An introduction to mortgages
Buying a home for the first time? If so, you'll want to make sure you know exactly what a mortgage is and how it works.
Buying a home for the first time? If so, you'll want to make sure you know what is a mortgage and how it works. Getting a mortgage can be one of the most daunting aspects of the home buying process.
Here, we’ll go over everything you need to understand about mortgages.
What is a mortgage?
A mortgage is a loan. If you're loaded and planning to buy a property outright, you won't need a mortgage. Otherwise, it is necessary for any buyer to finalize the real estate transaction.
The unique element that makes a mortgage different to any other loan is the fact that the property you are buying is used as collateral. With a mortgage, you'll make payments to your lender to pay back over time. If you ever stop making these payments, your lender has the right to take possession of the property through a lien. The lien is the clause in the loan that enables the lender the right to foreclose the property if you fail to pay your debt to them.
How much can I borrow?
Borrowing more than you can afford to pay back isn’t the greatest idea. Remember the huge financial crisis that came about a few years back? A considerable part of that crisis was caused by the impact of sub-prime loans. These loans were essentially a type of mortgage that offered amounts of money way beyond buyers affordability. In such circumstances, both the lender and the loanee are gambling. Both assume that the value of the property will rise to save the situation and evidently that didn't work out very well.
Today, lenders are far more strict with the amounts they offer to first-time buyers. The lender’s process makes sure you can actually pay back what you borrow comfortably. Lenders will take a good look at your financial situation before offering you a loan amount. During the application process, your income, any debts you have, as well as all payments you make for cars or credit card will be a decisive factor.
The maximum mortgage you are offered isn’t necessarily a good reflection of your affordability. There are other things you must take into account before you make this kind of commitment. What other aspects of your life will you need to spend money on? Do you love travel and holidays? Shopping or dining out? These costs are essential considerations that must be factored into your monthly budget.
The key here is to do your homework. Note down the things you are most likely to spend on, use mortgage calculators to get realistic numbers on your month by month affordability over the coming years.
Is it hard to qualify for a mortgage?
After the sub-prime loan catastrophe mentioned above, lenders are far more careful with those who apply for a mortgage. A huge part of the equation now is your debt to income ratio or DTI. It reflects how much you need to be paying out relative to how much you are receiving in income. If you're currently paying off debts, home buying might not be the best option for you.
What role does your credit score play?
Your credit score reflects your track record and ability to pay back what you borrow. Most people's credit score ranges from 300 - 700 or perhaps a little higher. Those with 700 or higher have a great score. Those that fall below 600 are generally perceived as having a poor credit score. The higher your score, the better looking you are to potential lenders and the lower your mortgage interest rate will be. The best way to achieve a high credit score is by having a credit card and ensuring payments are on time.
Are some mortgages better than others?
A mortgage is only useful if it is the perfect fit for your specific circumstances.
Interest rates, points, fixed and adjustable rates are some of the core differentiating elements between mortgages. The objective is to have these aspects align with your aims for the purchase. Do you want to live in this home forever? Or do you plan on selling it within the next few years? These decisions are the criteria on which you determine whether you prioritize a stellar interest rate, go with a fixed loan or take an adjustable one. Insurance and property tax rates are always bound to change no matter which type of mortgage you chose.
Fixed or adjustable?
There are two basic types of mortgage rates. A fixed rate mortgage offers a stable interest rate. Your monthly payments won’t fly at any point. If you want to live in the property for as long as you can, a fixed rate is the ideal mortgage. However, fixed interest rates are slightly higher than most adjustable rates. Stability does come with a price.
Adjustable rate mortgages are more suitable for situations where you don't plan to own the property in the long run. If you’re buying to sell in the near future, you can benefit from the lower interest rates that come with an adjustable mortgage.
Some adjustable rates give you the chance to have a fixed rate for a number of years before adjusting. However, the risk remains. If you don’t sell your property soon enough, you’ll be slammed with higher rates when they adjust each year. Refinancing on an adjustable rate mortgage is often far more difficult too.
What role do points play?
In the mortgage application process, 1 point reflects the value of 1% of your loan. Your lender may offer to sell you points and sweeten the deal by offering you a lower interest rate. But the degree of change in interest rate can vary. Buying a point doesn’t mean you're interest rate will drop by 1%.
The idea of points is to get your interest down steadily so your payments over the long term will decrease. It makes sense to buy points if you plan on sticking with your property for a long time, or even the rest of your life. To maximize your points, purchase them periodically. On the other hand, it makes far less sense to invest in lowering your payments by buying points if you're thinking of selling in the next few years.
Good and bad Interest rates
Your interest rate will be determined by your lender during your mortgage application and different factors can influence it. It can be influenced by location, various current market factors and timing. Always compare offers from different lenders at different times to see these changes.
What is APR?
The annual percentage rate (APR) incorporates fees and points to provide one clear annual rate. The APR is often the best way to quickly compare offers from varying lenders as they all have different ways of structuring their products.
A lender might offer you a great interest rate but then make up the real price with higher point costs than other lenders. The APR gives you a single plain summary for you to weigh up mortgage option against each other.
What is amortization?
Amortization is the exact amount that you are paying towards your loan each year. Whether your mortgage terms is set to last 10 or 30 years, there’s an amount you’ve borrowed, and the idea is for you to pay towards it until it is paid off. At the beginning of your term, the majority of your payments will go towards the interest. As you reach the end, the payments will go towards the loan principal instead.
Use an amortization calculator to work out how much of your principal you're paying off each year, as well as how long a term is best for you based on your current financial circumstances.
To put it very simply, the more interest you pay throughout your loan, the more you will have paid for your property overall. Making extra payments towards the principal will result in a lower amount paid overall. You’ll have a shorter period of paying for interests as the loan is paid sooner.
Prepayments can be very costly if your lender doesn’t allow it. Some mortgages are subject to penalties if some of the principal is paid early.
These types of mortgages offer very attractive rates or are offered to those who wouldn't be granted the loan otherwise. It might sound like a bad loan to accept, but someone who can't afford to make prepayments anyway could see it as advantageous to save thousands with the better rates on offer.
Private mortgage insurance, or PMI, is what lenders use to protect themselves should you default on the loan. PMI is common in mortgages where the homeowner puts less than a 20% deposit down on the property. Once the owner has 20% of the equity in the property, the PMI can be removed following certain conditions set forth by the lender.
We hope you've found the above information useful. By getting your head around these fundamental mortgage principles, you'll be far more confident in the search for the perfect one for you!