*As of April 20, 2020, Quicken Loans® isn’t offering conventional adjustable rate mortgages (ARMs).
A mortgage is a loan from a bank or financial institution that helps a borrower purchase a home. It is likely the largest and longest loan you’ll ever take out. Mortgages have three main elements that are combined in different ways, depending on the borrower and lender — loan type, interest rate, and loan terms. Knowing how these pieces work together can help you pick the right mortgage.
How Does A Mortgage Work?
When you take out a mortgage, the lender pays for your home upfront. In exchange, you agree to repay the money you’ve borrowed based on the agreed-upon terms and conditions, including the interest rate and the length of time you have to pay off the loan. In the meantime, the lender holds the deed to the home as collateral until the mortgage is fully paid off.
What Are The Different Types Of Mortgage Loans?
Along with choosing what type of rate you should get, you’ll need to determine what type of loan to get as well. There are three main types of mortgage loans to choose from: conventional mortgage loans, government-backed mortgage loans, and jumbo mortgage loans.
Conventional Mortgage Loan
Conventional loans are the most common. Conventional loans are backed by a private lender and typically offer better interest rates and more flexible term options than government-insured loan programs. However, they require a higher down payment and stronger credit score.
Government-Backed Mortgage Loan
A government-insured loan, like a Federal Housing Administration loan or a VA (U.S. Department of Veterans Affairs) loan, is backed by a government agency. These loan options have more flexible credit score requirements and may have options for buying a home with little to no money down. However, they also tend to come with additional restrictions and fees, like mortgage insurance.
Jumbo Mortgage Loan
Jumbo loans are mortgages that exceed the conventional loan limit. This means that you'll need a jumbo mortgage if your loan amount is $484,351 – $3 million.
What Are The Different Mortgage Rates?
One decision you’ll make as a borrower is whether you want a fixed-rate mortgage or an adjustable rate mortgage. The “rate” refers to how much you’ll pay in interest back to your lender. Mortgage rates change regularly, but you can find the most up-to-date mortgage loan interest rates here.
Fixed-rate mortgages have an interest rate that remains the same throughout the life of your loan. This is a great option for those who prefer consistency and ease while budgeting, as the monthly payment will never change. These types of loans are often built in 15-year fixed-rate loans or 30-year fixed-rate loans.
Adjustable Rate Mortgage
Adjustable rate mortgages, also referred to as ARMs, have interest rates that can change over time. This means your monthly mortgage payments won’t be the same throughout the life of your loan, though the initial interest rate you receive with an ARM is typically lower in comparison to a fixed-rate mortgage.
ARMs are generally 30-year loans with a fixed rate for a set time (typically the first 5, 7 or 10 years of the loan). After the fixed-rate period expires, your interest rate can adjust up or down based on market conditions. Don’t worry – there are caps in place so your payment won’t spiral out of control.
You’ll notice an ARM and its rate caps are usually formatted like this: 5/1 ARM with 2/2/5 caps. Let’s break down what each piece of that means.
- 5/1: The “5” is the number of years the interest rate is fixed. The “1” means that the interest rate can change once a year after the fixed period expires.
- 2/2/5: The first “2” means that the most a rate can change is 2% the year after the fixed period expires. The second “2” means that the rate can change 2% every year thereafter. The “5” represents the maximum percentage that can be added to the initial rate for the lifetime of the loan.
Keep in mind, caps can vary depending on the individual loan. For example, a 7/1 ARM might have a 5/2/5 cap structure. It’s important to ask your lender about the max you could possibly pay on an ARM so you can decide if it’s best to refinance after the fixed-rate period expires or to allow the rate to adjust based on the market.
What Goes Into A Monthly Mortgage Payment?
Multiple parts go into mortgage payments, and they’re usually made monthly. Mortgage payments are made up of four to five main costs — the principal balance, interest, taxes, and homeowners and mortgage insurance.
Your principal balance is the amount you initially borrow from a lender to buy your home. It’s factored into your monthly payment and paid off incrementally throughout the life of your loan. Once you purchase a home and begin making payments, the amount of principal you pay each month is relatively low. As the loan ages, more and more of your monthly payment will go toward the remaining principal amount.
Interest is the percentage of the principal you pay over the life of the loan to your mortgage company as a fee for lending you the money. At the same time, the amount that goes to interest will continue to decrease as you pay down your loan. This is referred to as mortgage amortization.
Your lender may include property taxes in your monthly payment if you have an escrow account, or a special account that your lender uses to hold the money meant to pay your property taxes. With an escrow account, you never have to worry about paying your property taxes since your lender takes care of that for you.
