Mortgages

Mortgages
Richard BarringtonApr 27, 2022
Key Takeaways:
  • The term “mortgage” simply means any loan secured by real estate.
  • Mortgages are offered by banks, credit unions, mortgage companies, and other providers.
  • If the borrower fails to repay a mortgage, the lender can foreclose and sell the property to get its money.

A mortgage is a loan used to buy real estate property, using the value of that property as collateral. 

While that may seem simple enough, there are several details and variations that can affect how mortgages work, what they cost and how risky they are. 

This article will cover some of the basics that will help you understand how to get a mortgage that’s right for your situation. Topics covered will include:

  • Definition: What Is a Mortgage?
  • How Mortgages Work
  • Types of Mortgages
  • Mortgage Rates
  • How to Get a Mortgage
  • Mortgage FAQs

Definition: What Is a Mortgage?

As noted in the introduction, a mortgage is a type of loan used to buy real estate property, using that property as collateral. To break this down in more detail:

  • A loan involves letting someone borrow something temporarily, on the understanding that they’ll pay it back. In finance, this almost always involves paying an extra amount, in the form of interest, to compensate the lender for making the loan.
  • Real estate property can be a house, a condominium, an apartment, vacation property, an office building or other type of business facility.
  • Collateral is something of value that’s pledged to guarantee the loan. If the borrower fails to make the agreed-upon loan payments, the lender has a legal right to claim the collateral. Collateral is also known as security for a loan.

How Mortgages Work

Beyond the basic definition, a closer look at how mortgages work helps explain what a borrower should consider when looking for this kind of loan.

Most mortgages are not paid back all at once. In fact, since real estate is generally fairly expensive, mortgages are designed to be paid back over very long periods. Thirty-year mortgages are common, and some are even longer than that. These payments are usually made in monthly installments.

To compensate the lender for the use of their money, the borrower pays interest on what they owe. So, the way most mortgages are set up, part of the monthly payment you make is interest, and the remaining part is principal. 

The principal on a loan is the remaining amount you owe. At the start, the principal equals the total amount you borrow. Then each time you make a payment, part of that payment reduces the remaining principal you owe. 

As the amount of principal you owe goes down, so does the amount of interest you’re charged. So, even though mortgage payments are usually for the same dollar amount over the life of a loan, the earliest payments are mostly interest because that’s when you owe the most. 

As principal gets paid down, the interest charged on the loan declines. So, as time goes on less and less of your monthly payments are interest, and principal starts being paid down faster. 

The length of the mortgage is known as the term. A longer-term mortgage spreads repayment of the loan out over more months, so the monthly payment will be lower. However, because this means paying down the principal you owe more slowly and paying interest for more months, a long-term mortgage will cost you more over the life of the loan. 

Types of Mortgages

There are different ways principal and interest can be structured within a mortgage. There are also differences in how you qualify for a mortgage - that is, how you convince a lender that it’s worth the risk of lending you the money.

Because of these differences, there are several types of mortgages, but some of the most common categories that a first-time mortgage shopper should be aware of are explained below. 

Fixed Rate Mortgages

A fixed rate mortgage means that the interest rate is agreed upon when you take out the loan, and doesn’t vary over the life of the loan. 

With a fixed rate mortgage, your monthly payment doesn’t change and you go into the loan knowing the total amount you would pay over the scheduled term of the loan. 

Adjustable Rate Mortgages (ARMs)

Interest rates change almost constantly, due to a variety of economic conditions. An adjustable rate mortgage is one where the interest rate you’re charged changes to reflect market conditions. 

This means your monthly payment can change over time, as can the total cost over the scheduled term of the loan. If interest rates fall, this works in your favor as the loan gets cheaper. However, if interest rates rise your mortgage would get more expensive.

There are limits on when and by how much the interest on an ARM can change. However, because an ARM does not lock in a fixed rate over the life of the loan, you run the risk of your mortgage payments becoming harder to afford.

Conventional Mortgages

Conventional mortgages are those that are not part of a special government program to help borrowers qualify. They are available through private lenders, though government-backed entities like the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) may provide financing to support those lenders.

With a conventional mortgage, you have to qualify based solely on your financial situation. This includes your credit history, your wages and job security, and how much your debt and other obligations represent as a percentage of your income. 

