Before learning about the dos and don’ts of mortgages in the United States, let us first understand basic principles, various types, and rules related to mortgaging.
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A mortgage is a real estate loan that may be used to buy property, homes, lands, offices, etc. The borrower has to make repayments as agreed to the financing company usually in monthly installments over a certain period. The property which is bought with this money works as collateral. Thus, the mortgage is a kind of secure real estate loan.
“A mortgage is an agreement between you and a lender that gives the lender the right to take your property if you fail to repay the money you’ve borrowed plus interest.” – as per Consumer Financial Protection Bureau.
Let us have a look at frequently used terminologies and jargon related to mortgaging.
The down payment is the upfront payment that has to be made to the lender. The minimum down payment for a mortgage is set at 3.5% by the Federal Housing Administration in the case of home loans. However, mortgage down payment requirements vary depending on the type of mortgage, region, etc.
The mortgage rate is the interest charged by a lender in the mortgage amount. It can be of a fixed nature for all terms or may vary depending on the market situation. The mortgage rate is usually higher for longer terms and is also dependent upon the mortgage down payment. Usually, the mortgage rate comes down if the mortgage downpayment is 20% or higher.
APR (annual percentage rate), is the cumulative interest rate that a borrower has to pay to the lender which includes various fees like service charges, mortgage insurance fees, etc. along with the interest rate. It is a better tool to consider for comparison.
A mortgage term is the period for which the mortgage is set up. The most common mortgage terms for homes are 15, 20, or 25 years.
There is a requirement of a minimum credit score of 620 for a smoother underwriting process. However, you still can get a mortgage even if you do not have a good credit score. You may look for government-supported schemes like FHA loans, VA home loans, etc. You can also try to improve your credit score by using credit cards sincerely, avoiding new credit cards and loan applications, etc.
Private mortgage insurance
Private mortgage insurance (PMI) is a mortgage insurance to safeguard the lender in case of default. PMI is usually payable if the mortgage down payment is less than 20%.
Right of rescission
Right to rescission enables the borrower to cancel the mortgage before a certain period of time however if closing documents are signed you cannot exercise this right.
Total interest percentage
The total interest percentage is the total interest that you have to pay over the life of the mortgage loan.
Mortgage underwriting is the process that banks or mortgage firms go through to decide whether you are capable of repaying your mortgage installments before approving the mortgage. It involves various checks like income details, investments, and liabilities. The mortgage underwriting process may take 40-50 days.
The “principal” in a mortgage refers to the initial amount of money you borrow to buy a home. It’s the main part of the loan that you need to pay back over time. As you make monthly mortgage payments, a portion of the payment goes towards reducing the principal, helping you gradually pay off the loan.
The “interest” in a mortgage is the extra money you pay to the lender for borrowing the principal amount to buy a home. It’s a fee for using their money. Interest is added to your monthly mortgage payment, and it’s how the lender makes money from the loan. As you make payments over time, a portion of the payment goes towards paying off the interest.
Since you buy property or home from the loan, you are liable to pay property taxes. In case a down payment is less than the threshold down payment the lenders set an escrow account on your behalf and collects fund for it from you adding a certain amount to your monthly installments. Property taxes in the U.S. vary from state to state. These are collected by tax authorities. The tax amount depends upon your assessment ratio, property value, and the tax rate of the concerned state.
Mortgage insurance covers the risk of the lender in case of default. A conventional mortgage requires at least 20% of the loan amount as a down payment. In case the borrower does not have availability of this much fund then he is not eligible but mortgage insurance can facilitate it by covering the risk involved with lower downpayment. Mortgage insurance increases the cost of a loan as monthly installments will have a component of mortgage insurance. You should always keep in mind that mortgage insurance only protects the lender. It does not cover the borrower’s risk.
In the case of conventional loans mortgage insurance is provided by private mortgage insurers (PMI) and in the case of government-supported mortgages it is provided by FHA (Federal Housing Administration), USDA (U.S. Department of Agriculture), or Department of Veteran’s Affairs. Insurance cost in the conventional mortgage is comparatively higher than the government-backed mortgage. We will explore government-backed mortgages in detail later in this article.
Mortgages can be classified into various categories based on rate and loan terms.
