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Mortgage 101: How It Works and How To Save Money

For most people, owning a house is the American Dream. However, unless you’ve got hundreds of thousands of dollars available to pay for one out-right, then you’re going to need to apply for a mortgage.

Simply put, a mortgage is a long-term loan that you finance so that you can afford to buy a home. In return, the lender technically owns the title of your house while you spend the next two to three decades paying the loan back.

A mortgage is likely to be one of the biggest financial commitments you’ll make in your adult life. Therefore, to get the best terms possible and possibly save yourself hundreds of thousands of dollars in the process, you’ll want to invest some time understanding how mortgages work and what they can mean for your overall financial situation. Here’s what you’ll need to know.

What are the Different Types of Mortgages?

Mortgages come in many different forms. Here are a few of the most common types you can apply for:

Fixed-Rate vs. Adjustable Rate

Fixed-Rate Mortgage

A fixed-rate mortgage is when the interest rate of your mortgage remains fixed. The conventional form of these loans (see below) are by far the most popular types of mortgages, representing 66.5% of loan originations in 2019. The payback schedule is usually 30 years or 15 years depending on which term you decide to go with.

Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage is when the interest rate is free to fluctuate after being fixed for a certain period (usually 3 to 7 years). ARMs can seem very attractive at first because the payments will usually be smaller. However, once the rate is free to adjust, your monthly payment can vary or sometimes even increase substantially.

Conventional vs Nonconventional

Nonconventional Mortgage

Nonconventional mortgages are loans with mortgage insurance or other guarantees from federal government agencies like the Federal Housing Administration (FHA), Veterans Affairs (VA), and the U.S. Department of Agriculture’s Farm Service Agency (FSA) and Rural Housing Service (RHS).

Federal Housing Administration (FHA) loan

FHA loans are mortgages that are insured by the Federal Housing Administration and issued by an FHA-approved lender. FHA loans are very similar to conventional mortgages but will accept lower down payments and work with people with lower credit scores (more on both of these points below). These loans represented just over 20% of all new mortgages in 2019.

Veterans Affairs (VA) loan

A Veterans Affairs (VA) loan is another form of a “nonconventional” mortgage. An individual secures a loan through a private lender, like a bank or mortgage company, but they are offered better terms on the loan because the VA guarantees a portion of the loan. These loans represented just over 10% of all new mortgages in 2019.

Conventional Mortgage

Conventional mortgages are loans originated through a private lender like a mortgage company or bank that have no form of guarantee or insurance. The standard size conventional mortgage represented 61.7% of all loans in 2019. Jumbo conventional loans, which are loans larger than the Government Sponsored Enterprises conforming loan size for a single-family home, represented 4.8% of all new loans in 2019.

Other Types of Mortgages

There are other types of loans such as “interest-only mortgages” and “payment-option ARMs”. However, these mortgages have become less common since many of them were blamed for the Housing Bubble which ultimately contributed to the Great Recession of 2008. In a nutshell, many lenders were irresponsibly offering these exotic types of mortgages to people who weren’t traditionally qualified to own homes, and the result was economically disastrous.

How Much Mortgage Can You Afford?

Ultimately, the size of the mortgage you will qualify for will depend on what the monthly payments calculate out to be. This will be considered from two important perspectives:

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Your Lender

Most lenders base the size of the mortgage they offer you on something called the 28/36 rule. This is where they will take your income and debt figures, and calculate how much they believe you can safely afford to pay each month. Under this rule, your mortgage payment and total debt should not exceed 28% and 36% of your income respectively.

Your Budget 

Even if a mortgage lender approves you for a certain amount, you should only agree to it if you know for certain that it will not cause financial stress. Therefore, before applying for a mortgage, you’ll want to look at your monthly budget and determine how much you think you can safely afford to pay each month. Discuss it with your spouse and make sure the number you both agree to will not impact your other financial goals. 

What Determines Your Mortgage Payment?  

In its simplest form, your mortgage is made up of two key elements – principal and interest.

