Mortgages

The 2020 Ultimate Guide to Mortgages

If you have mortgage questions, you’re not alone! Whether you’re a first time home buyer or it’s your Nth time to buy a house, it’s normal to have loan questions especially when it comes to confusing loan-related terms.

In this guide, we will break down what a loan is, what you need to prepare when you apply for a loan and what to expect after your home loan gets approved.

First Of All, What Is A Mortgage?

Simply put, a mortgage is a loan secured by a property. When you apply for a mortgage, the lender, which could be a bank or a financing company, will place a lien against your property. This lien represents your creditor’s interest in your property and it will also appear as an encumbrance on the property’s title. 

Once you pay the loan in full, you can remove the lien from the property. However, if you are unable to pay the loan, the lender may obtain legal ownership of the mortgaged property through foreclosure. 

Before You Get A Mortgage

Getting a mortgage is usually a lengthy and complex process. Before diving into how you can get a loan, here are some mortgage-prep tips that can help you get a loan approval faster.

1. Be conscious of your credit score. 

You are likely to get pre-approved for a loan if you have a good credit score. As early as now, make sure to do the following to increase your credit score.

  • Settle your bills on time
  • Use only up to 30% of your available credit
  • Refrain from opening new credit accounts
  • Look for errors in your credit report and file a dispute

Most lenders require a minimum credit score. You can refer to the following credit score range as a guide: 

  • FHA loans – 500 to 580
  • VA Loan – 580 to 620 
  • USDA Loan – 620 
  • Most conventional loans – 620 to 640

What if my credit score doesn’t qualify? Are there any home loans for bad credit?

While the typical lender requires a credit score of 640, most favor borrowers with a credit score of at least 670However, borrowers with bad credit may still qualify for a mortgage. 

Loans to borrowers with bad credit are not as common as they used to be. But if you have a low credit score don’t lose hope, you still have options. The Federal Housing Authority, for instance, extends loans to borrowers with a credit score of as low as 500 may qualify. However, a down payment of at least 10% may be required. Meanwhile, a borrower with a score of at least 580 may be eligible for an FHA loan with a 3.5% down payment. 

What do you need to get approved for a home loan with bad credit?

If you have bad credit, you need to show the lender that you can pay the loan back. Expect the loan application to be stricter. Aside from that, you will have better chances of getting approved if you can provide the following.

  • Down payment of at least 10% 
  • High income
  • Lower debt to income ratio
  • Good employment history
  • Stellar rental payment history with a monthly rent payment which is comparable to your future mortgage repayments

2. Check your debt-to-income ratio. 

Lenders prefer a maximum debt-to-income ratio of 36%. You can compute this ratio by dividing your monthly debt payment s by your monthly income.

If you are making debt payments of $10K every month and you make $30K, your debt-to-income ratio is 33.33% ($10K divided by $30K). To decrease this ratio, consider paying off some debts or increasing your income.

3. Set aside money for the down payment. 

Depending on your what kind of mortgage you’re applying for and your credit score, you may need to provide a down payment of 10 to 20%. The down payment is a percentage of the home price that you’re going to pay directly to the seller. 

If you can’t make a large downpayment, consider government-backed loans like the USDA, VA and FHA loans. These agencies offer 0% down payment mortgage loans for qualified borrowers.

Are there any other ways to fund the down payment?

A donor, who could be a friend or family member, can help you fund your down payment partially or in full. This financial assistance is known as gift money.

If you’re using gift money for the down payment, your donor will have to send a mortgage gift letter to your lender. This gift letter explains that the money given to you is a gift, not a loan and it usually contains:

  • Your donor’s personal information 
  • Your relationship to the donor
  • Gift amount 
  • Details of the transfer to your account
  • A statement from your donor that the amount was a gift, not a loan
  • Information about the property you’ll purchase
  • Your donor’s signature

What if I can’t provide the required down payment?

In cases where you can’t come up with the required down payment, lenders require mortgage insurance.

Also called private mortgage insurance (PMI), this type of insurance protects the lender in case you default on the loan, die or become unable to meet your mortgage obligations. 

Loan insurance policies differ from one lender to another. Some lenders may allow you to stop paying this insurance when you pay back 80% of the loan. 

If the PMI protects the interest of the lender, there’s also another type of insurance called mortgage life insurance which protects the family of the borrower.

What is mortgage life insurance? 

Your mortgage will not be wiped out when you die. If you pass away, the burden of paying back the loans falls on the shoulders of your family. To avoid this situation, you can get a policy known as mortgage life insurance. This insurance covers the outstanding loan balance in case the borrower dies.

4. Choose the right kind of loan.

There are different types of loans available to borrowers with different needs. For instance, some loans are only available to residents of a certain city. 

There are different kinds of loans available for each kind of buyer. Here are some of the common types of mortgage loans.