A fixed-rate mortgage has a constant interest rate over the term of the mortgage. Thus, monthly remains the same despite changes in economic conditions like interest rate hikes. This type of mortgage is very simple to understand and financial planning becomes easy.
Adjustable rate or variable rate mortgage
Adjustable rate or variable rate mortgage has changing interest rates over the term of the mortgage. Thus, the installment amount keeps on fluctuating from time to time. Though financial planning may become a little tricky for some people, variable-rate mortgages are usually beneficial in the long run because interest rates are kept lower compared to fixed-rate mortgages.
Introductory rate mortgage
In the case of introductory rate mortgages, the initial interest rate is kept comparatively lower and as time passes interest rate is increased gradually. So, if you expect your income to grow in the future and cannot afford higher installments at present then an introductory rate mortgage can be a good option.
A split-rate mortgage is a combination of a fixed-rate mortgage and a variable-rate mortgage. Some part of the interest rate is fixed and some part is kept variable.
Conventional Conforming mortgage
A conventional loan is a type of loan that isn’t backed by the government. It’s usually also a conforming loan. “Conventional” means a private lender gives you the loan without government help. “Conforming” means the loan follows rules set by Fannie Mae and Freddie Mac, which are government-related companies that buy loans from lenders to keep them able to lend money. People often like getting conventional loans. You can get one with a down payment of just 3% of the home’s price. But if you put down less than 20%, you usually have to pay an extra fee each month called private mortgage insurance. This fee helps the lender if you can’t pay back the loan.
Government Insured Mortgages
- FHA Mortgage: This mortgage is backed by the United States Federal Housing Administration with fixed-rate interest or adjustable-rate interest and a term of 15 years or 30 years. Since this scheme is supported by FHA, restrictions on eligibility are less compared to conventional mortgages. Down payment requirements are also as low as 3.5 %. You consider an FHA mortgage if your credit score is low but not less than 580 and fewer funds for the down payment.
- Veterans Administration Mortgage: VA mortgage is available only for military personnel, active-duty service members, National Guards, qualified reservists, qualifying surviving spouses, and veterans. This scheme is backed by the Department of Veterans Affairs. There is no requirement for credit score and mortgage insurance in the case of a VA mortgage. VA mortgage offers good interest rates and almost zero down payment requirements. VA mortgage requires a funding fee to be paid to the Department of Veterans Affairs if you put down less than 5% on the home purchase. The funding fee is 2.15% when mortgaging for the first time and 3.3 % on subsequent loans. This fee is tentative and revised from time to time.
Down payment in %
VA Funding fee
(As per August 2023 data)
- USDA loans: USDA (U.S. Department of Agriculture) Mortgages are only applicable for rural areas and some of the outskirts of the suburbs. You should be a U.S. citizen, U.S. non-citizen national, or Qualified Alien. You are eligible to take home loans under this scheme only if your household income is less than 115% of the median income. Important features of USDA mortgage are:
- 0% down payment option.
- No credit requirement.
- Interest rates are determined by individual lenders.
USDA Section 502 Guaranteed loans are offered for 30-year terms only at a fixed rate.
These are basic criteria that every lender certainly checks before sanctioning a mortgage to assess their risk exposure.
Lenders verify your income records to check your repaying capability. They ask for income proofs like income tax return details, pay slips, or bank statements to verify your income.
The borrower’s liability profile is thoroughly assessed before sanctioning of mortgage. You must have debt to debt-to-income ratio lower than 43% in order to avoid any issue. Lenders check that your monthly installment payment won’t exceed more than one-third of your monthly income.
Down payment fund availability
How much you need to pay upfront as a down payment relies on the lender and the specific mortgage you’re considering. If you’re looking at a standard mortgage, you’ll typically have to contribute at least 3% of the home’s price as a down payment. It’s worth noting that if you aim to avoid private mortgage insurance (PMI), your down payment should be 20% or more. On the other hand, if you’re considering an FHA loan, you’ll need to provide a down payment of at least 3.5%. Meanwhile, USDA and VA loans are exceptions, as they don’t mandate a down payment.
