If there’s one word that signifies the transition from youth to adulthood, it might be “mortgage.” It conjures up images of near-sacred responsibility and its role in achieving the American Dream.
What Is A Mortgage?
A mortgage is a loan from a bank or financial institution that helps a borrower purchase a home. It’s likely the largest and longest-term loan you’ll ever take out.
Mortgages are considered “good debt,” meaning that the debt helps create wealth, much like student or business loans. Over time, a mortgage leads to equity, appreciation and a host of other good things. There’s a lot to learn about the process of buying a home and getting approved.
How Does A Mortgage Work?
When you take out a mortgage, the lender pays for your home upfront. In exchange, you repay the money you’ve borrowed based on the agreed-upon terms and conditions. These include 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.
But let’s take a couple quick steps back to add context to how mortgages work in practice.
Know How Much Mortgage You Qualify For
When you decide to buy a home, one of the first things you’ll need to do is apply for a mortgage preapproval. At this time, your lender will consider your application and decide how much they’re willing to lend you. The lender will then write a preapproval letter to help you when searching for the right home.
Make Sure The House Is Worth Your Mortgage Amount
You will need to show your lender that the house you want to buy is worth the purchase price. To do this, you’ll order a home inspection and, because your lender will require one, an appraisal. The home inspection considers the physical state of the home, while the appraisal considers the location and current market conditions in addition to the physical state of the home.
Your lender doesn’t want the security for the loan – your prospective home – to be worth less than the loan amount. While you’re paying back the loan, the lender has a mortgage lien on your home. Your home needs to be approved just as thoroughly as you do.
Once your mortgage is approved, you’ll be ready to close on your new home.
Understand 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.
Types Of Mortgage Loans
As a borrower, you’ll need to determine what type of loan to get. 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 sometimes require a higher down payment and a higher credit score.
Government-Backed Mortgage Loan
A government-insured loan, like a Federal Housing Administration (FHA) 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 allow you to buy a home with little to no money down. They also tend to come with additional restrictions and fees, like MIPs.
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 $548,250 – $2.5 million at Rocket Mortgage®.
In high-cost markets, the loan limit to avoid getting a jumbo loan may be higher and the limit is $822,375 for all of Alaska and Hawaii. Conforming loan amounts are also higher if you have a 2 – 4-unit property. That may sound like an amount of money that buys an extravagant home, but, in the most expensive real estate markets, it can be difficult to find homes that fall within conforming limits.
You can also start an application online with Rocket Mortgage® by Quicken Loans® to see what mortgage you qualify for right away.
Mortgage Rate Options
Another choice 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.
A fixed-rate mortgage has 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.
With today’s low interest rates, the 30-year fixed-rate mortgage is probably the most popular choice for home buyers right now.
Adjustable-rate mortgages, or 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 fixed rates 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: 5/6 ARM with 2/1/5 caps. Let’s break down what each piece of that means.
- 5/6: The “5” is the number of years the interest rate is fixed. The “6” means the interest rate can change twice a year after the fixed period expires.
- 2/1/5: The "2" means there is a 2% increase/decrease cap on the initial adjustment. The "1" means the rate won’t increase/decrease more than 1% each adjustment after that. The "5" means the rate won’t increase/decrease more than 5% for the life of the loan.
Keep in mind that caps can vary depending on the individual loan. For example, a 7/1 ARM might have a different 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.
How To Qualify For A Mortgage
To qualify for a mortgage, you first need to apply for preapproval. This process 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 (see below)
- Income and assets that show good financial standing
- A debt-to-income, or DTI, ratio of 50% or less
- A down payment of at least 3%, depending on the loan
To get preapproved, 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.
If your credit is less than perfect, get started now on a program of cleaning up old debt and building up your credit score. The better your credit score, the lower your mortgage cost, because the interest rate you’ll be offered depends in part on how big of a credit risk you are.
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 W-2 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 other expenses mean you’re barely scraping by, 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. If you're a first-time home buyer, or a low- or moderate-income earner, there are a variety of down payment assistance programs available to help you put together your down payment.
You’ll often read about how it’s best to put 20% down when you buy your home, because at that point, you can avoid paying PMI or MIPs. While that is true, waiting until you have that amount has a cost too.
You might continue to pay rent while you’re trying to save money. You could be putting your rent toward saving money by building up your equity. And when you reach the level of 20% equity, you can apply to have that payment removed or, in the case of an FHA loan, apply for a conventional refinance.
How To Get The Right Mortgage For You
Mortgages have three main elements. These elements are combined in different ways, depending on the borrower and lender – loan type, interest rate and loan terms. Selecting the right combination of rate type, loan type and loan term depends on your financial situation and your goals.
For example, let’s say you’re in your mid-twenties, with a young family, and you’re about to start medical school in a different city while your spouse works to support the family. Your parents are helping you with your down payment, but you will have to make your monthly mortgage payment.
You will need the lowest possible monthly mortgage payment because you’re just starting out in your career. Also, you may move to another city after you graduate. Depending on mortgage rates available when you’re shopping, you might choose an ARM, with its generally lower monthly payment.
Once you become a doctor, you’ll enjoy a big jump in income, and might be ready for a forever home. Now, you might prefer the certainty and still relatively low monthly payments of a 30-year fixed mortgage. Ten years later, when you reach the peak of your earning potential, you might refinance and choose a 15-year fixed-rate mortgage, increasing your monthly payment so that your home gets paid off faster.
Our home affordability calculator will help you decide what you can afford now and our payment calculator can give you an idea of what your monthly mortgage payment will be. Or you can chat online or speak directly to a Home Loan Expert if you have any questions regarding the mortgages we offer and their terms.
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 an educated decision on what is right for you.
Keep Learning About Mortgages
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.
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.