Because conventional mortgages are approved based on the borrower’s financial situation, your chances of getting one and how low a mortgage rate you get will depend on how strong your finances are. 

Also, conventional mortgages are likely to require a substantial downpayment. The size of your downpayment can affect the mortgage rate you get.

FHA Mortgages

FHA mortgages are guaranteed by the Federal Housing Authority, a branch of the U.S. Department of Housing and Urban Development. 

This guarantee helps make them available to people who wouldn’t ordinarily qualify for a mortgage. This includes people with relatively less robust credit histories, and those who can only afford a modest downpayment. 

FHA mortgages are available with a downpayment as low as 3.5% of the home’s purchase price. You must use the property as your primary residence, and you will be required to pay for mortgage insurance, which adds to your total monthly payment. 

Other government-guaranteed mortgage programs are available from the U.S. Department of Veterans Affairs and the USDA Rural Housing Service. These can also make it easier for lower income and first-time home buyers to qualify for a mortgage.

Mortgage Rates

The interest rate on your mortgage has a major impact on the size of your monthly payment. In fact, over the life of a mortgage, interest costs often exceed the amount of principal borrowed. 

Mortgage rates fluctuate all the time, for a number of reasons. Inflation and concern about economic risks are two factors that affect interest rates in general. 

Besides those broad economic influences on interest rates, there are two things that affect mortgage rates that you can control to some degree:

  • Your creditworthiness. This is a combination of your credit history, your income and job history, and the total amount of debt and other financial obligations you have. The less of a risk you seem based on those factors, the lower your interest rates are likely to be.
  • The length of your mortgage. The longer you plan to take to pay back what you borrow, the riskier the mortgage is for the lender. For that reason, longer-term mortgages tend to have higher interest rates than shorter term ones. So, a 15-year mortgage will cost you less in the long run than a 30-year mortgage, both because it’s likely to have a lower interest rate and because you’ll be paying interest for fewer years. However, that shorter repayment period will make your monthly payments higher. 

How to Get a Mortgage

There are many types of lenders offering mortgages on today’s market. These include banks, credit unions and non-bank lenders. 

That variety means it’s a competitive market. That gives you an opportunity to get a better deal by shopping around. 

Before you shop for a mortgage, you should get some idea of what you’re looking for. A good place to start is by using a mortgage calculator to figure out what you can afford and what type of mortgage you want. 

For most mortgages, you’ll need to save up for a downpayment. While you’re doing that, you should check your credit record to see if there are any mistakes that need to be cleared up or ways you can improve your credit score. 

You should also avoid taking out other loans while you’re planning to apply for a mortgage, because this will affect your debt-to-income (DTI) ratio. A high DTI ratio is a red flag that could prevent you from qualifying for a loan. 

Also, if possible hold off on any job changes shortly before applying for a mortgage. Lenders are interested in both your income and the stability of your job history.

When you’re ready to apply, you can narrow down the field by comparing rates advertised online for the type of mortgage you want. Ultimately though, the exact rate you get will depend on the details of your situation. 

Get up to 5 competing mortgage quotes

Frequently Asked Questions

I have a limited credit history. How does this affect my chances of getting a mortgage?

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If you have a limited credit history, you may want to lean towards an FHA loan, or a VA loan if you qualify. The government guarantees of these loans helps make them available to people who haven’t established a long credit history. 

Instead of committing to a shorter-term mortgage with higher monthly payments, couldn’t I just get a 30-year mortgage and make extra payments to pay it down faster?

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This might be a good idea if you only expect to have extra money to put towards your mortgage every now and then. However, if you generally expect to be able to make higher payments, be advised that getting a shorter-term mortgage is likely to score you a lower interest rate. 

Since adjustable-rate mortgages have lower interest rates to start, does this make it cheaper to get an adjustable-rate loan and then refinance to a fixed rate loan once that low-interest period has expired?

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Whether or not this turns out to be cheaper depends on what happens to interest rates in the meantime. If interest rates rise sharply in the early years of your mortgage, you may find yourself with much higher rates on your adjustable-rate loan and unable to refinance without paying a similarly higher interest rate on a fixed-rate loan. Since you’d then be paying that higher rate for much longer than the initial low-interest period on an adjustable-rate mortgage, that could turn out to be more expensive in the long run.