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What Is a Mortgage?
Many potential home buyers are confused by the housing market terminology. They want to invest but are left wondering what the answers are to questions like, “What is a mortgage?”
There has been a lot of press recently about low mortgage rates, but new buyers need an coherent mortgage definition and a solid understanding of how they work before entering into the process of buying a home.
What is a mortgage?
Since most people can’t afford to buy their homes with cash out of pocket, prospective homeowners generally seek a mortgage loan from a bank or a lender to finance the purchase instead. Mortgage loans allow borrowers to spread out the cost of the home, with interest, into manageable monthly payments that are made over years or decades.
To qualify for a mortgage, you will need to meet several eligibility requirements, such as good credit, consistent work history and a good debt-to-income ratio. Although a mortgage is used to help you buy your home, you don’t fully own your home until that mortgage is paid off.
It can be hard work to find a good lender with a competitive rate, so you should research what lender is best for you before applying for a loan. Your monthly payment will not just be a sum of your principal balance, but will also include your interest and escrow payments, so it’s important that you are prepared to pay the full amount.
Differences between a mortgage and a loan
A mortgage is essentially a really large loan, but it has some specific features and steep consequences if you default. A basic loan is a monetary transaction in which a person receives money from a bank or a lender and agrees to pay it back over time, usually with interest.
A mortgage is a specific type of loan that can only be used to finance a home or property, and it is secured by your home. As part of your mortgage agreement, your home will become collateral, meaning that it is pledged as security for the repayment of the mortgage loan.
[ Related: How to Refinance Your Mortgage ]
Failure to pay your mortgage will result in the foreclosure of your home, a process through which the bank seizes your property and then sells it to recoup the money you owe on your loan.
Which type of mortgage is right for me?
- FHA loans are guaranteed by the Federal Housing Administration, meaning that the FHA will reimburse your lender if you default on your loan. These loans are great for first-time home-buyers because they require very little in the way of down payment and credit score, but you’ll have to pay extra monthly mortgage insurance in order to secure one of these loans.
- Conventional loans are one of the most popular choices, but they generally require a 20% down payment to secure the loan — unless you want to pay extra mortgage insurance, anyway. Borrowers without a full 20% down payment may still be able to get a conventional loan if they pay for mortgage insurance, but it costs extra each month to do so. Conventional loans work best for people who have a significant down payment or existing equity in another investment.
- USDA loans can be acquired in rural areas if you earn an average income within your community. These loans require 0% down, but you will only qualify if you live in the right area and your income doesn’t exceed 115% of the area median income.
- VA loans are exclusive to active duty military members and veterans. These loans are also 0% down and are guaranteed by the Department of Veteran Affairs. VA loans are one of the best options for military families.
How to get a mortgage
Your first (and most important) step in home-buying is determining a realistic budget. Once you have an idea of what you can afford, you should consider your options and compare lenders. If you need help determining what lender is right for you, this step-by-step guide to home loans will help narrow down the options.
Once you have a lender, you’ll need to decide what type of rate you want for your loan. The two main options are fixed-rate or adjustable-rate mortgages.
- Fixed-rate mortgage: This type of mortgage loan comes with an interest rate that stays the same over the life of the loan. This type of loan is generally paid over a span of 15 or 30 years and offers consistent monthly payments for the life of the loan because the interest rate won’t fluctuate.
- Adjustable-rate mortgage: This type of mortgage loan starts out with a fixed interest rate for a set period of time, but once that fixed-rate term is over, a variable interest rate kicks in and can change yearly based on a number of economic factors. An ARM may seem attractive because it often offers a low fixed rate at the start of the loan, but if rates increase once the variable term kicks in, your monthly payments can increase significantly.
Tips on getting a mortgage
Before you talk to a lender, make sure to determine a housing budget that you can comfortably stick to. Your housing costs should not exceed 30% of your monthly income.
Once you have a budget, you should think about what kind of loan would meet your needs. If you have very little saved up for a down payment or a shaky credit score, you may still qualify for an FHA loan.
[ More: Why Do You Need a Down Payment Anyway? ]
If you have a nest egg saved, think about a conventional loan. If you qualify for a USDA or VA loan, you could get in a house with 0% down, so look into those options as well to see if you meet the requirements.
Once you have an idea of what you want, consider shopping around with a few different lenders. Keep in mind that you will have a much easier time getting quotes if you know your budget and loan type — plus you’ll feel more prepared and confident about the process.
Most lenders will offer prequalification or preapproval to verify your eligibility for a loan. You should go through this process before you begin house shopping. Doing this means you’ll have a clear budget in mind so that you can confidently house hunt and make an offer on the perfect home.