A Guide to Understanding Mortgages
This in-depth guide covers all the mortgage essentials, from pre-qualifying to closing day to help guide you through all the steps of the homebuying process.
Published February 01, 2023
10 min read
Understanding all the steps of the mortgage process can be both an exciting and daunting journey for homebuyers. This guide covers the essentials of getting a mortgage, from pre-qualification to closing day.
We’ll take an in-depth look at the homebuying process to help you understand the components and options for mortgages, and how to evaluate your budget and finances as you begin your new home search.
Understanding mortgages
Buying a home is one of the most exciting (and potentially daunting) times in one’s life. Between getting your finances in order, finding the perfect property, getting home inspections, and more, there are a lot of factors to consider as a prospective homebuyer. One of the most significant factors, however, is the mortgage. With multiple options, lenders, and varying terms based on your unique situation, understanding mortgage basics will help you make informed decisions and build a stronger foundation for the future. Explore our interactive guide to help you prepare for your mortgage and homeowner journey.
What is a mortgage?
Simply put, a mortgage is a loan provided by a lender or bank to help finance a home purchase. Mortgage financing can be used to finance existing homes, new construction, and land you wish to build on.
The different types of mortgage loans
Lenders offer a variety of mortgage types. Most are for 30-year terms but there are other options. The type you choose should depend on several factors, like your down payment, monthly budget, and how long you plan to stay in your new home.
Fixed-rate mortgage
Adjustable-rate mortgage (ARM)
These are based on set interest rates typically with 10, 15, 20, and 30-year terms. Monthly principal and interest payments remain steady throughout the life of the loan, enabling you to more predictably plan monthly budgets and future finances. This is especially appealing if you plan on staying in your home a long time (likely a decade or more).
ARM rates are initially fixed, typically for five, seven, or 10 years, but later may fluctuate annually based on market conditions. After the fixed-rate period, an adjustable rate can increase your monthly payments. On the other hand, ARMs usually provide lower initial interest rates, which can be helpful if you only plan on being in your house for a short time. Also, ARMs cap how much a rate can change, upward or downward, annually or over the life of the loan.
Mortgage components
A mortgage is made up of several components. Typically paid monthly, your mortgage will cover:
Principal
The principal is the total amount of money you borrow from a lender when you take out your home loan. To calculate your mortgage principal, you’ll subtract your down payment from your home's final selling price.
Interest
Interest is the money you’ll pay to your mortgage lender in exchange for giving you a loan. Most lenders calculate your mortgage rate in terms of an annual percentage rate (APR) which is the amount of interest you pay annually (including any fees/costs).
Property Taxes
Your property taxes will include state, county, and local governments taxes, and will be assessed based on the value of your home and the tax rates for the county or city. Depending on your lender, property taxes may be included in your monthly mortgage bill.
Insurance
Homeowners insurance is required by lenders and protects both your interest and theirs. Some require private mortgage insurance (PMI), especially if a down payment is less than 20%. If you are paying PMI, it will automatically cancel when the loan-to-value reaches 78%. Flood insurance and homeowner association fees may also apply.
Evaluate your finances
Now that you know the mortgage basics, the next step is to assess your unique financial situation. Before approaching a lender, assess the following:
Debt-to-income ratio (DTI)
Your DTI is your total recurring debt – including auto loans, minimum credit card payments, student loans, etc. – divided by your gross (before taxes) monthly income. As you lower outstanding debt, both your DTI and purchasing ability will improve. One way to start immediately is to pay down high-interest credit cards.
Credit score and history
Lenders use your credit scores to determine your creditworthiness. A higher score can help you get approved or qualify for lower mortgage rates. They’ll also look at your credit history, which may be impacted by late payments, collection activity, past bankruptcies, or foreclosures. You can get a free credit report once a year at AnnualCreditReport.com to help you review and correct any errors before applying for a mortgage.
Income stability
Lenders gauge your ability to pay a mortgage and will want to verify two years of employment. If you’re self-employed, you will want to have a profit and loss statement and balance sheet for the current year. Regular paychecks are generally seen as more reliable income than income that depends on bonuses or commissions, but all income is weighed on an individual basis.
Assets
Lenders will also consider investments, properties, and other assets that you could sell for cash. These reserves help to demonstrate that you can manage your money and have funds, in addition to your income, to pay the mortgage and have funds needed for closing.
Develop a budget
Once you have assessed your finances, create a budget to help you better understand what monthly payment you can afford. Buying a home requires more than coming up with a down payment and sending along a mortgage check – you also need to make sure you have enough each month for utilities, groceries, and other living expenses. Your budget should consist of:
Needs
Essential required expenses – including housing, utilities, and minimum debt payments.
Wants
May include expenses you don’t always need, such as restaurants, travel, or entertainment.
Savings
Should include emergency funds, retirement, and extra debt payments.
When you have your budget outline, consider the additional homebuying costs below and place them into your budget under “needs” to better understand what you can afford.
Determine your down payment amount
As soon as you’ve created your budget and included all expenditures, you can determine how much of a down payment you can afford.
Historically, the standard down payment was 20% of a home’s value. With a down payment of 20% or greater, you will not need to pay private mortgage insurance (PMI), reducing monthly payments. Higher down payments can also save you a significant amount of money in interest over the lifetime of the loan, especially if you plan to stay in the home for a long time.
Many lenders allow buyers to purchase homes with down payments of less than 20%. While this is an option, realize it could affect how much you are approved to borrow, your interest rate, and require the additional expense of PMI.
Your Estimated Mortgage Results
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This calculator is for illustrative purposes only and does not include any taxes, fees, or Private Mortgage Insurance.
*20% down can help you avoid private mortgage insurance (PMI).
Are you a doctor? You may be able to avoid PMI with 0% down.
Getting your mortgage
When you are ready to approach a lender to apply for a mortgage, gather the necessary documents:
- Your social security number and date of birth, as well as suitable documentation if you’ve had a recent name change
- Employment pay stubs, typically for the past 30 days
- Signed federal tax returns for the previous two years
- W-2 forms for the previous two years
- Your two most recent bank statements
- Documentation of additional sources of income, as needed
- Documentation showing the source of down payment. If a relative provides you with funds, you will need a signed “gift letter.”
To learn more about mortgage lending options from Laurel Road, visit laurelroad.com/mortgage.
The mortgage process
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