For many years, a fundamental element of the American dream has been home ownership. For 63 percent of Americans, the dream of home ownership has come true. However, only 26 percent own their homes free and clear (source). The rest have a home loan or mortgage.
The vast majority of people who purchase a home cannot afford to pay the entire purchase price up front. So, they take out a loan to help them pay for the home. This loan, which is secured by the property or real estate, is called a home loan or mortgage loan.
What types of home loans are available?
Homebuyers today have many types of home loans from which to choose. Here are some of the better-known types of home loans available today.
With a fixed-rate loan, your interest rate remains the same throughout your entire loan term. Your mortgage payment is split into equal payments made each month for a term of 10, 15, 20, or 30 years.
With adjustable-rate loans, your interest rate can change several times throughout the life of the loan. Under the broad heading of adjustable-rate loans, you may find hybrid loans, which begin with a fixed interest rate for a certain number of years, and then change to an adjustable rate after that initial period is over. In such loans, there is a cap on how much the interest rate can change from adjustment to adjustment and over the life of the loan.
For instance, suppose you have a 5-year adjustable rate mortgage (ARM) with an initial interest rate of 4.75 percent, a cap of 1 percent per year thereafter, and a cap of 5 percent over the life of the loan. That would mean that for the first five years of your loan, your interest rate would be 4.75 percent. Then, each year, your rate could change by as much as 1 percent until your rate reached the upper limit of 9.75 percent.
Interest rates on adjustable-rate loans can adjust either up or down and are often dependent upon an independent financial index such as the prime rate established by the Federal Reserve or some other similar standard such as the activity of one, three, and five-year Treasury securities.
FHA loans are loans that are insured by the government through mortgage insurance that is funded by the loan. They do not require as much down payment as some other types of loans and are more lenient regarding credit scores. This makes them an attractive option for many homebuyers.
VA loans are guaranteed by the Department of Veterans Affairs and are available to military veterans and their spouses. They do not require a down payment and are quite popular among military families.
Rural borrowers who meet certain program requirements are eligible for loans provided through the U.S. Department of Agriculture and managed by the Rural Housing Service.
These are the most common mortgage types, though there are many others to choose from as well.
How do you apply and get approved for a mortgage?
There are a number of things you need to do before filling out a mortgage application. A good first step to take is to get a copy of your credit report. You should check your credit report to ensure that everything on it is correct and that your credit score is acceptable.
The higher your credit score is, the more likely it is that you will be able to get a mortgage loan with a favorable interest rate. This is important because you will be paying interest on a large sum of money over a long period. Just a small difference in your interest rate can amount to thousands of dollars over the course of a mortgage loan. If there are problems on your credit report, they should be addressed before you apply for a mortgage loan.
Once your credit score is in order, you will need to gather documentation for your lender, including items like W2s and recent check stubs to help verify your income. You will also need your social security card and your driver’s license or other photo identification. Some lenders may require additional documentation such as utility bills, phone bills, or tax returns.
The Mortgage Applications
The actual application for a mortgage loan is usually quite simple. Your lender will provide you with a standardized form to fill out. Once your lender has the completed form and all the documentation that is required, he or she will pull a credit report from one or more of the credit bureaus.
When everything on the application is verified and documented, the lender will send the application and documentation (or loan package) to an underwriter. Underwriters determine if you are an acceptable risk based on the loan amount you want to borrow and your current debt-to-income ratio. At this point, the underwriter decides what other documentation may be needed to continue with the process.
How much house can you afford?
Lenders base their decision of how much you can afford according to how much you can repay each month. How much you can repay is determined by reviewing your current income, current debt, available cash, and credit history. As a general rule, lenders prefer that borrowers keep all their monthly payments below 28 to 44 percent of their income.
To get an idea of what you can realistically afford, you can look at your budget, figure out how much money is left over after your current bills are paid, and see what amount you have available for a house payment. Remember to figure in items like home maintenance, property taxes, and homeowner’s insurance. If you want to get a ballpark figure of how much you can afford to repay, there are free online mortgage calculators that you can use but you can also calculate it yourself.
How are mortgage rates calculated?
Several variables come into play for lenders as they calculate mortgage rates. First, lenders start with a base rate that is largely determined by market conditions. So, you have no control over this base rate.
However, the other factors involved are somewhat under your control. Some of these factors are:
- The type of loan for which you apply (either fixed or adjustable rate).
- The type of home you choose (single or multi-family dwelling).
- The term of your loan (10, 15, 20, or 30 years).
- Credit score.
- Down payment amount.
- Your loan-to-value ratio, which is your loan amount divided by the value of your property.
Each of these variables plays a part in the final loan terms you are offered. For instance, if your credit score is excellent, you will likely get a lower interest rate. Similarly, the lower your loan-to-value ratio is, the better your rate will be.
What will your monthly payments be?
Your monthly payments will consist of several different components. This is a brief review of the main elements of your monthly home loan payment.