1. Government-backed Mortgages.

The US government several offers programs to help more Americans realize their dream of homeownership. Here are three US-government insured mortgages you may qualify for.

a. Federal Housing Administration Mortgages

FHA home mortgage is offered to individuals with low credit scores and who can’t foot the 20% down payment. With an FHA loan, borrowers can put down as low as 3.5% down payment. If you have a low credit score, you may have to provide a 10% down payment. However, you have to pay the mortgage insurance premium for the full term of the loan. 

b. Veterans Affairs Mortgages

A VA loan is a low to zero down mortgage offered to eligible military personnel (whether in active duty or not) and their families. You can check out the US Department of Veterans Affairs website for more information on eligibility requirements.

c. USDA Mortgages

The United States Department of Agriculture (USDA) loan is a zero down payment loan offered to individuals interested in living in rural or suburban areas. To be eligible for the USDA loan your income should be within the loan threshold for your state. The property you plan on buying should also be your primary residence. You can check out USDA’s official website for more information on the eligibility requirements and other mortgage programs.

2. Conventional Mortgages

A conventional mortgage refers to home loans which are not backed by the government. These loans may be available through private companies such as banks or backed by the government-sponsored companies Fannie Mae (Federal House Financing Agency) and Freddie Mac (Federal Home Loan Mortgage Corporation).

Loans backed by Fannie Mae and Freddie Mac should meet certain loan limits. In 2019, for instance, the maximum loan size for most states is $484,850. Loans within these limits are conforming loans or loans eligible for the financial backing of Freddie Mac and Fannie Mae. Loans that exceed these limits are considered non-conforming.

3. Jumbo Mortgages

Home loans that exceed the $484,850 ceiling ($726,525 in high-cost states and counties) may be eligible for a special type of financing known as the jumbo loan. 

Also called “jumbo mortgage”, a jumbo loan is a mortgage designed for purchasing luxury homes. Jumbo loans are not guaranteed or backed by Fannie Mae and Freddie Mac. 

Mortgage jumbo loan rates vary from one state to another. But the rates are often higher than conventional loan rates. Most jumbo loans also have an adjustable rate which means that the interest rates change over the life of the loan. 

4. Balloon Mortgages

A balloon mortgage is typically a short-term home loan. In fact, most balloon mortgages have a 10-year term.

Balloon mortgages have a low payment structure, often asking the borrower to pay interest-only. At the end of the term, the borrower needs to pay the full balance, hence the term balloon. 

5. Interest-only Mortgages

With interest-only mortgages, borrowers are allowed to pay the interest-only for a given period. After the interest-only payment period ends, the borrowers will start paying the principal amount plus interest. Because of this arrangement, interest rates for this type of mortgages are typically higher.

6. Second Mortgages

Also called a home equity loan, a second mortgage allows you to take out a loan based on your home equity. You can think of home equity as the sum of the payments you have made on your existing home. Second mortgages usually have higher interest rates than your first mortgage. 

7. Reverse Mortgages

A reverse mortgage is a kind of loan offered to seniors who are 62 years old and above. This loan allows individuals to borrow an amount from their home equity without having to make monthly payments. Borrowers may receive the loan as a lump-sum payment or as monthly payments. The loan becomes payable when the borrower dies or sells the property.

5. Get a pre-qualification from your lender

Getting pre-qualified means that a lender has determined that you are eligible for a loan based on the information you disclosed. It is an informal process and at this point, your lender won’t verify your income, employment or assets  

Pre-qualification for a mortgage is also the point where you make your first contact with a mortgage loan originator. A mortgage loan originator is a person who is responsible for reviewing your financial background to see if you are a suitable candidate for the loan or mortgage you’re applying for. 

Your mortgage loan originator can be the loan officer in a bank of financing company you visited or a mortgage broker you hired to help you apply for a home loan.

Is there a difference between a loan officer and a mortgage broker?

A mortgage officer directly works with the lender or the bank as an employee, while the mortgage broker usually works independently. A loan officer does not have to be licensed. On the other hand, a mortgage broker needs to be licensed by the state.  

Getting a Mortgage

How much mortgage can I afford?

The mortgage you can afford depends on factors like your current income and existing debt.

To have a better idea of how much of a loan you can afford given your current financial status, use a mortgage affordability calculator. Most of these calculators which are available online require the following information.

  • Monthly income
  • Monthly expenses
  • Other debts
  • Down payment you can provide
  • Loan term

How much can I borrow?

While the final amount you can borrow will ultimately depend on your lender’s loan evaluation, there are a number of factors that affect this decision, such as:

  • Appraised value of the house you’re planning to buy
  • Debt to income ratio 
  • Credit score
  • Income
  • Down payment

How much should I budget for my future mortgage loan payments?

