Mortgage Basics

Buying a home is one of the most significant financial decisions many citizens make. At the heart of that process is the mortgage. A mortgage is a long-term commitment with rules and trade-offs that affect monthly cash flow, long-term wealth, and personal risk. However, with careful preparation and informed choices, a mortgage can be a powerful tool for building home equity and financial stability.

What is a Mortgage

Mortgage is a loan agreement between a borrower and a lender that allows the borrower to purchase real estate without paying the full cost upfront. Typically, the loan is secured by the property itself; hence, the lender can foreclose and take the property if the borrower fails to make payments.

Also, in a mortgage, the borrower agrees to repay the loan amount, plus interest, over a fixed period. Payments often include not only the principal and interest, but also property taxes and insurance through an escrow account.

Mortgage vs. Deed of Trust

While sometimes used interchangeably, mortgages and deeds of trust are different legal instruments.

A mortgage is a two-party instrument involving the borrower (mortgagor) and the lender (mortgagee). If the borrower defaults, the lender must generally go through a judicial foreclosure process, which involves court action and varies by state.

On the other hand, a deed of trust involves three parties: the borrower, the lender, and a neutral trustee. The trustee holds the property title as security until the loan is repaid. If the borrower defaults, the trustee can carry out a nonjudicial foreclosure, which tends to be faster and less costly than judicial foreclosure.

Types of Mortgages

There are different types of mortgages, including the following:

Fixed-rate mortgages: The interest rate in fixed-rate mortgages stays the same for the life of the loan. Hence, monthly principal and interest payments are predictable. Common terms are 30 years and 15 years.
Adjustable-rate Mortgages (ARM): An ARM offers a lower initial rate for a set period and then adjusts periodically based on an index plus a margin. While ARMs can save money when interest rates are low, they carry interest-rate risk.
FHA Loans: Insured by the Federal Housing Administration, FHA loans allow lower down payments and more flexible credit requirements than many conventional loans. FHA loans require mortgage insurance premiums that remain for a period based on the down payment and loan terms.
VA loans: Backed by the Department of Veterans Affairs, VA loans offer eligible veterans and service members no-down-payment options, competitive rates, and no PMI. However, they require a VA entitlement and typically a funding fee unless exempted.
USDA Loans: These loans are designed for eligible rural buyers. They offer zero-down financing and reduced mortgage insurance costs for properties in qualifying areas.
Jumbo Loans: Mortgages that exceed conforming loan limits (set by the Federal Housing Finance Agency) are considered jumbo. These loans require stronger credit profiles, larger down payments, and typically higher rates or fees.

Mortgage Process Overview

The mortgage process typically follows these steps:

Prequalification and pre-approval: At this stage, the lender evaluates the borrower's credit, income, and debts to determine how much can be borrowed. Pre-approval strengthens your bargaining position with sellers when house hunting.
Loan Application: Here, the borrower submits a full application with income documentation, bank statements, employment verification, and identification. Lenders provide a loan estimate detailing the estimated interest rate, monthly payment, and closing costs.
Processing and underwriting: The lender verifies all submitted information and documentation. After, an appraisal is conducted to confirm the property value.
Clear to close: Once underwriting approves the loan and all conditions are satisfied, the lender issues a clear-to-close and prepares final documents.
Closing: At this stage, the borrower signs the loan documents, funds their down payment closing costs, and the title transfers. The lender funds the loan, and the borrower's mortgage is recorded with the county.

Escrow and Payments

Typical monthly mortgage payments include principal, interest, property taxes, and homeowners' insurance. To protect both the borrower and the lender from missed payments, the lender collects a portion of the borrower's yearly tax and insurance bills with each mortgage payment into an escrow and pays those bills when due. Escrow is an account managed by the lender to ensure that taxes and insurance are paid on time.

Refinancing Overview

Homeowners often refinance to replace their current mortgage with a new one. This allows them to lower their interest rate, reduce monthly payments, shorten the loan term, switch from ARM to fixed rate, or tap into home equity. Note that while refinancing can save the borrower money, it comes with closing costs, typically 2-5% of the loan amount.

Common types of refinancing include the following:

Rate-and-Term Refinance: Lowers the borrower's rate or changes your term, such as from 30 to 15 years.
Cash-Out Refinance: The mortgagor borrows more than they owe and takes the difference in cash.
Streamlined Refinance: This is a simplified mortgage refinance option offered through FHA, VA, or USDA loan programs. It features reduced paperwork, no appraisal, and minimal credit checks.

Foreclosure Risk

Failing to make mortgage payments puts your home at risk of foreclosure. Foreclosure is a legal process where the lender takes possession of the home to recover the unpaid balance. Risks for foreclosure include missed or late payment, default notices, and escrow shortages.

Lender Lien Position

When you take out a mortgage, the lender places a lien on your property. This means that the lender has a legal claim to the home until the loan is paid off. Also, if you default, the lender has first rights to foreclosure proceeds.

The mortgage that is recorded first typically holds the first lien position, meaning that lender has priority for repayment from sale proceeds. Subsequent liens, such as second mortgages or home equity lines, are subordinate and paid only after the first lien is satisfied.

Mortgage-Related Questions

The following are frequently asked mortgage questions.

Which loan type should I choose

Choose based on how long you will stay in the home, tolerance for changing payments, credit profile, and eligibility for government programs.

How much should I put down on a home?

Standard down payments range from 3% to 20%. A higher down payment reduces monthly payments and may eliminate mortgage insurance.

What's the minimum credit score to get a mortgage?

FHA loans accept scores as low as 500 (with 10% down). Conventional loans usually require 620 or higher.

What's included in closing costs?

Closing costs include lender fees, appraisal, title insurance, taxes, and escrow setup. You can expect to pay 2-5% of the loan amount.

Can I pay off my mortgage early?

Yes. Most modern mortgages do not have prepayment penalties. Paying extra toward principal reduces interest over time.

Do I need mortgage insurance?

If you put down less than 20% on a conventional loan, you will need PMI (Private Mortgage Insurance). FHA loans require MIP regardless of down payment.

How do I improve my loan offer

You can improve your loan offer by raising your credit score, lowering revolving debt, increasing documented savings, and shopping multiple lenders for loan estimates to compare annual percentage rates and fees.