Mortgages might be one of the most essential and common parts of the home-buying experience, but they're also one of the most misunderstood. Whether you're on the search for your first home or just need some clarification, here's how mortgages work—and what you need to know.
In the simplest terms, a mortgage is a loan from a bank or other financial institution that enables you to cover the cost of your home. It's a legal agreement with the bank saying you will pay the loan back (plus interest) over the course of years—decades, usually. Unless you have the money to pay cash for your property, you’re going to need a mortgage.
Your first action item is to seek pre-approval from a lender. It's important to note that pre-approval and pre-qualification are two different processes. For pre-approval, the lender will check your credit and other financial information to determine what price home you can afford. (You can use an online mortgage calculator to give you a ballpark figure on how much home you can afford.) This will give you a price range to stay within during your home search and lets buyers know that you’re serious when you make an offer. Getting pre-approval for a standard loan should take a couple of days.
According to John Lyons, a broker and real estate agent in Chicago, getting a typical mortgage takes an average of 30 to 60 days. So if you’re itching to buy right away, you’ll want to start the pre-approval process soon so you’re ready to go when you find the right house. Lyons recommends getting pre-approved by a reputable company and having all of your financial documentation ready in order to increase your chances of securing a mortgage in a timely fashion.
Some people also choose to get pre-qualified before getting pre-approved. A mortgage pre-qualification is an initial assessment of the type of mortgage you can qualify for, more of a big-picture idea of what you can afford. But it doesn’t carry the same weight with sellers or mortgage lenders as a pre-approval.
Lyons says a low credit score and a high debt-to-income ratio can hurt your chance of getting a mortgage. To calculate your debt-to-income ratio, divide your monthly debt by your gross monthly income.
According to the Consumer Financial Protection Bureau, a 43% debt-to-income ratio is the highest ratio at which a borrower can get qualified for a mortgage. Credit scores, on the other hand, range from 300 to 850, and while lenders have varying qualifications, most want to see a score of 660 or above.
Much like you'd shop around for a car before buying one, you should also research different types of mortgages to find one that best suits your financial needs. The two main types of loans are a fixed-rate mortgage and an adjustable-rate mortgage, or ARM.
With a fixed-rate mortgage, the interest rate will not change over the life of the loan. It's a good choice for someone who likes the certainty of knowing the mortgage payment will never go up. ARMs start with a lower interest rate for the first few years and adjust after a predetermined period (usually five years) based on the housing market. This type of loan can seem risky as interest rates have the potential to rise significantly, but there are caps in place to keep the rates from rising to astronomical levels.
Loans also have “terms,” or time periods for how long you’ll have to make monthly payments. The two most common terms are 30 years and 15 years.
To find mortgage lenders, inquire with your bank, nonbank lenders, or mortgage brokers.
Once you find a home you want to put an offer on, you have to obtain the actual mortgage loan. Apply for a loan with your chosen mortgage lender. Within three days of your application you should receive a loan estimate that includes closing costs, the interest rate, and the monthly amount you’ll pay for the principal, interest, insurance, and taxes. After that, it’s off to the underwriter, who will review all of your financial information and make the final call to approve or deny your loan.
Yes, you can actually still be denied even after you’ve been pre-approved for a home in that range. Denials most frequently occur when some aspect of your financial picture shifts between the time you’re pre-approved and the time you apply for the actual mortgage (e.g., you lose your job or use a large portion of your savings).
If approved, you’ll sign the final mortgage loan documents during closing.
Getting a mortgage and buying a house is a milestone, so once the process is done, it's time to celebrate! Take the time to revel in the excitement, because it won't be long until you have to actually start paying back that loan.
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