Mortgages are commonly used to buy real estate. Rather than paying cash for a property, individuals, including real estate investors, can take out a mortgage, borrowing money from a financial institution to purchase the property, and repaying the debt back over time. If you're looking at options for purchasing property and aren't familiar with what is a mortgage, continue reading to learn what a mortgage is, the various types of mortgages that exist, how they work, and common terms of a mortgage loan.
What is a mortgage?
A mortgage is a legal contract between a borrower and lender that outlines the terms for repayment of a loan, called a promissory note. The promissory note designates the amount borrowed, interest rate, and other terms of debt repayment. The mortgage designates the roles, rights, and obligations of the parties and securitizes the lender with the property in the event of default on the promissory note. This can include who's responsible for paying property taxes, property maintenance, property insurance, or any obligation to have mortgage insurance, as well as the legal actions required to regain title to the property through a foreclosure action.
Many people refer to a note and a mortgage as if it's one document, but they are actually two separate documents created in conjunction during the financing transaction for a real estate loan. The mortgage is what secures the note, making the home or property loan a secured loan.
How mortgages work
If someone wants to purchase real estate but doesn't have the up-front money or wants to pay for the property in cash, they can apply for a mortgage. Lending institutions, including a bank, nonbank lender, or credit union, will lend a portion of the purchase price to the borrower, usually after receiving a down payment.
The principal, or total amount lent to the borrower, is then repaid with interest over a specified period of time, called an amortization period. The principal and interest (P&I) is repaid each month until the loan matures in full. The amortization period shows how the principal and interest is applied over the length of the loan. In most amortization periods, P&I payments repay more interest than principal at the beginning of the loan, until around the halfway point, at which time more of each monthly payment goes to the principal than interest moving forward.
Taking on a mortgage loan should involve more than using a mortgage calculator to figure out whether you can afford the monthly mortgage payment. That matters, of course, but you also need to consider:
- your financial situation over the life of the loan,
- whether there's anything that may impact your ability to repay the loan, and
- the financial institution you'll be partnering with.
Getting a mortgage takes a lot of work, and it’s important to have some basic things in order before you start the process.
Types of mortgages
It’s important to know the different kinds of mortgages. For example, there are two common loan terms:
- 30-year mortgage loans: You have 30 years to pay the loan off.
- 15-year mortgage loans: You have 15 years to pay the loan off.
And there are two common types of interest:
- Fixed-rate mortgage loans: The interest stays the same for the term of the loan.
- Adjustable-rate mortgage (ARM) loans: The interest rate can change, usually at specific intervals.
You can get a 30-year fixed-rate loan, a 15-year adjustable-rate loan, or any other combination.
Adjustable-rate mortgages can be risky and generally make more sense when you intend to sell the property quickly. A 15-year loan, which is less common, can be tempting, but it means higher monthly payments.
And, of course, there are many different loan amounts, based on your down payment and the price of the house.
In most cases, there's no penalty for paying your loan off in less time than the standard term. You save a lot of money in interest, too. With a mortgage loan, you pay interest for each day you take to pay the loan off. Paying down the principal ahead of time will save you money in the long run.
If you make extra payments, tell your mortgage lender that you want the money applied to the principal balance. You might think the lender should know this, but it’s best to be careful
People often make one additional principal payment -- basically an extra mortgage payment -- per year to shorten the life of their loan. One way to do that is to make your payment every two weeks instead of once a month. This results in 13 full payments, rather than 12, in a year. Consult your mortgage lender to figure out the best way to make this happen.
The most common type of mortgage in real estate today is a fixed-rate mortgage. A fixed-rate loan means the annual percentage rate (APR), or interest rate, is locked for the duration of the loan, which could be a 15-year, 20-year, or most commonly, 30-year mortgage -- for example, receiving a 4% APR for the entire 30 years of the loan.
This type of mortgage is appealing because it locks in a set monthly mortgage payment. Longer repayment periods make the mortgage payment more affordable. However, the longer the term of the mortgage, the more the borrower will pay in interest.
An adjustable-rate mortgage (ARM) is when the mortgage rate changes periodically over the life of the loan. ARMs are typically tied to an index, adjusting periodically according to a repayment schedule outlined in the promissory note, and typically include a balloon payment.
You may see an adjustable rate mortgage as 5/1, 7/1, or even 10/1. The first number indicates the term for repayment before the balloon is due, and the second number indicates the number of times in a given fiscal year the rate adjusts. Using the example of a 5/1 ARM loan, the mortgage interest could start at 4% but adjusts 0.05% every year, with a balloon on year five.