Homeowners insurance, which can cover damages from fires, storms, or other accidents, is required by mortgage lenders. They may collect the premiums with your mortgage payment, like tax money and then pay your insurance bill from your escrow account when it’s due.
If you make a down payment of less than 20% of your home’s total cost, most lenders will require you to pay mortgage insurance as a protection against a default on the loan. There are two types of mortgage insurance – private mortgage insurance and insurance for government-backed loans, like FHA or VA loans.
How Do You Qualify For A Mortgage?
To qualify for a mortgage, you first need to apply for a mortgage and get preapproved. Preapproval will help you understand how much you can afford and will put you in the best position to make a strong offer. To make sure you qualify for a mortgage, the lender will review your assets, your income and your credit. The lender needs to review this information because there are a few eligibility requirements you must meet to qualify for a mortgage. While they differ by lender, here are a few basic requirements:
- A FICO® Score of 580 for an FHA loan and 620 for a conventional loan
- Income and assets that show good financial standing
- A debt-to-income ratio of 50% or less
- A down payment of at least 3%, depending on the loan
Getting preapproved may not require you to provide too much, or any, documentation. In this first step, you’ll answer some questions about your income and assets and give the lender permission to pull your credit report. This will be considered a hard inquiry on your report and may cause your credit score to lower by a few points. It is during the underwriting process that the lender will really dig into your financial history and current situation to qualify you.
Your credit score and history help the lender determine the type of borrower you will be. A good credit score shows that you are a responsible borrower, which can help you qualify for a better interest rate.
Income And Assets
A lender reviews your income and assets to ensure you can make your monthly mortgage payments with the money you earn monthly or have set aside. To verify your income and assets, you’ll need to provide certain documents to your lender. Such documents may include:
- Bank statements for your checking and savings accounts
- Wages and tax statements, like a W2 or 1099
- Recent pay stubs
- A copy of your most recent federal tax return
Income is just one piece of the puzzle. Your DTI will also help the lender determine if you can afford your monthly payment since some of your income will go to paying off other debts, like credit cards, student loans and auto loans. To ensure you don’t default on the loan because of other debts, the lender will set a maximum DTI, typically below 50%. Keep in mind that the lender does not consider your other financial obligations, like utility costs, transportation expenses or groceries. If these expenses make it so you are barely scraping by with an additional mortgage payment, you may want to borrow less money or wait until you have more income or less debt before purchasing a home.
Depending on the type of loan you get, you’ll need to make a down payment of at least 3 – 3.5% of the purchase price. This is an upfront payment due at closing that you must pay out of pocket. While you can make a lower down payment, it is recommended that you put down at least 20% to avoid paying a PMI. It may also lower your monthly bill because you’ll be borrowing less and you may also get a better rate.
How Do You Get The Right Mortgage?
Selecting the right combination of rate type, loan type and loan term depends on your financial situation and your goals. Our home affordability calculator will help you decide what you can afford and our payment calculator can give you an idea of what your monthly payment could be, and you can speak to a Home Loans Expert if you have any questions regarding your mortgage and its terms.
You can also start an application online with Rocket Mortgage®by Quicken Loans®to see what mortgage you qualify for right away.
More Mortgage Basics
Now that you have basic knowledge of what a mortgage is, you can begin to dive deeper into understanding the ins and outs of the loan. Several online resources can help, including more from the Quicken Loans Learning Center. Here are a few topics to learn more about to start your mortgage education.
Mortgage Terms to Know
When you’re getting ready to purchase a home with a mortgage, there are specific mortgage terms to know to make the process less confusing and complex. Knowing these terms will help you better understand each step of the mortgage process and what to expect during your loan origination (when you’re buying the home) and servicing (after you close).
Home Buyer Guide
Our home buyer guide provides specific, detailed information based on each step of the home buying process, from determining if you’re ready to buy a home all the way through closing on your home and managing your mortgage. It will provide specific questions to ask yourself, pros and cons to consider and what is expected of you every step of the way.
First-Time Home Buyer Loans And Programs
If this is the first time you’re buying a home, it may be helpful to learn more about first-time home buyer loans and programs. Knowing what each program is, what you get with each and what you should consider will help you make a more educated decision on what option is right for you.
If you wish to speak with someone to learn more and have your questions answered, reach out to one of our home loan experts. They’ll be happy to chat about your different mortgage options, answer your questions and help you determine the best options for your situation.