Buying a home or property can be a huge investment, and if you’re like most people it’s an investment that you can’t pay for out-of-pocket. As you may be aware, that’s where a mortgage comes into play… but do you really know what a mortgage is? Sure, it’s a loan on a house or other piece of real estate, but there’s a lot more to it than that.
Mortgages come in a variety of types and time spans, and can be used to either purchase a new home or piece of real estate or to secure additional money using that real estate as collateral. The implications of this are pretty straightforward… you get the money, but if you don’t pay it back then that house or property belongs to the bank. Of course, it’s not entirely that simple… but what else is involved in getting a mortgage?
Basics of a Mortgage
When buying a house or any other piece of real estate, there’s a good chance that you’ll have to finance the purchase through a bank or other lender. Chances are they’re not going to lend you the entire amount that you need (though occasionally you can find one that will), so the first thing that you’ll need is a down payment. The down payment is the amount of money that you’re going to pay personally for the real estate, and reduces the amount that you’ll have to borrow in your mortgage. The larger your down payment, the lower your payments will be (because you have less to pay back), though in a lot of cases your down payment can be as low as 5% of the total value of the property or less.
Once you’ve decided upon your down payment, you’ll apply for a mortgage to cover the rest. The mortgage will, of course, have to be paid back… and the bank or loan company will figure out the amount that you have to pay for each payment using a system known as PITI.
The principal is the total amount of the loan, and is calculated by subtracting your down payment from the final price of the property. Obviously, the higher your principal is the more you’ll have to pay back, so a higher down payment creates a lower principal and therefore lower monthly payments.
As with all loans, you’re charged interest on the amount that you borrow for your mortgage. The interest is based upon interest rates set by the federal government, as well as any rates that the bank or lender might be offering. The interest that you have to pay on your mortgage will be figured from the principal amount that you’re borrowing.
When you purchase real estate, you’re going to have to pay property taxes on it. Failure to pay these taxes could result in the property being seized by the government, and that would be against the best interests of the lender… therefore, a portion of your property taxes will often be added to your monthly payments so that it can be placed in escrow (or held by a third party until a certain time) until your property taxes are due.
Since the lender that issued your mortgage has a definite interest in your property until they get their money back, you’re going to need insurance. The amount of insurance that you have can seriously influence your monthly payments… having good coverage from fire, theft, and acts of nature can reduce your payment a great deal. If you have less than 20% equity in your property (equity meaning the portion of it that you’ve already paid for), then you’re likely going to have to take out private mortgage insurance as well (also known as PMI.) Private mortgage insurance can get rather expensive at times, so this is another reason that it’s good to make a large down payment.
Once you’ve gotten your mortgage approved and they’ve figured up the payments using the PITI system, you’ve got to take care of your closing costs. Closing costs are additional fees that cover the work that various members of the mortgage, realty, and legal teams do, as well as applicable taxes and fees that are due once the property has been purchased. Depending upon where you live (and where the property is located), you can usually expect to pay between 3% and 6% in closing costs. Keep in mind, though, that certain areas have higher closing costs than others, and some lenders offer a no-closing-cost option on real estate loans (wherein the closing costs are usually absorbed into the payments that you make for your mortgage.)
What Types of Mortgages are Available?
Generally, there are three types of mortgage loans that you will have access to… fixed-rate mortgages, adjustable-rate or balloon mortgages, and government loans. Each type has its own advantages and disadvantages, as well as unique loan options.
A fixed-rate mortgage is a loan that’s made with a locked-in interest rate, meaning that no matter how much the real estate market may fluctuate you’ll be paying the same amount for the entire time you’re paying back your loan. If you lock in a low rate now on a 20-year loan, then 20 years from now you’ll be paying that same rate no matter how much the interest rates have risen. On the down side, if you lock in a rate and interest rates fall, you’re still paying that same amount that you locked in.
Fixed-rate mortgages come in 15-year, 20-year, and 30-year options, with 15-year and 20-year having the highest payments but lower taxes, and 30-year having lower payments but higher taxes. The 30-year mortgage is also usually the easiest to qualify for.
Adjustable-Rate or Balloon
An adjustable-rate mortgage has an interest rate that fluctuates depending upon national rates and market trends. The rate that you pay changes at regular intervals depending upon the type of loan that you have, as well as caps that are in place on the maximum amount you’ll have to pay based upon increased interest rates. There is usually initial period of time in which the rate will not change, and once it has passed then your rate may change every 6 months, 1 year, 2 years, or more, depending upon the terms of your mortgage.
A balloon mortgage is a bit different, in that it offers fixed lower interest rates than most fixed-rate mortgages for 5 to 7 years and then you are required to make a “balloon” payment that pays off the mortgage in its entirety. Monthly payments tend to be low, though there is the large payment at the end… however, if you plan on refinancing or selling the property before the balloon payment is due then this is probably your best bet.
Government loans tend to offer much lower interest rates, though you usually have to meet certain standards to qualify for the loans. They are designed to help low-income individuals, veterans, and those living in rural areas to own their own homes. Most government loans are processed either through the Federal Housing Administration, the Veterans Administration, or the Rural Housing Service. Each group has their own qualifications and rules concerning loans that they make, so you should consult the appropriate agency to make sure that you qualify.
Qualifying for a Mortgage
In order to get a mortgage, you need to qualify first. Most lenders require you to have what is called a debt-to-income ratio of 28/36, meaning that no more than 28% of your income can go toward your mortgage payment and no more than 36% of your income can go toward your total monthly debts (including all other loans, credit cards, and your mortgage payment.) If you don’t have at least 64% of your gross monthly income to spend on food, taxes, and other expenses, then you might want to consider saving up some more money so that you can make a larger down payment (thus reducing your mortgage payments.)
Once you’ve cleared the 28/36 hurdle, you’ll need the following to take with you for your mortgage application:
- The amount of your down payment (making sure you have enough left over to cover closing costs)
- Sales contract signed by both the buyers and sellers of the property
- Social security numbers of all applicants
- Complete addresses for all applicants for the past 2 years (including names and addresses of landlords)
- Listing of all employers and all income earned for the past 2 years
- W-2 forms from the past 2 years
- Current pay stub showing year-to-date earnings
- Banks and account numbers for all bank accounts, including loans, credit cards, checking and savings accounts, and any stocks, bonds, or certificates of deposit
- 3 months worth of your most recent bank statements
You may also include child support or other court costs if you wish, bringing proof of payment… the best way to be prepared, though, is to consult a real estate attorney in your area and get them to help you prepare your materials. After all, they’ll be able to tell you if you’re missing anything or have something that you don’t need for your state or area.
Finally, you should understand the difference between being pre-approved and being pre-qualified. If you’re pre-qualified, then it means that a lender has looked at the material that you’ve provided for them and they’ve given you an estimate of how much you can afford to borrow. If you’re pre-approved, then they’ve checked your credit report and figured out your debt-to-income ratios and still consider you an acceptable risk to lend money to. It’s better to get pre-approved than to simply pre-qualify, since that way you know there aren’t going to be any nasty surprises waiting for you when the potential lender pulls up your credit report.