While factors like a steady income, employment history, and stable housing are crucial to lenders, your credit score is an extremely important indicator of your debt-paying capability. This three-digit number, ranging from 300 to 850, helps lenders gauge how risky it might be to lend you money.
A higher score signifies lower risk in the eyes of lenders. Consequently, you’ll be eligible for better loan terms. Lenders assess a homebuyer’s credit score and report from the three major credit-reporting agencies: Equifax, Experian, and TransUnion. While assessing your mortgage application, these agencies generally use a specific FICO score, as it’s currently favored by Fannie Mae and Freddie Mac, the primary buyers of home loans in the secondary market.
However, since the precise FICO score can vary between the three credit-reporting agencies due to disparities in reported information and timing, mortgage lenders consider the middle score to guide their decisions.
Check credit score
Credit reports obtained from the three major credit bureaus generally do not include credit scores. However, you might obtain a credit score from your credit card provider, financial institution, or loan statement. Alternatively, you can utilize a credit score service or a website that offers free credit scoring. You can get your credit scores in the following ways:
- You can check your credit card, financial institution, or loan statement as credit card companies and banks usually provide credit scores to their customers.
- You can purchase your credit scores directly from credit bureaus like Equifax, FICO, etc.
Calculate deposit requirement
In the United States, a 20% down payment is most common. The buyer’s credit score, income, and debt-to-income ratio are three major factors in deciding the mortgage interest rate, amount borrowed, and mortgage terms. If possible you should go for a higher down payment as it has some inherent advantages.
The minimum down payment requirement is approximately 3% for home loans, as per the norms set by government entities Fannie Mae and Freddie Mac. For the FHA loan scheme, which is aimed at helping families with annual income on the lower side of the spectrum achieve homeownership, the minimum down payment required is 3.5%, if you fulfill certain eligibility criteria.
Choose the type of mortgage
You must decide which type of mortgage suits your financial conditions.
Assess Your Finances: Evaluating your financial situation before applying for a mortgage is crucial. The interest rates that you will be offered and the type of mortgage that you can qualify for depend upon your credit score, debt, and income profile.
Explore Benefit Programs: Special mortgage programs, such as VA loans for veterans and active-duty military personnel or USDA loans for rural areas, can offer competitive terms if you meet the eligibility requirements. Veterans often get favorable terms through the VA home loan program, while USDA loans can be beneficial for those looking to buy homes in rural locations.
Evaluate Your Home Duration Plans: Your plans for how long you intend to live in the home can influence the type of mortgage you choose. Fixed-rate mortgages provide stable monthly payments over the long term, making them suitable for “forever” homes. Adjustable-rate mortgages (ARMs) may be worth considering if you plan to move or refinance in the near future.
You can also seek professional advice if you find it difficult to decide by yourself. Buying a home and selecting the right mortgage is a significant financial decision. If you’re unsure about the best mortgage option for your specific circumstances, seeking advice from a mortgage professional or a third-party advisor can provide valuable insights and help you make an informed decision.
Gather related documents
- Income proofs: Every mortgage application requires valid income proofs. So, keep these documents prepared in advance to avoid last minute rush.
- Your personal federal tax returns for the last 2 years.
- Your two most recent W-2 forms and your latest pay stub.
- If you’re self-employed, your 1099 forms or business tax returns.
- Assets and liability proofs: You may be asked to produce these documents to assess your portfolio and debt profile.
- Account statements covering up to 60 days, confirm the funds in your checking and savings accounts.
- The latest statement from your retirement or investment account.
- If you sold any assets before applying, like a car, include documents of the sale, such as the title transfer copy.
- Proof and verification of any gift funds deposited into your account within the last 2 months.
- Credit documents: Lenders want your credit reports to check your credit history, foreclosure, and bankruptcy. If your credit history has some dents then keep supporting documents ready to justify the reason behind it otherwise it may give a wrong signal to the lender. e.g., you may have missed some installments because of an accident or a medical emergency. So, keep supporting documents like your medical records ready to justify it.
