Personal Finance

How do mortgages work?

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If you’re in the market for your first house or plan to get one in the future, you may be more used to paying rent than paying a mortgage. While there’s certainly crossover — they’re both monthly payments you have to make — mortgages have a bit more complexity to them.

A mortgage payment is a type of loan used to finance a piece of property. Mortgages are secured loans, meaning the borrower (you, the homebuyer) promises collateral (your home) to the lender if you’re unable to make payments. 

While that sounds scary, it’s helpful to understand the different types of mortgages and how the mortgage process works.

How the mortgage process works

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While everyone’s mortgage experience will look a little different, you’ll commonly go through these five steps.

  1. Get pre-approved

Before you start visiting homes, it’s wise to get approval (also called pre-approval or pre-qualification) from your mortgage lender. A lender can verify your information upfront and let you know how much you qualify for. When you shop for homes, you’ll know what your budget is and what you can reasonably afford based on your income, assets, employment history and other factors.

  1. Look for a home

Go shopping for your new house! Make sure to have a checklist of things to ask about, such as rooms, lighting sources, yards and what kind of condition the appliances (especially air conditioners and heaters) are in — they may need to be replaced. If you can, try to ask other people nearby how they like living in the neighborhood.

  1. Make an offer

If you’re interested in a home, you’ll likely have to make an offer quickly. A real estate agent can help you find more places to visit and take care of paperwork and negotiating with sellers.

  1. Get final approval

If your offer is accepted, your lender will verify any details that still need to be confirmed, such as your income, employment status or other assets. You’ll also need an appraiser to evaluate the home’s value and condition with a home inspection. Finally, your lender will enlist a title company to ensure everything is ready to transfer ownership over to you.

  1. Close

Once the loan is fully approved, you’ll have a meeting with your lender and realtor to sign the final paperwork and close your loan. You’ll also pay your closing costs and down payment during this time (which is typically wired from your bank account) and get the keys to your new home!

Types of mortgage payments

Mortgage payments can have slightly different terms and conditions, but they generally fall into one of two categories:

  • A fixed-rate mortgage keeps your interest rate the same throughout the duration of your mortgage. Whether you have a 15-year, 20-year or 30-year mortgage, you’ll pay the same interest rate the entire time. This type of mortgage tends to provide a more stable and predictable monthly payment.

 

  • An adjustable-rate mortgage (ARM) has you pay a fixed rate for a set time before the rates change. The fixed rate may be for five or ten years, and then the remaining payments are updated on a monthly or annual basis. This type of mortgage leads to more unpredictable and potentially higher monthly payments, though if the interest rates continue to drop, you could see lower mortgage payments, instead.

Elements of your mortgage payment

Now that you know the types of mortgage payments, what are all the expenses you need to consider when buying a home?

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1. Closing costs

Buying a house is an exciting time, but it can also add up quickly. Closing costs are often a surprise if you’re not paying attention.

Typically, the home buyer pays for things like mortgage fees (including the loan origination fee, loan discount fee and loan application fee), mortgage insurance, credit report and mortgage broker fee. The seller will pay real estate commission and the property taxes equivalent to the amount of time they spent in the house that year.

Other closing costs to watch out for includes homeowner’s insurance, title insurance, document recording fees like your home’s deed, a property appraisal and a payment cushion for escrow items, which is typically two months of your mortgage payment.

There’s also a down payment on the principal. Usually, this payment is about 3-7% of the total principal. However, if you can pay 20% of the home’s down payment when you purchase, you can avoid paying private mortgage insurance (PMI), which is an additional required expense until you’ve paid off 20% of your mortgage.

2. Principal

Unless you pay for your house entirely in cash upfront, you’re borrowing money from a lender to make the purchase. Your principal payment is the total amount you borrow with your mortgage. You’ll see what your principal is before you close, as well as when you’re making your monthly payments.

With most fixed-rate loans, you’ll pay the same amount of money each month, though your principal will slightly go up as you pay more off your loan. You can also add money to your principal payment each month, as well.

For example, if your mortgage payment is normally $2,200 and you instead pay $2,500 each month, a portion of that $2,200 will go to your principal, and the entire amount of that extra $300 will go toward your principal. It’s a way to potentially pay off your mortgage even quicker, though don’t feel like you have to overpay if it would put you in a financial strain. 

3. Interest

The interest rate is determined by current market rates and the level of risk the lender is taking on to lend you money. If you have a higher credit score, that can help lower your interest rate. You’re required to pay interest with your principal payment each month.

As you go through the life of your mortgage, your monthly interest payments will go down slightly. Let’s say that after all of your closing costs and down payments, your principal is $300,000 with a 4% interest rate. Your annual interest rate would equal $12,000 (300,000 x .04). That first interest payment would be $1,000, the monthly equivalent of the annual rate.

However, as your mortgage goes on, the interest payment would drop because the total principal is also decreasing. By the time your remaining principal was at $125,000, that 4% interest rate would instead be $5000 annually, or $416.67 for the interest portion of your monthly payment. In turn, more of your monthly payment would go toward paying down your principal.

That example applies to a fixed-rate mortgage. However, if you have an ARM, your monthly payments are less predictable, since the interest rates fluctuate.   

4. Taxes and insurance

You’ll also need to pay property taxes and home insurance on any house you buy. These are typically an annual expense, but to avoid having a massive sum once a year, most lenders will increase your monthly payments and put the excess money in an escrow account.

Your escrow account generally consists of a two-month “cushion” of payments. When it’s time to pay your taxes and insurance, the lender simply withdraws the money from the escrow fund. Your lender will periodically reevaluate your escrow account and make adjustments if need be. 

For instance, if property taxes in your area rise, or something happens that requires your insurance to cover you, you may see an increase in those costs, and thus, a higher escrow payment each month. Those increases are reflected on your total monthly payment.

Occasionally, an escrow may cover other costs, but taxes and insurance are the most common.

Buying a home is a major accomplishment. Though the closing process and mortgage payments can appear to be overwhelming, with some research, preparation, and patience, you’ll come out the other side looking great and be set up for success throughout your mortgage.

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