If you find yourself asking mortgage questions like “how much would the mortgage payment cost?” it’s time to use a mortgage calculator

A mortgage calculato is a tool to help you calculate how much monthly payment would be depending on how much the property costs, the term of the loan and the prevailing interest rates. These calculators also give you a good sense of how much you’ll need to save for the down payment based on your budget for your first home. 

Most banks and financing company websites have handy mortgage calculators. Some calculators include fields for property taxes and other related costs while others do not.

How much would the mortgage cost?

How much the mortgage costs will depend mainly on the interest rate of the loan. Mortgage interest rates are the annual cost to borrow money from a lender. The average interest rate for mortgage loans is between 2.82 to 4.86%.

The rate charged by the lender depends on factors such as the current market rate and your credit score. 

What kinds of mortgage interest rates can you choose from?

Lenders offer different kinds of mortgage interest rates, and the most common types include the following:

a. Fixed-rate

A fixed-rate mortgage is a secured loan where the interest rate remains the same for the entire loan term. In a fixed-rate loan, your mortgage payments remain the same for the full term of the loan.

Fixed-rate mortgages usually range from 15 to 30 years. Most people prefer longer loan term even if fixed-rate mortgage loans with shorter terms charge lower interest rates. In fact, 90% of borrowers in the US  choose mortgage loans with a 30-year term. 

b. Variable-rate mortgage

With variable mortgages, the rate may increase or decrease depending on the market fluctuations. The monthly loan payments for a variable-rate mortgage are usually fixed but the payment that goes to interest and the principals varies depending on the interest rate. If the rate increases, the interest charges become higher and principal payment decrease compared to the previous period.

c. Adjustable-rate mortgage

The adjustable-rate mortgage or ARM is a type of variable-rate mortgage where your payments increase or decrease depending on the current market rates. ARM rates reset periodically depending on the agreement between the lender and borrower agreement. Traditional ARMs reset annually although some lenders reset rates every six months. One type of ARMs, the hybrid ARM, is becoming a popular choice for borrowers.

What is a “hybrid ARM”?

A hybrid adjustable-rate mortgage has an initial fixed-rate period followed by an adjustable-rate period. The loan term has the same format as the regular ARM. 

The ARM loan term is expressed as two numbers separated by a slash sign. The first number always refers to the number of years where the loan has a fixed interest rate. 

For instance, 5/1 ARM means that the loan has a fixed interest rate in the first 5 years and then the rate resets every year (1). A 5/6 ARM, therefore, refers to a loan with a fixed rate for the first 5 years and where interest rates reset every 6 months. 

Sometimes, the second number refers to the number of years you have to pay adjustable rates. For example, a hybrid ARM with a 5/25 term refers to a mortgage with a term of 30 years (5 plus 25). The interest rate is fixed for the first 5 years mortgage and the adjustable-rate will apply for the next 25 years. 

Can rates go out of control with adjustable-rate mortgages?

While ARMs can increase yearly, rate caps protect borrowers from excessive rate increases and declines. ARMs usually include these rate caps:

  • Initial adjustment cap. This cap, which is usually between usually 2 or 5%, indicates how much the interest rate could increase during the first adjustment.
  • Subsequent adjustment cap. This cap, which is usually 2%, limits the increase in interest rates after the first adjustment.
  • Lifetime adjustment cap. This cap indicates how much the interest could increase during the full term of the loan. This cap is usually 5 to 6%.  

What is an “Option ARM”?

If you want more flexibility in your payment choices, consider getting an option ARM.  With this type of loan, the borrower can choose from any of these loan options every month:

  • 30-year loan repayments applied to interest and principal
  • 15-year loan repayments applied to interest and principal
  • Interest-only 
  • Minimum payment set by the lender

Adjustable-rate mortgages can be complex and terms may vary from one lender to another. It’s always better to ask your lender to explain how much you’ll owe and what the terms are.

How To Apply For A Mortgage 

After finding the property to purchase and finding the right mortgage lender for your needs, here are the next steps:  

1. Provide the documents to support your income.

A stable income ensures that borrowers are able to pay the amount owed to the lender. One of the requirements of a mortgage is a stable income, so lenders would ask borrowers to provide proof of their stable income in the form of payslips, employment certificates or tax returns. Most lenders will require the following documents:

  • Bank statements
  • Tax returns or W-2s for the past 2 years
  • Payslips for the last 3 months

2. Get pre-approved.

After submitting all the documents your lender requires, you have to wait for pre-approval. During the pre-approval process, a mortgage underwriter will approve or deny your loan application based on a careful and detailed analysis of your borrower profile. 

Being pre-approved for a mortgage means that your lender has reviewed your financial background, employment credit history, and other requirements and has determined that you are a suitable candidate for a loan. You should receive a pre-approval letter from your lender which shows the loan amount you’re pre-approved for. 

