How Do Mortgages Work?
Intro
For many Americans, buying a home is a sign of wealth, The American Dream, and adulthood. It's also seen as the stepping stone to starting a family. But homes are expensive — the average home price sits at close to $400,000 nationwide with homes along the coastline being closer to $600,000.
It's safe to say that very few people actually have that kind of money sitting around to go purchase a home. Enter, the home mortgage.
Mortgages are fairly complex with lots of terms and conditions attached to them. In this article, we'll go through the basics with later articles to explain more nuances.
How does a mortgage work?
To put it simply, mortgages allow you to borrow money from a bank, you pay interest on the money you borrow on a fixed schedule called an "amortization schedule", which means you pay more interest upfront (since the balance is higher), and less towards the end.
Amortization will be discussed in a later article.
Downpayments
To do this, you are required to put down a downpayment. This downpayment varies from 0% with specialized loans upward to 25% on investment properties. Typically, increasing the amount on the downpayment results in a lower interest rate. With downpayments lower than 20%, you are typically required to buy Mortgage Insurance.
Mortgage Insurance
Mortgage insurance is used to protect the lender, not you. You pay a premium to pay for the insurance if you do not have enough capital to reach the 20% limit for a conventional loan. This may be also be called Private Mortgage Insurance (PMI) if you are financing outside of a specialty low capital loan.
Closing Costs
However, the mortgage doesn't come cheap. Even though you are already paying for interest, there are front-loaded costs called Closing Costs.
This is basically for all of the documentation and upfront legal work that goes into purchasing a home. You should typically budget around 5% of the loan amount, however, this price varies from person to person as well as lender to lender.
You can commonly request that the seller pay for part of the closing costs as well as the lender. This means you can shop around for lenders who will offer to reduce closing costs or pay for a portion of them.
This is one huge disadvantage to a mortgage as All-Cash buyers do not have to pay these transaction costs.
Monthly Payments
The monthly payment is rather straightforward. It is calculated using your interest rate, the loan amount, the length of loan (longer loans lead to lower payments, but higher total interest paid), taxes, insurance, and mortgage insurance (if applicable). Googling "Mortgage Calculator" can give you a good estimate on what your monthly payment will look like.
Calculating this is straightforward, but needs some explanation. It will be discussed in a later article.
Qualifying For a Loan
Typically, lenders want you to borrow as much money as possible, but there are rules they abide by to minimize their risk exposure. They look at something called your debt to income ratio.
In most cases, a lender will not loan you money if your debt-to-income ratio is higher than 36%. This means that for every 1 dollar of income, you pay more than 36 cents to debt payments. This is often referred as The 36% Rule.
There are other criteria outside of income that will be discussed in future articles:
Job History
Credit Score
Other Debt
Cosigners
The Lending Process
Talking to your personal bank or real estate agent will be the first logical step. These people will have connections to connect you to a recommended lender.
Once connected to a lender, they will do a preliminary check on your credit and finances to see how much is possible with them. If it doesn't work for them or you, they may be able to point you in the right direction or help you fix it. If it does work out, they'll give you a pre-approval letter that you can share with the sellers as it is required to put down an offer on a home in most cases. In this pre-approval letter, you will also likely get a "good faith estimate" of the closing costs at the end.
Once an offer gets accepted, the lender will be able to underwrite the home and loan. They'll dig in deep here to get a grasp on your finances. During this process, do not do anything that could jeopardize or change your credit. This means, do not make any large purchases (furniture, cars, etc) and do not open any new lines of credits. Changing credit may nullify a pre-approval letter.
Once due diligence is complete (inspection + appraisal), the lender will approve your loan, give you exact numbers for closing costs, and you can close on your home!
Then, it's congratulations for becoming a homeowner 🙂 .
Conclusion
And that's the high-level overview on mortgages. With each section, we can dive deeper on exactly how mortgages work, different opportunities to take advantage of, as well as the math from the lender and the investor side.
This is just the start — doing your research and due diligence is highly recommended.