Last Updated on April 21, 2021 by Mark Ferguson
Buying a house is a dream for many people. Houses are expensive and they keep getting more and more expensive. Very few people have the cash needed to buy a house outright but mortgages are available, allowing the majority of people to own a home. In the United States, about 67% of households own the home they live in. A mortgage allows homeowners to put down very little money and pay a low interest rate to purchase a home. Buying a home has also proven to be a good investment for the majority of homeowners. While some people may say that owing money on a home is not the best way to buy, using a loan or leverage allows you to control a very expensive asset with very little money. The risks are very low when using mortgages compared to the rewards that can come when prices increase. Mortgages can be confusing, but they are easy to understand when explained correctly.
How does a mortgage work?
Many lenders, agents, and even wealth gurus make a mortgage sound really complicated, but they are pretty simple when you look at how they work. When you take out a mortgage you borrow money from a bank. You also pay interest on the money you borrow. A mortgage is set up so that you pay back part of the mortgage with every payment you make. The amount of money you pay off over time is calculated using an amortization schedule. The longer the mortgage term, the lower the payments will be because you pay off the balance over a longer period of time. You also pay more interest with a longer-term loan, because you make payments over more time.
- Down payment? Lenders will require the buyer to pay a down payment when getting a loan. The down payment can vary from 3 percent (VA offers $0 down), 5%, 10%, or as much as 25% on investment properties.
- Closing costs? Besides the down payment, the borrower will have closing costs as well. The closing costs consist of lenders fees, appraisals, pre-paid insurance, pre-paid interest, title insurance fees, and title company fees. The closing costs can be from 2 to 6 percent of the loan depending on the state you live in. In some cases, the borrower can ask the seller of a home to help pay the closing costs.
- Mortgage payment? The monthly payment is determined by an algorithm that takes into account the interest rate, the length of the loan, taxes, insurance, and mortgage insurance. Property taxes and homeowners insurance are usually included with most mortgage payments.
- Qualifying? The lender will decide how much you can qualify for. This does not mean you should try to max out that number! The lender is not concerned with how much money you can save, only if you can make the payments.
How is the payment figured on a mortgage?
Every month part of your payment is used to pay interest and part of your payment is used to pay principal (the amount of your loan). It is not easy to figure your payment, because the amount varies based on how long the loan term is and your interest rate. On a $200,000 house, your payment would be $1,755 a month at 10 percent interest on a 30-year loan. If the interest rate was 5 percent, the payment would be $1,074 a month. If the interest rate was 5 percent on a 15-year loan, the payment would be $1,582 a month. The payment is much higher on a short-term loan because you have less time to pay off the balance.
On the $200,000 loan, with a 5 percent interest rate, $249 of your payment would go towards paying off your loan and $833 would go towards paying interest in the first month. The cool part about mortgages in the US is the interest is tax-deductible in most cases. The longer you have the loan, the more of your payment will go toward paying the loan, and less will go toward interest. In three years, $279 will go towards your principal and $794 will go towards interest.
Every month the amount of principal and interest paid will change. You will pay much more interest at the beginning of the mortgage than at the end. Here is a great site for calculating the mortgage payment. Besides the interest and principal, most mortgages include taxes and insurance. Every property will have property taxes you have to pay to the government and the lender will require you have homeowners insurance. Those costs are included in the payment because the lender wants to protect their investment. Tax rates can vary greatly by the state you are in. In some states, taxes and insurance might add $200 a month to your payment and in other states, $800 might be added to your payment.
Are mortgage payments front-loaded?
Many people think that a mortgage has a front-loaded interest or that more interest is paid at the beginning of the loan than at the end. It is true that more interest is paid in the beginning but it is because the loan amount is higher. The interest rate does not change on a fixed-rate mortgage. If the loan is $100,000 and the interest rate is 10%, you pay $10,000 a year in interest. As the loan amount is reduced you pay less interest accordingly. When the loan amount is $50,000, you will pay $5,000 in interest with a 10% interest rate. It is very easy to calculate what the interest paid is. The complicated part is figuring out how much principal you pay each month.
The only thing paying a loan off early does is reduce the principal balance of the loan, which in turn reduces the interest paid. It does not magically save a ton of money because mortgages are “front-loaded”.
To learn how to get the best deal and make the most money, check out my book: How to Buy a House: What Everyone Should Know Before They Buy or Sell a Home. It is on Amazon as a paperback or Kindle.
When do you have to make your payment on a mortgage?
When you first get a mortgage the first payment is not usually due the next month. If you buy a house on December 15th, your first payment most likely will not be due until February 1st. It is nice that borrowers get to skip a payment, but they still have to pay that interest upfront for the skipped loan (prepaid interest). Even though the payment is due on the first of the month, it is not considered late until the 15th of the month. You can safely make your payment on the 15th, pay no late fees, and not hurt your credit with most loans. If you make the payment after the 15th of the month it is considered late. The lender will assess late fees, which will be detailed in your loan documents. The lender may report the late payments to the credit bureaus hurting your credit rating as well. If you start to miss payments, you risk the loan going into default. The laws are different in each state, but a lender can foreclose on a loan after a certain amount of missed payments.
The bank cannot take the home away from borrowers after a couple of missed payments, they must foreclose on it. That means they have to go to the courts, trustee, or sheriff (depending on the state you live in), show proof the borrower missed payments, and start the foreclosure process. The homeowner must be notified of the foreclosure and given a chance to catch up on payments to bring the loan current. In some states, it can take a few months to foreclose, and in other states, it can take years. The average time to foreclose in the United States in 2019 was over 700 days!
