Understanding the basic elements of a mortgage will give you confidence as a home buyer and help you navigate the loan process with greater ease.
Every mortgage loan needs a solid foundation to support it, which is based on the borrower’s eligibility. That foundation can be thought of as the 4 legs of a chair ― each “leg” represents a requirement that’s needed to qualify for a loan. This includes the following:
- Income (supported by your tax returns, W-2s, paystubs, etc.)
- Assets/Reserves (any money you have in checking, savings, stocks, bonds, 401k, retirement accounts, etc.)
- Credit Score (evaluates your financial history and measures your future risk)
- Property (the loan amount is compared to the value of the property ― usually its appraised value ― to determine the loan-to-value ratio, or LTV)
Also remember that you’ll need to supply cash for a down payment. A larger down payment generally leads to lower interest rates and smaller monthly mortgage payments. 20% down is ideal, although some loans require as little as 3.5% or 5% down.
The Type of Mortgage Loan
There are many types of mortgage loans ― conventional loans, government-backed loans, and alternative financing options such as lease-purchase agreements and home equity. Some loans have strict requirements while others are designed for lower income homebuyers. The terms of your mortgage will be based on which type of loan you choose (and qualify for).
The next 3 components form the main structure of a mortgage agreement and have a direct effect on your monthly mortgage payments. They are: the size, the length, and the interest rate of the mortgage loan. The lender assigns each component a specific value and then uses those numbers to compute your loan. If you know the loan terms, you can use the “Comprehensive Mortgage Calculator” (see below) to determine the total amount you will eventually pay for your house.
The Size of the Mortgage Loan
The amount of money that you borrow from a lender to buy a house
The mortgage loan amount will depend on the home’s price (how much you need to borrow), how much you’re approved to borrow, and the loan-to-value ratio (LTV). The LTV is a percentage that compares the property’s value to the size of your loan. The lender may use the appraised value or the sale price as the “property value.” The higher the LTV, the riskier the loan. Most lenders do not approve loans with mortgage amounts exceeding 90% of the home’s value. Also keep in mind: the larger your down payment is, the less money you’ll need to borrow.
The Length of the Mortgage Loan
How long it will take you to fully pay off the loan
The length of your mortgage loan, also called the “loan term,” refers to the amount of time (months or years) it will take you to repay the debt. A mortgage term may be anywhere from 5 to 30 years, or even more. The longer your repayment period is, the lower your monthly payments will be ― but the interest rate will be higher (meaning you will end up paying more interest over the life of the loan). A shorter loan (such as a 15-year mortgage) will have higher monthly payments, but you will save money on interest because you’ll be repaying the loan much faster.
The Interest Rate
The recurring fee that the lender charges you for borrowing money
For the privilege of borrowing money, you are charged interest by the lender. The interest rate (also called “mortgage rate”) is a percentage of your loan balance which is typically calculated on an annual basis. The lower the interest rate is, the lower your monthly payments will be. Interest rates play a major role in the affordability of loans. In the end, the interest rate of your mortgage will determine the total amount you are paying for the loan. Depending on the type of mortgage you obtain, it may or may not have fluctuating interest rates.
- A fixed-rate mortgage (FRM) will have a steady interest rate throughout the life of the loan.
- An adjustable-rate mortgage (ARM) will have interest rates that change after a specified period of time, based on national mortgage rates.
Each month, as you repay your loan, part of your payment goes towards the principal balance (the total amount you borrowed to buy the house) and part of it goes towards the interest charged by the lender. The amount you pay towards interest is highest on your first payment and lowest on your last payment. Conversely, the amount you pay towards principal is lowest on your first payment and highest on your last payment. This repayment method is known as “amortization.”
Enter your loan amount, loan length, and the interest rate into the “Comprehensive Mortgage Calculator” (see below) to determine the total amount you will eventually pay for your house.
Additional Components of a Mortgage Loan
Mortgage Points ― A mortgage point is a fee charged by the lender. These points are paid at closing and are generally tax-deductible. When choosing a mortgage loan, borrowers typically have the option of paying points in exchange for a lower interest rate. Each point is equivalent to 1% of the loan amount. (For a $100,000 loan, one point is equal to $1,000.)
Mortgage Insurance ― Mortgage insurance protects the lender in case you fail to make the mortgage payments. If your down payment is less than 20% of the home’s purchase price, you will be required to purchase mortgage insurance.
Homeowners Insurance ― In order to get a mortgage, you must insure the property. You can ask an insurance company or agent for an estimate. Note that some areas have special requirements for hazard insurance (e.g., floods, earthquakes and wind).
Property Taxes ― Property tax is an “ad valorem” tax, meaning that property is taxed “according to value.” In general, all residential real estate is subject to taxation. Most property taxes are enforced locally (by counties, cities, or other districts) based on fair market value. Contact the local taxing authority for the rates that apply.
NOTE: While taxes and insurance are not determining factors for your mortgage loan, they are considered part of your monthly housing expenses. The lender may require you to deposit money into an escrow account to ensure payment of these items, though some borrowers may choose to pay the taxes and insurance on their own instead.
You can use a mortgage calculator to help determine the total amount you will eventually pay for your house.