Mortgage 101: Understanding the Basics
If adulting had a to-do list, buying a home would occupy one of the biggest checkboxes for many of us. Of course, buying a home isn't a one-step process. An essential move toward homeowner status is understanding how to apply for a mortgage.
Whether you’re at the “What is a mortgage?” stage or already have a decent idea, it never hurts to review the pros and cons of different types of mortgages, what to expect from the application process, and where to find the best rates. And speaking of top rates, did you know credit union mortgage rates are among the best in the country? Brush up on mortgage basics below, then visit your local credit union to see for yourself!
What Is a Mortgage?
One of the most common types of loans, a mortgage, is an agreement between you and a lender to borrow money toward purchasing or refinancing a home.
Each mortgage payment to your lender includes a portion that pays off the principal (the initial loan amount) and part that covers the interest due on the loan. As you pay down the loan, the interest portion becomes smaller. As a result, more of your payment goes toward the principal.
Depending on your mortgage agreement with your lender, your monthly payment might also cover amounts due for homeowners insurance and property taxes.
Types of Mortgages
There are several types of mortgages and terms available from most lenders. You may also be able to take advantage of federal or state programs to lower your interest rate or down payment.
It helps to be familiar with all your options before shopping for a mortgage.
Fixed-Rate Mortgages
If you choose a fixed-rate mortgage, you’re betting that interest rates will stay the same or rise. This type of mortgage has a monthly payment that typically remains the same over the life of the loan.
Pros of a fixed-rate mortgage:
- It protects you from rising interest rates that would increase your monthly payment.
- Monthly budgeting is more manageable because housing costs will be predictable over time.
Fixed-rate mortgages do have potential drawbacks. Cons of a fixed-rate mortgage include:
- If interest rates drop, you cannot take advantage of the lower rate without refinancing.
- You will not have access to a low introductory rate that can make getting a home more accessible.
Adjustable-Rate Mortgage
If you choose an adjustable-rate mortgage (ARM), you’re betting that interest rates will stay the same or drop. This type of mortgage has a monthly payment that can increase or decrease based on changes in interest rates.
Adjustable rate mortgages can deliver satisfying returns under the right circumstances. Pros of an adjustable-rate mortgage include:
- They help you save thousands if rates drop and stay lower than when you got your loan.
- A low "introductory" fixed rate often found with ARMs can give you some financial relief for the first few years of your loan.
However, an adjustable-rate mortgage might be more trouble than it's worth. Cons of an adjustable-rate mortgage include:
- You can really lose your shirt if you opt for an ARM when interest rates are low but then rise significantly.
- Adjustable-rate mortgages can have very complicated structures and fees, leading to unhappy surprises later on if you don't understand the fine print.
Government-Backed Mortgages
The federal government has multiple homebuyer programs that decrease initial costs like down payments — especially when some lenders require as much as 20% of the price of the home to be paid upfront.
The different types of government-backed mortgages include:
- FHA Loans. You can qualify for a Federal Housing Authority (FHA) loan with as little as 3.5% of the purchase price, and your credit score can be lower than with other types of home loans. However, in addition to your monthly mortgage payment, you'll pay a mortgage insurance premium (MIP).
- VA Loans. Active-duty military service members, qualified veterans, and certain surviving spouses are eligible for VA loans through the U.S. Department of Veterans Affairs. VA loans have low or no down payment and do not require mortgage insurance.
- USDA Loans. USDA loans are guaranteed by the U.S. Department of Agriculture's Rural Development Guaranteed Housing Loan Program, which encourages people to move to some regions of the country. This loan could be perfect if you've ever dreamed of living in a small town or rural area. The top attractions of a USDA loan are that you can qualify with no down payment and no MIP requirement.
The Mortgage Application Process
Before you throw yourself into the house-hunting process, you'll want to understand what you are getting into. From pre-approval to closing, each step has potential pitfalls and opportunities.
- Pre-approval. Getting pre-approved knocks out some of the paperwork from the get-go and gives you a good idea of what you can afford. While it can be tempting to skip due to the work involved, pre-approval shows sellers you are serious about committing to a home purchase and can give you an advantage over other buyers.
- Application. Most lenders have moved their mortgage application process online, with personal support available when needed. Online or offline, you'll need to provide documentation, including proof of your identity, address, employment, and income — which may require up to two years of tax returns. You should also be prepared for a hard credit check.
- Underwriting. After the lender receives your application and verifies your documentation, you will still need underwriting before closing on your new home. Underwriting is when lenders determine if the financial risk of lending you money is worth it for them. The underwriters look for things like hidden debt, a poor payment record, or a spotty employment history.