  • The principal. The principal is how much money you plan to borrow (not including the interest). This is typically the cost of the house minus your down payment. For example, if you’d like to buy a house for $250,000 and plan to put down the usual 20 percent down payment ($50,000), then the principal amount you’d owe is $200,000.
  • The interest rate. This is how much interest you must pay your lender over the life of the loan. Because most mortgages last for 30 years, the amount of interest you will pay over this period can be substantial. For example, with an APR of 4.0 percent on a $200,000, you’ll ultimately pay $143,800 in total interest over the life of the loan. 

Combining these parts, this means you’ll owe the lender $200,000 in principal and $143,800 in interest for a total of $343,800. Broken down over 30 years, that’s a monthly payment of $955.  

How Does Mortgage Amortization Work?

Unlike other types of loans, your monthly mortgage payment is not equal parts principal and interest. Instead, lenders use something called an amortization schedule to structure how much principal and interest will be applied with each payment you make.

Because the lender wants to collect their interest payments as quickly as possible, the majority of your first years of mortgage payments will be made up of mostly interest rather than principal. As time goes on, you’ll gradually pay less towards the interest and more towards the payment. 

Here’s a great, short YouTube video that explains how amortization works:

What is Private Mortgage Insurance?

Not everyone has 20 percent available to put towards a down payment on their house, and that’s okay. Most lenders will still grant you a mortgage even if you bring less to the table. However, as a precaution, they will require you to pay something called “PMI”.

PMI, or private mortgage insurance, is a special type of insurance policy that protects the lender (not you) in case you’re not able to pay the mortgage. From the lender’s perspective, because you did not have 20 percent available for the down payment, you’re viewed as a higher risk and therefore required to pay PMI. In some cases, this can add approximately $100 extra dollars on top of your mortgage payment that does not go towards your mortgage principal.

You’re not required to pay PMI for the life of the loan. Generally, once your loan to value (LTV) ratio crosses 20 to 25 percent, you can either request that PMI be removed or refinance your mortgage. 

Tip: You need to take action to remove the PMI. If you do not then you will keep paying it until the bank is forced to recognize that you no longer hold the same risk. 

What is Escrow?

Some lenders may require that you also pay something called “escrow” in addition to your mortgage payment. Your escrow is simply an account that you pay into which covers the taxes, homeowner’s insurance, and PMI if applicable. 

Paying into an escrow is common because it helps ensure that you will not default on these crucial parts of home ownership. Effectively, it forces you to build up a small pool of money that the mortgage company can then use to make these important payments.

Is Mortgage Interest Tax Deductible?

Yes. If you itemize your deductions (instead of taking the standard deduction) when you file your Federal Income Tax Return, then the amount of money you paid on the interest portion of your mortgage for the year is typically deductible.

How Often Do Mortgage Rates Change?

Mortgage rates are free to change daily based on a variety of market factors such as the economy, inflation, job growth, etc. Typically, when the Fed raises and lower rates, mortgage rates will react by moving in the same direction.

What Other Factors Set The Mortgage Rate?

There are also a lot of factors about you that can determine your mortgage interest rate. For example,  the duration of the loan, like choosing a 15-year mortgage instead of a 30-year mortgage can result in a different interest rate. Your credit rating will play a big part in determining what type of interest rate you qualify for. Also, the “Loan-To-Value” or LTV of your mortgage will impact the rate. If you put 20% down, and your mortgage is 80%, then your Loan-To-Value is 80%.  

What are Mortgage Points?

Another variable that can influence your mortgage interest rate is the concept of paying “points”. 

In reality, a lender is prepared to offer you any interest rate you want. However, in return, they will charge you a large sum of money to have points taken off of your interest rate. This can also work in reverse where you will receive money if you agree to a higher than normal interest rate.

Here is some more detailed information about how mortgage points work.

