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What is a Mortgage and How Does it Work?

Simply put, a mortgage is the loan you take out to pay for a home or other piece of real estate. Given the high costs of buying property, almost every home buyer requires long-term financing in order to purchase a house. Typically, mortgages come with a fixed rate and get paid off over 15 or 30 years. Most people think of home buying in terms of square footage or location, but understanding mortgages is critical to securing a fair price for what you buy.

What is a Mortgage?

Mortgages are real estate loans that come with a specified schedule of repayment, with the purchased property acting as collateral. In most cases, the borrower must put down between 3% and 20% of the total purchase price for the house. The remainder is provided as a loan with a fixed or variable interest rate, depending on the type of mortgage. In most cases, the monthly payment owed on a mortgage is a predetermined mixture of interest and principal payments. The size of the down payment may also affect the amount required in closing fees and monthly mortgage insurance payments.

In a process called amortization, most mortgage payments are split between paying off interest and reducing the principal balance. The percentage of principal versus interest being paid each month is calculated so that principal reaches zero after the final payment. For example, a standard 30-year mortgage will be split into 360 equal payments, each consisting of different amounts for interest and principal. A few mortgages allow interest-only payments or payments that don't even cover the full interest. However, people who plan to own their homes should opt for an amortized mortgage.

Common Mortgage Types

When you shop for a home, understanding the common types of mortgages and how they work is just as important as finding the right house. For instance, fixed-rate and variable-rate mortgages may advertise similar APR figures initially, but a rising rate environment may increase monthly payments for a homeowner in a variable mortgage. In other cases, a new mortgage might help you reduce payments or pay off faster by refinancing at a lower rate.

Fixed Rate Mortgages

The most popular mortgages offer a fixed interest rate with repayment terms of 15, 20 or 30 years. Fixed rate mortgages offer the guarantee of the same rate for the entire life of the loan, which means that your monthly payment won't increase even if market rates go up after you sign. Assuming a similar rate, mortgages with longer terms offer lower monthly payments than shorter ones, but the increased number of payments means that you'll pay more in total interest as well.

Adjustable Rate Mortgages

Adjustable rate mortgages (ARMs) include any mortgage where the interest rate can change while you're still repaying the loan. This means that any increase in market rates will raise the borrower's monthly payments, making it harder to budget for the cost of housing. Still, ARMs are popular because banks tend to offer lower interest rates on an ARM compared to a fixed rate mortgage. The most common ARM is the 5/1 ARM, in which the initial rate stays fixed for the first five years and is then subject to change each following year.

Other Mortgage Types

While most people will end up with a conventional mortgage with a fixed or adjustable rate as described above, there's a wide variety of alternatives meant for special cases. FHA and VA mortgage loans, for example, require much smaller down payments from borrowers or no down payment at all from veterans. However, a lower down payment adds extra expenses like mortgage insurance to your monthly payment —and it also means that you're paying off a larger principal balance from the start.

For homeowners who see their current property as an investment or a source of capital, variations like the interest-only mortgage and the cash-out mortgage offer increased financial flexibility. For example, paying just the interest charges on a mortgage means you won't make progress repaying the balance. However, if you plan on selling your home in a few years, interest-only mortgages can help minimize monthly payments while you wait. Cash-out mortgages run in the opposite direction, allowing you to refinance your old mortgage with a larger one in order to withdraw the difference as cash. People sometimes rely on cash-out mortgages as a way to meet large expenses like college tuition.

What Determines Mortgage Rates?

While the terms and conditions of mortgages are fairly standardized, lenders adjust the mortgage rates they offer based on several factors. These include information from the borrower's financial history, as well as larger figures that indicate the current state of the credit market. However, the amount offered as up-front payment will usually have the greatest impact on a mortgage rate.

Points and Down Payment

The more you pay at the beginning of a mortgage, the lower your rate will be. This happens in two ways: down payment percentage and the purchase of mortgage "points". Lenders consider mortgages to be riskier if the borrower's down payment is smaller, with conventional loans requiring at least 20% down to avoid the added monthly expense of private mortgage insurance. Loan-to-value ratio (LTV) is another commonly used measure of the same figure, only in reverse: a 20% down payment results in a mortgage with an LTV ratio of 80%.