You can get pre-approval from various lenders, not just one. In fact, the government encourages borrowers to talk to several lenders and compare rates before finalizing their loan application.

For more information on the requirements for pre-approval, you can check out this article.

3. Submit the required documents.

After getting your pre-approval, what’s left is to choose your lender and submit your mortgage application! 

If the lender approves your loan application, your home purchase is almost complete. On closing day, the lender funds your loan and pays the seller in exchange for the property title. To seal the deal, lenders require you to sign the mortgage note and the mortgage deed. 

A mortgage note, also called the promissory note or a real estate lien, is a written promise to repay the loan within a specified time frame. If you ever applied for any type of loan such as a student loan or car loan, you should be familiar with this document.

A mortgage deed, on the other hand, is the legal document that signifies that the property serves as collateral for your loan. The mortgage deed gives the lender the power to take the property if you can’t keep up with your monthly payments. The installment payment you make to pay back the loan is also known as your monthly amortization. 

Your monthly amortization has an interest and principal component. The interest charged for each period is based on your outstanding loan balance.

Although your lender will explain how much you should pay each month, you should also receive a loan amortization schedule. This schedule lists the deadline for the monthly mortgage amortization you need to make until the end of your loan term.

After You Get A Mortgage

After getting a loan, you can face different scenarios. 

Scenario 1: Pay installments on time

Borrowers need to make their payments on time to avoid penalties. Aside from avoiding late fees and penalties, paying your loan on time will boost your credit score. 

Scenario 2: Pay off your mortgage before the loan term ends 

If you have extra cash to spare, you can make advance payments or prepayments on your loan to pay your loan before the term is up. However, ask your lender about their prepayment policy since some banks and financing companies charge prepayment penalties.

Prepayment penalties may be less common now but some lenders charge as high as 80% of the loan interest for six months charges on the original loan amount. Here’s a quick example of how much the penalty would be based on $200K loan with a 5% interest.

The monthly interest rate based on the original loan would be $833.33 (5% of $200K divided by 12 months). If the prepayment penalty applies, you may pay a hefty penalty of $4K (80% of $833.33 multiplied by 6 months). It’s good to note, however, that FHA loans don’t have prepayment penalties.

What are the benefits of paying off the mortgage early?

Apart from keeping you away from penalty fees, there are benefits you can enjoy as you pay off a loan early,

  • Financial security. Without having to pay your loan month by month, you can now focus on building your nest egg or your emergency fund.
  • Protection from an unstable housing market. Being able to fully pay your home means that you won’t have to keep up with increasing mortgage costs in the case of market instability. 
  • Budget flexibility. With the loan ticked off your list of growing expenses, you’ll have more breathing room in your budget. When your loan is out of the picture, you can focus on paying off other debts, consider investing or starting your own business!

If you wish to pay off the mortgage early but don’t know where to start, you can use these early mortgage payoff calculators:

 Scenario 3: You were unable to keep up with monthly payments

What happens when you don’t pay your mortgage?

If you miss your loan payment, lenders impose penalties which is usually 3 to 6 percent depending on your lender or your state.

Mortgage payments are considered late after the first month, but some lenders have a grace period before they impose late fees. Lenders usually allow 5 to 15 extra days from the actual payment date so you can make your monthly payment without the late fee. 

If you fail to make the payment after the grace period, your loan may be in default. A mortgage default happens when a borrower starts to fall behind his monthly payments. Your mortgage will be in default if no payment is received from you 30 days after your due date. When a loan is in default and you don’t make the necessary payments even with repeated reminders from your lender, you may risk foreclosing your home.  

In some cases, the lender and the delinquent buyer decide to enter a mortgage forbearance agreement. 

What is mortgage forbearance?

It is an agreement between the lender and a delinquent buyer. This agreement states the borrower agrees to a payment plan to catch up with his payments. In exchange, the lender will not take legal action against the borrower.

Scenario 4: Refinance the loan

Borrowers who find lenders offering better interest rates or those with delinquent accounts may also decide on refinancing. 

Mortgage refinancing is the process of replacing your existing mortgage with a new one. But don’t confuse loan refinancing with a second mortgage. A second mortgage is an additional loan. In mortgage refinancing, you apply for a new loan which usually has a lower interest rate and use the money you receive to pay your old mortgage.

Your Mortgage Questions, Answered

Mortgage terms are often intimidating, but once you learn the basics, it’s easier to understand what your lender is talking about. 

If you’re planning to get a home loan, learn as much as you can about the process. Start thinking about the best way to come up with your down payment. Don’t forget to check your credit score and track your debt-to-income ratio. These things will have the largest impact on the loan amount lenders may grant you and the applicable interest rates. 

We hope our ultimate guide helped you gain a basic understanding of what a mortgage involves and clarified some of the confusion surrounding home loans!

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