Prequalify for a Mortgage

When you are thinking about buying a home, it is a GREAT idea to get prequalified for a mortgage, yet only 10% of Americans took advantage of this in 2019. A mortgage prequalification is usually an informal process where the lender will look at your financial situation and determine if you’d make a good candidate for a loan. It is non-binding, meaning you do not have to go with that company, but it gives you leverage in the home buying process. This is because it shows the seller that you are a qualified buyer.

The review consists of:

  • Your income and debt
  • Your credit score
  • The terms of the loan (amount, interest rate, and payback term).

To put yourself in the best possible position, make sure your credit history is in order and try to reduce your other debts as much as possible.

What is Home Equity?

The longer you live inside your house, two things are likely to happen:

  1. Your continued mortgage payments will pay down more of the mortgage principal.
  2. Your home may increase in value.

Combined, this will mean that you’re building something called “equity” in your home. 

Equity is the fair market value of your home minus the balance of the mortgage principal that you still have to pay. For example, if the value of your home is $250,000 and your remaining mortgage balance is $150,000, then you’ve got $100,000 in equity.

This equity is considered a financial asset, and many lenders will often let you borrow against it. This is commonly done in two ways:

  1. You can apply for a home equity loan. Sometimes called a “second mortgage,” this is where you borrow a portion of the equity for a fixed period and interest rate. In the example earlier, you’d borrow a portion of that $100,000 and then pay it back over 5 years generally with interest. 
  2. You can apply for a home equity line of credit (or HELOC). Rather than borrow against all of the equity in your home upfront, you can tap it as a secure line of credit that you will have to pay back over time (similar to a credit card).

People will often apply for equity loans to pay for major repairs (such as fixing a roof or remodeling their homes). You should use these with caution since every dollar you borrow means less of a percentage of your property that you physically own.

What Does It Mean to Refinance Your Mortgage?

Naturally, after you’ve owned your property for a while, things may make you want to refinance: 

  • The housing market interest rates may drop.
  • Switch from an ARM to a conventional mortgage.
  • Lower your monthly payments so that you have more cash flow.

For these reasons and many others, you are always free to do what’s called “refinance” your mortgage. This simply means that you and a lender will pay off your old loan and agree to a new one under newly negotiated terms.

Mortgage refinances are quite common and most frequently used when interest rates have dropped. For example, say you have a monthly payment of $2,026 based on a 4.5% APR. If you refinance to a rate of 3.75%, that drops your monthly payment down to $1,897. This saves you $25,000 in interest over the life of the loan.

Two things to keep in mind when you refinance: 

  1. The bank is going to charge a fee for originating the new loan. The rule of thumb is that you want your annual savings to be equal to or greater than that fee. This means that you will have paid that back by the end of the first year. 
  2. When you refinance the mortgage, you go back to the beginning of the amortization schedule. This means you are paying mostly interest again as opposed to building equity. 

Smart Money Home Recommendation

Mortgages are an essential part of the home buying process. Since taking one on is a huge financial commitment, you should approach it with caution as follows:

  • SHOP FOR YOUR MORTGAGE! Little changes in interest rates amount to tens of thousands of dollars over the life of the loan. Make sure that you are getting the lowest rate possible.
  • Understand the terms of the mortgage you’re applying for. 30-year conventional mortgages are the most common. They are also safe in that your payment is the same for 30 years. But, make sure you understand what flexibility and penalties exist.
  • Calculate upfront how much mortgage payment you can safely afford to pay each month. Spend some time reviewing your budget and decide on a maximum number; even if it’s less than what a lender may qualify you for.
  • Understand how your mortgage payments are structured. You will want to know how they will influence the percentage of your home that you own. Don’t forget that escrow and PMI can increase your monthly payments.
  • Financially, your goal as a homeowner should always be to build as much equity in your home as you can. This is an asset that you can tap for short-term loans or take with you if you ever sell the property.

The more you know about how your mortgage works, the higher your chances of being able to successfully make your payments every month. Spend some time becoming familiar with these concepts and it will give you the peace of mind that you deserve as a responsible homeowner.

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