Adjustable-rate mortgages were popular just prior to the Great Recession because of the lower initial interest rate. While far less popular for residential home loans today, adjustable-rate mortgages can still be found frequently among commercial real estate loans.
A balloon mortgage can have an adjustable interest rate or fixed interest rate, but instead of the loan being repaid in full over the entire amortization period, the loan matures, or balloons, on an earlier date.
For example, a loan can be amortized over a 30-year period but "balloons" and becomes payable in full in year 10. Balloon mortgages can provide borrowers with a lower monthly payment similar to what they might achieve with a conventional mortgage and are very common in the private mortgage market and with commercial loans.
A jumbo loan is a mortgage that exceeds the conforming loan limits set by the Federal Housing Finance Administration (FHFA), which at the time of this writing starts at $548,250, depending on the location of the property.
A second mortgage is a subordinate mortgage, meaning the loan is taken out after an existing mortgage and thus falls in a secondary position in the event of mortgage default. A common example of a second mortgage is a home equity line of credit (HELOC), which taps into a homeowner's equity.
A reverse mortgage is a specific loan created for homeowners ages 62 and up who want to tap into their homes' equity, borrowing against the value of their home. Lenders can issue a reverse mortgage with a lump payment, with fixed payments over time, or as a line of credit, drawing on the limit amount on an as-needed basis. The type of reverse mortgage taken will determine the method and terms of repayment, typically payable in full when the homeowner dies or sells the property.
Start with the mortgage loan basics
Getting a mortgage loan can be daunting, but it helps to break it down into some basic steps:
- Know your income and debts: To figure out how much of a monthly payment you can afford, you need to fully understand your finances. In general, you should be pessimistic if your income or expenses fluctuate.
- Understand your credit score: It’s easy to learn your credit score (most credit cards and checking accounts offer the ability to check it), but you should also know how your score makes you look to banks. We’ll cover that in greater detail later on.
- Know where you want to live: The more flexibility you have, the better. The location of a house impacts its price -- sometimes significantly.
- Get your paperwork in order: Most mortgage lenders require two years of taxes, at least a year of bank records, documentation on any significant financial holdings, and personal identification.
That seems like a simple list, but it can get complicated. Don’t let that scare you away. Many people with less-than-perfect finances and mediocre (or even bad) credit can find a financial institution willing to extend them a mortgage loan.
Get your finances in order
Many people don’t have a clear picture of their finances. That might be because you’re making so much money you don’t have to consider it -- but it's probably because nothing ever forced you to take a hard look.
Before you apply for a mortgage, audit your finances. Look at your income, your fixed costs (car loan, student loan, utilities, rent, food, and anything else you have to pay every month), and your discretionary budget. Once you've done that, you can see if you can follow the unofficial 28/36 rule.
Banks and other financial institutions want your mortgage loan payment to be no more than 28% of your gross monthly income. All of your debts together shouldn't exceed 36%. This isn’t a hard-and-fast rule, but it’s a good guideline as to what you can afford.
You may want to examine what debts with monthly bills you can pay off to improve your financial situation. Paying off a car loan or student loans will improve your standing. Paying off credit card debt will do that, too -- and should raise your credit score (sometimes by a lot).
It may make sense to put off buying a home until you can get your finances in decent shape. This can include paying off debt, saving up for a down payment, or increasing the length of time you've spent in a job (lenders generally want to see two years of salary and employment history).
More about your credit score
Your income is important, but even with a solid down payment and a high-paying job, your credit score can keep you from getting an affordable loan. It's important to know the numbers and do as much as you can to raise your score.
Here are some guidelines on how your credit score ranks:
- Less than 580: poor.
- 580 to 669: fair.
- 670 to 739: good.
- 740 to 799: very good.
- 800 or higher: exceptional.
If you want to improve your credit score, it helps to know how it's calculated:
- Payment history: 35%.
- Amounts owed: 30%.
- Length of credit history: 15%.
- New credit: 10%.
- Credit mix: 10%.
Try not to open new credit card accounts or take out any loans for as long as possible before applying for a mortgage.
There's one major exception: If you don’t have much available credit, adding a new card with a high limit can raise your score by lowering your credit utilization ratio.
This ratio looks at the percentage of available credit you're using. You can lower that number by taking on more credit or paying down existing cards. It's good to get your utilization below 30%, but lenders also consider how much you owe compared to your income. To get a mortgage, it’s best to owe $0.
To figure out the best credit moves for you, try a credit simulator tool. Some mortgage brokers can also look at your application and credit report to see if adding a card makes sense for you or whether paying down balances is a better choice.