Buying points on your mortgage means paying a fixed fee to reduce the interest rate by a set amount of percentage points, usually around 0.25% per point. This can help homeowners reduce their monthly payments and save money in the long run. Each point will typically cost 1% of the total cost of the home, so that a $400,000 purchase will come with $4,000 mortgage points. Paying for extra points up front in exchange for a reduced rate will require a calculation of the break-even point, since you'll only make back the initial cost of those points after a period of time.

Credit Score

Your credit score affects the mortgage rates lenders are willing to offer you. According to FICO, the difference can range from 3.63% to as high as 5.22% on a 30-year fixed rate mortgage depending on which bracket you fall into.

Average Mortgage Rates by FICO Credit Score

FICO Score15-Year Fixed30-Year Fixed
760-8502.87%3.63%
700-7593.10%3.85%
680-6993.27%4.03%
660-6793.49%4.24%
640-6593.92%4.67%
620-6394.46%5.22%

Keeping close track of your credit score is a good practice whether or not you're considering a mortgage in the near future, and it never hurts to start building credit early. When you consider the fact that mortgages can last up to three decades, even a few tenths of a percentage can translate into thousands of dollars in extra interest costs.

Index Rates

Finally, lenders like banks and credit unions all keep a close eye on the current state of the larger market for obtaining credit. This includes the rates at which corporations and governments sell non-mortgage instruments like bonds. Because mortgage lenders themselves need to pay for the cost of borrowing money, the mortgage rates they offer are subject to any changes in that underlying expense. In some adjustable rate mortgages, the borrower's interest rate is actually tied directly to a major index rate such as the 10-Year US Treasury bond or the London Interbank Offered Rate (LIBOR). While you can't control the movement of debt markets as an individual, you can keep an eye on where they're headed.

How to Shop for Mortgages

The shopping process for mortgages will be somewhat different for first-time home buyers and current homeowners. Purchasers must consider not only the mortgage but the property and their long-term plans, while current homeowners may simply want to refinance at a better rate.

Shopping as a First-Time Home Buyer

For most people's first homes, shopping for a mortgage should as you're searching for a house. We'd recommend comparing lenders or going through a broker to obtain a pre-approval letter, finding out how much banks are willing to lend you, and determining how affordable your typical monthly mortgage would be. This way, when you find your house, you will have most of your ducks in a row to submit your bid. You also need to consider how long you'll be living there. For instance, someone looking to move after five years may seek a 5/1 ARM or an interest-only mortgage in order to minimize monthly payments until the balance is paid off early by selling the home. People who plan to live in one home until they fully own it will instead opt for a good fixed rate lasting 15 or 30 years.

Most prospective home buyers end up relying on their real estate agent for information about the mortgage process. Few people go through the home buying experience more than once or twice in their lives, and their inexperience means that realtors often play more of a guiding role. As a result, many home buyers end up choosing a mortgage lender referred by their real estate agent. While this arrangement is suitable in most cases, keep in mind that a realtor's priorities are to secure fast approval, not to negotiate the best interest rate. If minimizing your mortgage payments and fees are a priority, then we'd highly recommend comparing rates from at least three lenders.

Shopping for Refinance Mortgages

Refinancing your mortgage when market rates are low can be a good way to reduce your monthly payments or the total cost of interest. Unfortunately, these two goals lie in opposite directions. You can reduce monthly payments by getting a lower-rate mortgage of the same or greater length as your current loan, but doing so generally means accepting a greater cost in total interest. Refinancing also runs the risk of added closing costs, which come with the process of obtaining any new mortgage.

Amortization, the process of splitting payments between interest and principal, reveals how early payments mostly go towards interest and not to reducing the principal balance. This means that starting over with a brand new mortgage —however attractive the rate —can set you back in your journey to full ownership. Fortunately, lenders are required to provide you with detailed quotes outlining estimated rate, payment schedules and closing costs. Inquiring at multiple banks and lenders may take you many hours, but with so much money and years of payments at stake, an up-front investment of effort is more than worthwhile when it comes to refinancing.

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