Principal and Interest on the Loan
Your principal is the amount you borrowed from your lender. Each month, a portion of your payment will be applied to your principal balance. The interest is the money you have agreed to pay the lender for the loan. Each month, a portion of your payment will be applied to your interest amount.
When you own a home, you must pay the municipality where you live property taxes for that home. Your lender may require that a portion of your payment every month include a percentage of the annual property tax due. This money will be held in escrow by your lender. Then, when your property tax bill is due, the lender will pay the appropriate municipality the tax that is owed.
This insurance protects your home and belongings from damage or theft. The home insurance premium payment may be a part of your monthly home loan payment, although some lenders let you pay this yourself. You will need to check to see what your lender allows.
Private Mortgage Insurance
Private mortgage insurance (PMI) is required by some lenders when you have less than 20 percent equity in your home. The best way to avoid PMI is to have a down payment of 20 percent or greater on your home when you purchase it. If that is not doable, you will need to pay PMI until you own 20 percent of your house.
All of these items together will make up your monthly mortgage payment. Online mortgage calculators can give you a general idea of what your payment might be, but your lender can give you an exact figure once the terms of the loan have been set.
What do you need to know about mortgage rates?
Mortgage rates can vary a lot from lender to lender. They can also vary a lot with the same lender, based on factors like your credit score, the loan terms you are looking for, and the type of loan you choose.
Your mortgage rate matters because a one-percentage point difference in mortgage rates translates into at least a 10 percent difference in the monthly mortgage payment (source). So, it pays to shop around for a great rate.
How can you find the lowest home loans rates?
The single most important factor under your control when shopping for a good mortgage rate is maintaining a good credit score. If you have credit card debt, consider paying it down substantially before applying for a home loan.
If your credit is in tip-top shape, take the time to explore all your options to find the best mortgage rates. Ask yourself the following questions:
How long do you plan to stay in your home?
What are the current interest rates offered by mortgage brokers and banks in your area?
Can your budget handle fluctuations in interest rates if you choose an adjustable-rate loan?
Finding a mortgage lender you can work with early in the process will help you get a good mortgage rate. A knowledgeable lender can walk you through the process and provide education about options you may not have considered. It is a good idea to talk with several mortgage lenders to compare the options they present.
Family and friends may be able to steer you in the right direction with referrals to a good lender. Or, you may choose to work with a mortgage broker. A broker will find a lender for you and help you navigate the process.
Can you get a mortgage if you have bad credit?
It is possible to get a mortgage loan even if you have bad credit. However, there are some serious factors to consider first. For instance, if you have reason to believe that your credit scores will improve in the next few months or years, you might want to consider waiting to purchase a home until the scores go up.
Remember that a poor credit score typically translates into higher interest rates on any loan you get. In the case of a mortgage loan, that higher interest rate will apply for the entire term of the loan, even if it is 30 years. When you consider it that way, you might decide it is best to work on improving your credit score before you apply for a home loan.
If you cannot wait, however, there are some things you can do to find a loan. First, you might consider working with a broker. Though there are fees involved, a mortgage broker may be able to find you a better deal than you can find on your own.
You can also increase the chances of getting a mortgage loan by putting down a hefty down payment. The larger your down payment is, the more likely your lender will be favorable to your application.
If you are working directly with a lender, you might consider explaining why your credit score is low. Some lenders view events like the loss of a job or a divorce less harshly than they view irresponsible spending.
Additionally, if you can prove that you have paid your rent on time for 12 consecutive months, lenders may look more favorably on your loan application.
What is the difference between banks and mortgage companies?
Banks are direct lenders, meaning that when you get a mortgage loan with your bank, the money your seller is paid comes from the bank itself. Banks offer consumers the mortgage products specific to their financial institution. Advantages to getting a mortgage loan through your bank are that you have an established relationship with your bank and may be eligible for a better rate based on that relationship.
Mortgage companies, on the other hand, are not direct lenders. Mortgage brokers work with multiple lenders to shop around for the best deal for your particular situation. Because they have developed relationships with multiple lenders, mortgage companies can often be a bit more creative in their approach to finding the right mortgage loan for you.
What should you know before choosing a mortgage company?
The most important thing to know before choosing a mortgage company is that not all mortgage companies are created equal. It is wise to check out the credentials of your mortgage company before getting too far into the loan process. You can check with the Better Business Bureau and also check for online reviews to help you make your decision. Good questions to ask your mortgage company are:
- How long have you been in business?
- How many lenders do you deal with?
- What are your fees?
- Do you have any special areas of expertise?
Where can you find the best mortgage companies?
Getting a referral from family or friends who have used the services of a mortgage company can give you some peace of mind regarding your choice. Remember that it is wise to compare companies for yourself to find the one that will work best for your particular situation. A mortgage company should be willing to talk with you at length about the options you have and explain everything about the mortgage loan process to you in a transparent way.
Online reviews can also be very useful when you are searching for a reputable mortgage company. SuperMoney maintains a database of unbiased reviews you can check for free to see what consumers think of a lender before you commit. You can find the best mortgage companies and their reviews right here.