgage payment will include the principal and interest on the loan. The principal goes toward your home’s equity, while the interest is the agreed-upon rate that will go toward the lender.

You’ll also pay property taxes as part of your monthly payment. These taxes vary depending on your location and the assessment of the value of your home.

Homeowner’s insurance is required of all homeowners, and this is typically “bundled” into your mortgage payment as well. If you have to pay PMI, this will also be a separate charge. Read your monthly mortgage statement carefully to get a clear explanation of all the costs.

Make the Most of Your Mortgage

Now that you know the answer to “how do mortgages work”, you’ll be better equipped to make a wise decision. Reach out to several lenders or hire a mortgage broker who can work with you to get your application approved.

The more you know about how mortgages work, the better the odds are you’ll find the home of your dreams at a great price.

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