Apply for preapproval
Now once you have gathered all the necessary documents and decided which type of mortgage you want to take, you can apply for preapproval. Mortgage preapproval is an offer extended by a lender to grant you a specific loan amount based on specific terms. however, preapproval is done only for a limited period usually lasting 90 days. It’s crucial to carefully review the details and keep in mind the validity period specified in your preapproval letter. It’s advisable to apply for preapproval when you’re ready to search for homes and are in a position to present an offer. You must note that preapproval does not guarantee a mortgage.
Moreover, it’s important to note that the lender’s preapproval offer may not be valid if there are changes in your financial situation after preapproval.
It’s advisable to be cautious throughout the mortgage process, as it involves significant financial commitments. Preapproval provides a helpful starting point, but it’s not an absolute assurance of loan approval, and there are additional steps and considerations before the mortgage process closes.
Find the property
Start looking for the property if you have not already decided. You can also search real estate online portals. Keep in mind that listing prices are not always accurate. Keep a buffer of at least 10% on the preapproved mortgage value. Also, online portals may not list all properties in the location of your interest. So, it’s a wise decision to get in contact with reputed offline brokers in the concerned area. After you find a suitable property and finalize it. Now you have to put down earnest money (1%-2% of the price) which is put towards a down payment if you close on a property.
Finally, sign the closing document
Now approach the lender who gave you the preapproval. You are required to submit many documents to the lender at this stage including your income proofs, employment details, assets, debts, credit history, etc. If everything goes fine, your lender will offer you a loan estimate usually within three business days. This loan estimate is valid for 10 business days. You can compare loan estimates of different lenders in this phase and if you accept the loan estimate your loan processing starts.
Then underwriting process starts which involves a thorough assessment of your mortgage application and documents by underwriters. Underwriters may reject, approve, or approve your mortgage with conditions. If the mortgage gets approved, you have to lock in your interest rate with the lender.
Now you have to close on the property by signing loads of documents with the title company. The closing disclosure form is one of the important documents here which clearly states the final costs. If you find any major difference between the loan estimate and closing costs do not hesitate to ask from lender and real estate agent. If you don’t get a satisfactory answer, you can still come out of the deal as there is a provision of a three-day review period. And if you are satisfied with closing costs, congratulations you are the owner of your home.
Loan is a very wide term. It could be secured or unsecured. Loans can be taken to finance cars, gadgets, apparel, and many more wide varieties of things. While mortgage is a special type of real estate loan in which property bought from the given fund is kept as collateral by the lender.
A reverse mortgage allows senior citizens to take loans by keeping their home as security without rendering the title of the home. The borrower need not repay the borrowed amount unlike a simple mortgage instead loan amount with added fees and interest is repaid when the borrower leaves the home (either death or sale of the property). So, it is basically a home-to-equity conversion method. Money borrowed by reverse mortgaging is usually repaid by selling the home. Home Equity Conversion Mortgage is applicable only for senior citizens who are 62 or above.
- Age must be 62 years or above.
- The home must be your principal residence (means where you spend the majority of the year).
- There should not be any mortgage balance on the home.
- You should not have any federal debt.
- Your home must be in a good shape.
A home equity line of credit is a special type of loan with a revolving line of credit that you can take on the equity part of your home (part for which there is no mortgage). Revolving line credit means you can borrow more than once during the borrowing period until your borrowing limit exhausts. The borrowing period is usually 10 years. You have to pay interest only on the money you borrow just like a credit card. The only difference is that here your home is kept as collateral. Interest rates on home equity lines of credit are usually lower and variable. There is a provision of least minimum monthly payments on borrowed amount during borrowing period and after the borrowing period ends repayment is done just like any other loan.
Amortization refers to the progression of the ratio of the repayment amount that goes to the principal head and the amount that goes to the interest head. During earlier periods weightage of the interest component is higher and as time passes interest component reduces and the principal component increases in installment. Amortization helps lenders reduce their risk in the earlier phase of the mortgage as amortization increases the debt-to-equity ratio of the borrower during the early phase of the mortgage.
An escrow account is required to be open in case the down payment is less than 20%. An escrow account is opened by the lender to accumulate funds on your behalf to pay insurance and property taxes. Your monthly mortgage payment includes this component. Interest earned on this account is not kept by anyone but rather added to the principal escrow fund amount. You can choose not to open an escrow account if your downpayment exceeds 20% and pay your taxes and insurance by yourself.