What are the different types of mortgages?
Not every mortgage is the same. There are private mortgages and government-backed mortgages. The government-backed mortgages were created to help more people buy homes with less money down and make buying a house less risky. Before The Great Depression, many loans had only 5 or 7-year terms, which meant the borrowers had to repay the entire loan back after 5 or 7 years. if the market went down or the borrower could not refinance the house after 5 years the bank could demand the loan be paid in full and foreclose if it was not. The introduction of the 30-year loan helped alleviate this problem because if a borrower found themselves in trouble or the market went down they could keep making payments for 30 years. In the past, banks would also require at least 20 percent down to buy a house. Now there are many programs that allow people to buy homes for less than 5 percent down.
- Conventional: This loan is from a bank, with no government-backed down payment assistance programs.
- FHA: This loan is insured by the federal government. A regular bank will lend the money to the borrowers, but a certain amount of the loan is guaranteed by the government allowing a lower down payment.
- VA: This loan is for veterans of the military and active duty. The loan is guaranteed by the government and is available with zero money down.
- USDA: These loans are available in rural areas and allow low down payments backed by the government.
- Local and state programs: there are many state and even city programs that give grants to homeowners.
- Reverse mortgage: A type of mortgage available to homeowners 62 years and older which allows them to tap into their primary residence’s home’s equity.
What determines the down payment when you get a mortgage?
Typically the lower the down-payment the more expensive the loan will be. Banks are comfortable loaning 80 percent of the value of a home since the borrower would need to bring the other 20 percent as a down payment. The bank feels safe knowing the borrower has skin in the game (they are spending some of their own money), and if something goes wrong the bank has built-in equity. Luckily for many borrowers who do not have 20 percent down, there are private mortgage insurance companies and government programs that will allow a lower down payment. FHA has as little as 3.5 percent down payment and some conventional loans as little as 3 percent down payment. With the lower down payment comes more costs. Both loans will have mortgage insurance which can be hundreds of dollars a month. VA has no mortgage insurance and no down payment, but can only be used by those in the military or veterans.
The best strategy depends on the borrower’s financial position. If a borrower can get a conventional loan with private mortgage insurance, it is usually better than FHA. The costs on FHA loans are higher and the mortgage insurance cannot be removed on FHA but may be removed on conventional. The home value must exceed 80 or 75 percent of the loan for the insurance to be removed. The advantages of FHA are the borrower can qualify for more and have a lower credit score.
How can you qualify for a mortgage?
The banks look at debt to income ratios when determining who can qualify for a loan and for how much. Someone who makes $100,000 a year may qualify for less than someone who makes $50,000 a year if the person making $100,000 a year has a lot of debt. The bank will look at monthly debt payments versus monthly income. High car payments, credit card payments, child support can increase debt to income ratios making it harder to qualify for a home. For those with low income and little cash, FHA coupled with a local down payment assistant program can be a great option to get into a house. FHA allows higher debt to income ratios than conventional loans.
There are many other factors to consider when qualifying for a loan.
- You must have worked at the same job or in the same field for two years.
- You must have decent credit (usually at least 620).
- You cannot have had a short sale or bankruptcy recently.
What is the process for securing a home loan?
The first step to getting a mortgage is to talk to a lender or banker. If you are looking to buy a house, many real estate agents can recommend a good lender. There are good lenders and bad lenders, and a bad lender can cost the borrower a lot of money. We have had bad lenders cause many problems with buyers of the houses we fix up and sell. It is amazing the difference a really good lender can make! It is not easy to find out who is good and bad without a recommendation from someone who is in the business.
- Once you find a lender they can pull your credit score and look at your finances to determine how much or if you can qualify for a loan. If there are problems with your credit or income the lender can often point you in the right direction for free to fix those problems.
- Once you have talked to the lender and they have looked at your finances they will give you a pre-qualification letter or pre-approval letter that will let sellers know you have the ability to get a loan and buy their home. This is required to make an offer on most homes and some sellers require one just to view a home. The lender should also give you a good faith estimate for what the closing costs will be.
- Once you have the pre-qualification letter, you can decide how much you want to spend on a house and look at houses in those price range. You can make an offer on the home, and if it gets accepted the lender will start the process of underwriting the loan where they look at your finances in depth to see if there are any issues or problems they missed when qualifying you.
- Make sure you do not make purchases on credit when you are trying to buy a house! if you buy a new car with a loan or even put furniture on credit it may make the house loan fall apart! Always wait to make those purchases after you buy the home. The lenders will recheck your credit before closing to make sure you have not bought adding any new credit.
- During the home buying process, the lender will need to complete an appraisal which you may have to pay for and can cost from $400 to $1,000 depending on the house. The appraisal ensures the home is worth what you are paying for it. The appraisal also makes sure the home is in decent shape to live in and does not have any major problems, although this does not substitute for an inspection.
- If everything goes well, the lender will approve your loan and give you the exact figures for how much money you will need to bring to the closing. You can close on the home and move in with the new loan in place!
Buying a home ends up being most people’s best investment they ever make. 66% of American’s net worth comes from their home and homeowners are much better off than renters statistically. That does not mean jumping into a home without doing your research is a good idea. Make sure you don’t overextend yourself with a mortgage and just because a lender says you can qualify for some much money does not mean you have to get a loan for the most you can.