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Wait, What Exactly Is A Mortgage?

Wait, What Exactly Is A Mortgage?

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Most people have a basic understanding of what a mortgage is. People who own a house usually have one, and they pay towards it monthly. That’s simple enough, but when you apply for one yourself, you discover all kinds of paperwork and contracts, as well as things called ARMs and PMIs. Suddenly, it can feel a little daunting.

In the simplest terms, a mortgage is a secured loan that enables you purchase a home. Being secured, the loan requires the borrower to put up an asset as collateral, and in the case of the mortgage, the asset is the house itself. A mortgage typically comes from a bank or other financial institution, and is paid back in monthly installments over a pre-determined period of time – usually 20 or 30 years.

Understanding exactly what a mortgage entails is critical to a successful home-owning experience, but it doesn’t have to be intimidating. Here are some mortgage basics to help you get a handle on what it will mean for you to have your own mortgage someday…

Photo: Flickr.com/Scott Lewis

The Different Types

There are different types of mortgages you can get, each with their own unique conditions. For example, USDA, FHA, and VA loans are all government-sponsored loans.

USDA loans are guaranteed by the United States Department of Agriculture, and are designated for rural or suburban homeowners under certain income limits.  These loans require no down payment, and no private mortgage insurance (PMI).

FHA loans are designed to assist first-time homebuyers with lower income, and they are guaranteed by the Federal Housing Administration. These loans are less strict than conventional loans, as they don’t require high credit scores or large down payments.

VA loans are available specifically for active service members, veterans, and some surviving military spouses. While this loan, which is guaranteed by the Department of Veteran Affairs, does have the benefit of not requiring a down payment or mortgage insurance, borrowers must pay an upfront funding fee.

The most common type of mortgage taken out is the conventional mortgage. These are much stricter that the others listed above, because they are only available to people with good credit, and they require PMI if the down payment is less than 20% of the entire loan.

A conventional loan can either be conforming or non-conforming. The conforming loans will follow dollar amount limits, while riskier non-conforming loans go beyond those limits and have higher interest rates.

Photo: Flickr.com/Alan Cleaver

How It Works

If you decide to take out a home loan, you will sign a mortgage note, which is a legal contract where you agree to repay what you’ve borrowed with interest. This included the condition that if you don’t repay, your house will be foreclosed on.

Each month, you will be required to make a payment toward your loan. These payments cover a variety of costs, where the two main ones are the principal balance and interest accrued. The principal balance is the amount you still have left to pay on your loan after subtracting your down payment.

While a portion of each monthly payment will go toward your principal balance, that portion will likely vary on a monthly basis. Many payment schedules are interest-heavy upfront, so toward the end of your loan more goes toward the principal balance. The mix of interest and principal changes throughout the life of your mortgage through a process called amortization.

If you are wondering why you have to pay interest on top of the principal balance, that’s a great question. Interest is basically a payment to the financial institution for letting you borrow their money, and it’s expressed as an annual percent of your loan.

There are two different types of interest when it comes to mortgages: adjustable or fixed.

An adjustable-rate mortgage (or ARM) lets you pay a fixed rate at the beginning of your loan term, then the rate can go up or down based on a certain benchmark. On the other hand, a fixed-rate mortgage remains steady throughout.

Fixed interest tends to be a better choice for those with stable income because payments stay the same. However, since an ARM allows you the option of choosing how much principal to pay each month, it could be a better choice if your income fluctuates.

Other costs include mortgage insurance, property (and other) taxes, and possibly homeowner’s insurance.

Photo: Flickr.com/Refracted Moments

Tips To Get The Lowest Interest Rate

One of the best ways to lower your interest rate is to make a larger down payment when you buy a home. In other words, apply as much cash money as possible to the home purchase upfront. A good rule of thumb is to have at least 20% of the purchase price covered, so you can avoid PMI. Though it might seem overwhelming to cash out such a high sum upfront, you’ll be glad you did in the long-term based on savings, like insurance and interest.

Another great way to get the best interest rate is to lower your debt-to-income ratio. This ratio is a comparison of your monthly payments to your monthly income. The more money you have left over each month after covering your cost of living, the better. This signals to your lender that you can manage money well, and are living within your means. You can lower your debt-to-income ratio by increasing your income or paying off debts.

Boosting your credit score is another solid method to lower your interest rates on mortgage loans. Basically, you want to put your best foot forward to show the lender that you’re worth the risk.

Now you are armed with a bit of knowledge when it comes to what a mortgage is, how it works, and what you can do to get the best deal. When the time comes, you can move more confidently toward your goal of homeownership.