how mortgages work

By Katie Skinner

After I graduated college in 2019, I thought my husband and I were ready to buy our first home. We had rented for the first 7 years of our marriage without realizing how much money we were losing by not having a place of our own. We ended up buying our first home in 2020, however, we wish we had known the following before we started the buying process. These are some of the things I wish I learned in school to better prepare us for buying a home: 

What is a mortgage? 

A mortgage is a loan used to fund the purchase of a property or home when a person can’t pay for the full cost out-of-pocket. Mortgage loans come in different types and quantities. Knowing which one is right for your financial situation is important in order to make mortgage payments comfortably. In order to qualify for a mortgage, certain criteria need to be met, which is determined through a pre-approval process. 

What are the three types of mortgages? 

There are three main basic types of mortgage loans: fixed rate mortgages, adjustable rate mortgages, and interest-only mortgages. 

A fixed rate mortgage, or a conventional mortgage, has a set interest rate with a consistent monthly mortgage payment. This is the most common mortgage loan and is available in various term lengths. 

With an adjustable rate mortgage, the interest rate isn’t fixed and changes as the market changes. This is an option for those who are waiting for interest rates to drop and think they can lock it in at a lower interest rate after closing. 

An interest-only mortgage is when only the interest portion of the loan is paid instead of the full payment during the first five or 10 years of the loan. After the determined timeframe where only interest is paid, then the rest of the loan is paid off like a fixed rate mortgage. 

How do I get a mortgage? 

In order to get a mortgage, you must first get pre-approved by a lender to determine if you qualify. This process will also let you know how much you can afford when it comes to buying a home. 

First, you must find a lender you may want to go with. However, know that a pre-approval with a lender doesn’t mean you have to go with that lender when you decide to buy a home. During the pre-approval process, the lender will look at your income, assets, credit history, and debt-to-income ratio. Once you are pre-approved, you will have a better idea of how much you can borrow. 

Once you are pre-approved and find the home you want to buy, then you are ready to formally apply for the mortgage loan of your choice. You will need to submit your most recent financial information for review again. This process will be a bit more in-depth than the pre-approval process. The lender will then take this information to begin the underwriting process. During this process, the underwriter will order a home appraisal and evaluate your financial history to finalize the mortgage loan. 

When the underwriting is finalized and your mortgage loan is approved, you are ready for closing day! On closing day, you will need a few things in order to finally obtain your mortgage and house keys like homeowners insurance, title insurance, and the cash to close. Once these steps are finalized, you are a homeowner with a mortgage! 

Shop Around for a Lender 

Since not all lenders are the same and not all lenders offer the same terms, incentives, and customer service, it’s best to shop around to find a lender that fits your home buying needs. Besides, you may be working with this lender for the lifetime of your mortgage loan, so make sure they are good at communicating with you and are helpful. Also, ask if they sell your loan to another lender during the duration of your loan. This could make things tricky later on if the loan is sold to a lender you aren’t familiar with.  

Because we shopped around before finalizing our loan, we were able to get a better interest rate. They were also way more helpful, friendly, and caring than the previous lenders we were pre-approved with. 

How does a mortgage payment work? 

A mortgage payment consists of four main components: principal, interest, taxes, and insurance. The principal is the amount that goes towards paying off the loan while the interest rate is determined by the current market and the level of risk the lender is taking when lending a person money. Property taxes are determined by location and the insurance varies depending on the downpayment and other factors. 

Should I make extra mortgage payments? 

Making an extra mortgage payment can save you money, so even making one extra mortgage payment per year can be a smart move. The more you pay towards your principal, the less you pay in interest over the lifetime of the loan. However, if you can’t comfortably afford more than your initial mortgage payment, then this may not be the best option for you. Also, some loans may have prepayment penalties, meaning you will have to pay a fee if you pay off your loan too quickly. 

Even though we went in not knowing much about mortgages before buying a home, we can now tell other first-time homebuyers not to make the same mistakes as us! Do your research on mortgage loans and find a mortgage and lender that is right for you before buying a home. 

Life Benefits Commentary

Many people stumble through the mortgage process without having a clear idea about what to expect.  Katie’s article, above, is a good resource for someone who wants to know what to expect when applying for a mortgage, maybe you, maybe your children, maybe someone you know.

We’d like to give a big shout out and thank you to Katie for actually writing down some of the things she wished she would have known before buying their first home.

There is one point we would like to add to Katie’s article in answer to the question: “Should I make extra mortgage payments?” There are two major considerations to make when deciding if you should pay off your mortgage quicker. One consideration is financial; the other is emotional.

Financially, paying off a mortgage sooner can cause you to lose money that you could have made with the money you used for making extra payments. The technical term for this is “lost opportunity cost”.  To see the difference between making extra mortgage payments and using that money in another way watch this video presentation called Fun with Real Estate

The second consideration is emotional. Some people get emotional satisfaction from having their home paid-off. It is important to take emotions into consideration too because wealth is not just money.  It’s important to fully understand the financial cost or benefits of both options and balance the financial consequences and emotions for the ultimate outcome.

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