How Does a Mortgage Work?

Houses are expensive, and most people do not have $200,000 in cash, which is the median U.S. price. Many banks will finance a house, and there are government-backed programs that encourage homeownership through low down payments. When you borrow money for a house, you most likely will use a mortgage. 

A mortgage is a loan that can be paid off over varying amounts of time. The most common mortgage has a 30-year term, meaning if a homeowner paid the minimum payments, they would pay off the loan in 30 years. There are 25-, 20-, 15-, 10- and even 5-year terms. The longer the term, the lower the payment. 

For every payment made, some money goes to the principal balance and some to interest. Early in the loan, much more money goes to interest than principal, but as the loan matures, more money will go to principal. The bank will base the loan amount on the value of the house, which is determined by an appraisal.

Things to consider before when applying for a mortgage

What is the down payment? 

Lenders will require the buyer pay a down payment. The down payment can vary from 3 percent (VA offers $0 down), to 5 percent, to 10 percent, or to as much as the borrower wants to pay. When you have a lower down payment, you will most likely pay mortgage insurance, which can add hundreds of dollars to your payment. 

What are the closing costs? 

Besides the down payment, the borrower will have closing costs. Closing costs consist of lender’s fees, appraisals, pre-paid insurance, pre-paid interest, title insurance fees, and title company fees. Closing costs range from 2 to 6 percent of the loan amount. In some cases, the borrower can ask the seller to help pay the closing costs. 

What is the payment? 

The monthly payment is determined by an algorithm that includes the interest rate, the length of the loan, and any mortgage insurance. If you get a 15-year loan, the payment will be much higher than a 30-year loan. The lower the interest rate, the lower your payment. 

How much house can you qualify for? 

The lender will tell you how much you can qualify for. This does not mean you should try to max out that number! The lender is not concerned with how much money you can save, only whether or not you can make the payments.

How is the payment calculated?

Every month, part of your payment is used to pay interest and part is used to pay principal (the amount of your loan). Calculating your payment isn’t easy because the amount varies based on the loan term and interest rate. 

For a 30-year loan on a $200,000 house, your monthly payment would be $1,755 at 10 percent interest. If the interest rate was 5 percent, the monthly payment would be $1,074. At 5 percent for 15 years, the monthly payment would be $1,582. 

The payment is much higher on a short-term loan because you have less time to pay off the balance. On a $200,000 loan with a 5 percent interest rate, $249 goes toward principal and $833 toward interest in the first month. 

The cool part about mortgages in the U.S. is the interest is tax deductible in most cases. The longer you have the loan, the more of your payment will go toward paying it off and the less will go toward interest. In three years, $279 will go toward principal and $794 will go toward interest. Every month, the principal and interest will change. 

You will pay much more interest in the beginning than at the end (online mortgage calculators can tell you exactly what your payment will be). Besides the interest and principal, most mortgages include taxes and insurance. 

Every property will have property taxes you must pay to the government, and the lender will require you to have homeowner’s insurance. Those costs are included in the payment because the lender wants to protect their investment. 

Tax rates can vary greatly between states. In some states, taxes and insurance might add $200 to your monthly payment, and in other states, they can add $800.

When do you have to make your payment?

When you first obtain a mortgage, the first payment is usually not due for two months. If you buy a house on December 15th, your first payment most likely will not be due until February 1st. Getting to skip a payment is good, but you still must pay the interest on the skipped payment up front (prepaid interest). 

Even though the payment is due on the first of the month, it is not considered late until the 15th of the month. You can safely make your payment on the 15th, pay no late fees, and still protect your credit with most loans. 

If you make the payment after the 15 th , it is considered late. The lender will assess late fees, which will be detailed in your loan documents. The lender may report the late payments to the credit bureaus, which hurts your credit rating. If you start to consistently miss payments, you risk going into default. Laws are different in each state, but a lender can foreclose on a loan after a certain amount of missed payments. 

Banks cannot immediately take the house away from borrowers after a couple of missed payments: they must foreclose on it. That means they must go to the courts, trustee, or sheriff (depending on the state you live in), show proof the borrower missed payments, and start the foreclosure process. 

The homeowner must be notified of the foreclosure and be given a chance to bring the loan current. In some states, foreclosure takes a few months, and in other states it takes years.

What are the different types of mortgages?

Not every mortgage is the same. There are private mortgages and government-backed mortgages. Government-backed mortgages were created to help more people buy homes with less money down. In the past, banks required a down payment of at least 20 percent. Now, there are many programs that allow people to buy for less than 5 percent down.

  • Conventional mortgage: This is a mortgage from a bank and has no government-backed down payment assistance programs. 
  • FHA: This is a loan insured by the federal government. A regular bank will lend to the borrowers, but a certain amount of the loan is guaranteed by the government, allowing a lower down payment. 
  • VA: This loan is for veterans of the military and those on active duty. The loan is guaranteed by the government and requires zero money down. 
  • USDA: These loans are available in rural areas and allow low down payments backed by the government. 
  • Local and state programs: Many states and even cities have programs that give grants to homeowners.

Learn more about the difference between fixed-rate and adjustable-rate mortgages.

What determines the down payment?

Typically, the lower the down payment the more expensive the loan. Banks are comfortable loaning 80 percent of the value of a house since the borrower supplies the other 20 percent as a down payment. 

Banks feel safe knowing the borrower has skin in the game (they are spending some of their own money), and if something goes wrong, banks have built-in equity. Luckily, for many borrowers who do not have 20 percent down, there are private mortgage insurance companies and government programs that will allow a lower down payment. 

FHA requires a down payment of as little as 3.5 percent, and some conventional loans require as little as 3 percent. With lower down payments comes higher costs. Both loans will have mortgage insurance, which can cost hundreds of dollars a month. 

VA loans require no mortgage insurance and no down payment but can only be used by active or veteran military personnel. 

The best strategy depends on the borrower’s financial position. If a borrower can get a conventional loan with private mortgage insurance, it is usually better than FHA. FHA loan costs are higher, and the mortgage insurance cannot be removed. 

However, insurance may be removed on conventional mortgages. The advantages of FHA loan are the borrower can qualify for more, even with a lower credit score. If a borrower can put 20 percent down, that may be the best strategy to avoiding mortgage insurance.

How can you qualify for a mortgage?

Banks look at debt-to-income ratios when determining who can qualify for a loan and for how much. Someone who makes $100,000 annually may qualify for less than someone who makes $50,000 if the person making $100,000 has a lot of debt. 

Banks will look at monthly debt payments versus monthly income. High car payments, credit card payments, and child support payments can increase debt-to-income ratios, making it harder to qualify. 

For those with low income and little cash, an FHA loan coupled with a local down payment assistant program can be a great option. FHA allows higher debt-to-income ratios than conventional loans. You should consider many other factors when applying for a loan:

  • You must have worked at the same job—or in the same field—for two years.
  • You must have decent credit (usually a score of at least 620).
  • You cannot have had a recent short sale or bankruptcy.

What is the process for securing a home loan?

The first step is talking to a lender or banker. If you are looking to buy a house, many real estate agents can recommend a good lender. There are good lenders and bad lenders, and a bad lender can cost the borrower a lot of money. Do not assume any lender can get you the right loan and complete it on time.

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