For many buyers, getting approved for a mortgage is one of the most significant steps towards achieving their real estate dreams. With dozens of options to choose from and no standardized application and approval method, the mortgage process can also seem like a challenging and unpleasant hurdle. But it doesn't have to be. Taking some time to understand the basics of what mortgages are and how they work goes a long way toward dispelling some of the angst and confusion surrounding them.
What is a mortgage?
Simply put, a mortgage is a monetary loan specifically designed for the purchase or refinancing of property (i.e., a home).
Are there different types of mortgages?
Yes. In general, there are four types of mortgages that buyers apply for:
Conventional – a mortgage loan given by a private institution that isn't backed by the Federal Housing Administration. That is, if you default on your loan, your mortgage lender won't be able to get its money back from the government. Because of this, conventional loans typically have more stringent approval requirements in terms of your overall financial health.
FHA – a mortgage loan given by a private institution that is backed by the Federal Housing Administration. Approval requirements for FHA loans are determined by the government and are typically lower than conventional loans. FHA loans are also only for buyers that intend to buy a home and make it their primary residence.
USDA – a mortgage loan specifically designed for rural homebuyers. It requires buyers to have a higher credit score and a specific income level but, if qualified, allows them to receive the mortgage without putting any money down.
VA – a mortgage loan designed for active-duty military members and veterans. Similar to USDA loans, VA loans let buyers get a mortgage with no money down. Also, VA loans don't require buyers to get private mortgage insurance.
Do I need a mortgage?
It depends on your financial situation. Most homebuyers don't have enough cash on hand to make a single lump-sum payment that large. Therefore, they need a lender to cover the full price of a house and allow the buyer to pay back the loan over a predetermined period of time.
In other cases, a buyer may have enough money to buy a house outright, but doing so would prevent him or her from investing in other assets.
Where do I go to get a mortgage?
Private banks, credit unions, and online mortgage lenders are the most popular places people go to get a mortgage. If you do a quick search online, you'll see that the marketplace has dozens of options.
Doing research and identifying what matters most to you will help you sort through your choices. Think about it like shopping for a new television or computer. Questions you should think about when looking at mortgage lenders include: What kind of loan do I want? What rate can I afford to pay? How important is face-to-face service to me?
How do mortgage payments work?
Depending on your mortgage terms, the first payment you'll make to your mortgage lender is the down payment - typically 20-25% of the home’s value for a primary residence (the down payment requirements typically increases for second and third homes). The down payment represents the amount of equity one has in their home. Conventional loans, which in the case of NYC will almost always be Jumbo Loans, typically require a minimum of 20% down, however, some banks have special programs for individuals in certain professions they deem as safer candidates to lend to such as doctors and lawyers. Committing to a higher down payment (or lower loan-to-value ratio - LTV) may get you a lower interest rate since the bank would consider this less risky.
After the down payment, you'll make monthly payments to your lender until the loan is paid off. These payments generally break down into three parts: principal, interest, and taxes & insurance.
Principal – refers to the actual amount of money that was loaned to you. Let's say your lender gave you a mortgage of $300,000 to purchase your home and you put $10,000 down. That means you owe $290,000 over the agreed-upon life of the mortgage (which typically is 15 or 30 years).
Interest – the amount you'll pay to your lender each month on top of the principal (it's how the lender makes money). The interest rate, the terms of which will have been agreed upon beforehand, is usually a fixed or a floating/adjustable rate. Fixed rates mean that the amount you pay will remain the same throughout the life of the mortgage. A floating/adjustable rate is tied to a financial index (usually the 10-year U.S. Treasury) and means that your interest payment can go up or down during the life of the mortgage. Weighing which rate type (fixed or floating) is right for you is an important consideration when choosing a mortgage. Floating rate loans will generally have a lower initial rate. However, there is more risk associated with them since they can potentially increase by several percentage points depending on underlying market conditions, inflation, lack of quantitative easing, and other macroeconomic factors. Generally speaking, most floating rate loans have a ceiling cap in terms of how much your interest rate can increase in a single year as well as over the course of the entire loan. Put simply, floating rate loans are riskier since they are subject to change. Though, if you understand them, they can be a valuable financial instrument to use in your real estate portfolio.
Taxes & Insurance – refers to the costs associated with owning a home. Property taxes and homeowner's insurance are sometimes included in your mortgage payment as part of your agreement. When taxes and insurance premiums are due, your lender will pay them out for you. With condominiums and co-ops you will also have homeowners association fees. While not necessarily intertwined with the mortgage payment to your lender, this is a monthly expense you still must budget for.
Is there anything else?
Some other terms you should be familiar with are listed out below.
Amortization – refers to how your monthly mortgage payment gets broken up. Typically, lenders will require that your earlier payments are weighted towards the interest you owe rather than the principal amount you owe. Some lenders require you to pay off the interest entirely before you can pay off the principal.
Debt-to-Income Ratio – a ratio used by lenders to determine your financial health and what type of mortgage you qualify for. You can calculate this yourself by adding all your monthly debt payments (i.e., car payments, credit cards, student loans, utility bills, insurance payments, etc.) and dividing it by your gross monthly income. The lower the ratio, the better you look to a potential lender. You should aim to have a DTI of 50% or less.
Loan-to-Value Ratio – another ratio used by lenders to determine your eligibility for a mortgage. This ratio is calculated by dividing the amount of your loan by the appraised value of the home you want to buy. Again, the lower the ratio, the better you look. Keep in mind the LTV is calculated by the appraisal value the bank and you agree upon, not necessarily the purchase price or what you think you can obtain on the open market. In some cases, a bank may take the viewpoint that a client overpaid for the property - hence the reason the LTV is based on the appraised value and not always the purchase price.