- Closing. Once your loan is successfully underwritten and funded, you can close on your home. You'll still need to pay closing costs (unless you've negotiated for the seller to pay them), but you should know what those expenses will be from your loan estimate documentation. Specific processes vary by area, but your lender should confirm closing costs in a disclosure document before closing.
Mortgage Rates
A crucial part of knowing how to apply for a mortgage is understanding mortgage rates. Mortgage rates are part of the price you pay to the lender for providing the mortgage.
The Federal Reserve has a base rate, called the federal funds rate, which it raises and lowers depending on the economy.
How much interest lenders charge you above this rate base will vary with perceived risk and the lender. For instance, not-for-profit credit union mortgage rates are typically lower than at other financial institutions.
Factors that affect mortgage rates
When your lender underwrites your application, they assess the risk of extending a loan to you and assign a mortgage rate. This can be affected by:
- Your credit score. Higher credit scores typically qualify for a lower rate.
- Your down payment. The more money you put down on the home, the more likely you will get a lower rate.
- Your loan term. A shorter term, such as a 15-year mortgage rather than 30 years, can mean a lower rate.
- The type of mortgage. An adjustable-rate mortgage may come with a lower introductory rate than other options.
How to get the best mortgage rate
The most common way to lower your interest payments on a mortgage is by making a larger down payment. If you can afford it, this can save you thousands over the life of the loan. Similarly, a shorter loan term can save you tens of thousands on interest, although your monthly payment will be higher.
You can also shop for better rates and look at alternative lending sources. Never settle for the first rate. However, know that you can likely do little about the short-term interest rates you encounter.
If interest rates are exceptionally high at the time you'd like to house hunt, you may be able to save money by waiting. On the other hand, housing prices generally trend upward, and waiting for a lower interest rate may only save you a little if home prices rise significantly.
You can also take steps to improve your credit. Again though, this takes time, usually at least six months, to see a difference, so paying down debts is not likely an immediate option when looking for the best mortgage rate.
Repaying the Mortgage
Traditionally, mortgage payments are due on the same agreed-upon date each month. If you have a fixed-rate mortgage, payments are the same every month. If you have an adjustable-rate mortgage, your payments can and likely will change over time.
You can also pay a mortgage off early, either with a lump-sum payment or by making an extra monthly payment.
However, this may open you up to prepayment penalties. Review the details of your loan agreement before signing so you know how, when, and whether you can take advantage of paying it off early.
Amortization
Amortization is the calculation of when each payment is due, how much the total payment is, how much of each payment goes to principal or interest, and the date you will pay the loan in full.
The longer your amortization period, the smaller your monthly payments. However, remember that you will also pay more interest this way and ultimately pay more for your home, even if the interest rate is lower. Alternatively, a shorter amortization period results in larger payments and usually a higher interest rate, reflecting the lender's reduced time for charging interest.
Whichever you choose, you have options if your finances change. Common actions include refinancing to lengthen the term of your loan or making extra payments to lower your total interest paid. However, remember that interest rates may change significantly over time, so do not count on securing a better rate down the road.
Extra payments
One extra house payment a year can take four to six years off your amortization period. You can also make additional monthly payments directly to the principal to reduce your interest. You will need to communicate with your lender to set up this process.
Refinancing
Mortgage refinancing is basically a do-over of your home loan. A refinance takes the balance of your loan principal and resets the amortization period and monthly payment according to the new loan terms. Many people refinance to lengthen their amortization period and lower their monthly payments or to take advantage of a lower interest rate.
Further Resources on How to Apply for a Mortgage
Applying for a home loan can be arduous, but the right lender will be ready and willing to walk you through every step. Make sure you protect yourself and your financial future by considering the following:
- Watch out for predatory lending. The Fair Housing Act (FHA) and the Equal Credit Opportunity Act (ECOA) protect consumers by prohibiting predatory lending, as well as discriminatory and unfair lending practices, particularly in housing. Find out what to look out for regarding predatory lending.
- Avoid mortgage closing scams. Some unscrupulous individuals can find out who is about to close on a home, then send emails impersonating the seller, real estate agent, or lender with instructions to wire the closing costs to the scammer. Don't fall victim to mortgage closing scams.
- Understand pre-qualification vs. pre-approval. While these terms might sound identical, they aren't. Pre-qualification is based on data that aren't checked or verified; it's simply an estimate of what you can borrow. In contrast, pre-approval is a thorough check by your lender, with the results usually holding up through the underwriting process.
Ready to Mark Mortgage Off Your List?
Committing to a mortgage can be an exciting step toward solidifying your future. Knowing how to apply for a mortgage, what affects your rate, and how to improve your chances of having an offer accepted will all get you closer to the satisfaction of scratching ‘homeowner’ off your to-do list.
What’s your next move now that you can confidently answer the question, “What is a mortgage?” How about checking out our Credit Union Locator Tool to find the perfect lender!
