What is a Mortgage?
A mortgage, in its most basic definition, is a loan to purchase real estate
The dream of owning a home goes beyond home tours and deciding between an open floor plan or a large backyard. For generations, owning a home signifies success. It’s an accomplishment many people dream of and few people achieve. A home is more than a place to live, it’s one of the greatest ways to build wealth and offers you a tangible asset to pass down for generations.
For millions of people across America, the home buying journey gets serious when they begin shopping for a mortgage. You’re not alone if the first time you hear about a mortgage is when you get serious about buying a home. Talking about mortgages does not get you cool points with your friends. So at the expense of being cool, I will lay out the basics of what a mortgage is and how it impacts your home buying journey.
A mortgage, in its most basic definition, is a loan to purchase real estate. According to the Federal Reserve Economic Data, the average home price in America is $428,700. For most buyers who want to make the American Dream a reality, using a mortgage to purchase a home is their only option. Understanding what a mortgage is and how it works will help you make an informed decision when it comes time to purchase a home.
How it Started
Although mortgages were around before the 1800s, they came to be what we know of them today around the late 1800s. During this period, mortgages were known as Balloon Mortgages. A Balloon mortgage allowed the borrower to only make interest payments for the first five years of the loan. Then, at the end of the five years, a balloon payment was made to pay off the remainder of the loan on the property. Banks typically would only lend out 50% of the loan amount to buyers. This meant that buyers would need to be well qualified and have a significant amount of money to purchase a home.
You may remember balloon mortgages from the early 2000s which lead to the housing crash. The difference between the two time periods is in the late 1800s buyers were qualified for the loans they received and had a significant amount of cash to make the balloon payment when the interest-only term expired. In the early 2000s, lending standards were loosened significantly to allow less qualified buyers to obtain balloon mortgages. At the end of the interest-only term, buyers did not have the cash to make the balloon payment required to avoid defaulting on their mortgage. This led to foreclosures and the housing crash in 2006.
The National Housing Act was signed on June 27, 1934, by President Franklin D Roosevelt. The act created the Federal Housing Administration (FHA) which provided insurance to lenders that the government would guarantee the loans they issued. Before the National Housing Act was signed, mortgages required a large down payment of 50% and full repayment in 5 years. The act was intended to strengthen the real estate market and promote homeownership during the Great Depression. And it worked.
Borrowers who once were unable to afford homeownership because of down payment requirements and loan terms, now found themselves able to qualify for a mortgage at more favorable terms. The down payment requirement was reduced to 20% of the loan amount while the loan term was extended to 15-30 years. Unlike many other programs enacted to combat the Great Depression, lawmakers saw a purpose for the FHA and it’s still in existence today.
How It’s Going
We now know what a mortgage is, a loan used to purchase real estate. And we know how it started and what it has evolved to today. Now, let’s take a look at what it means to obtain a mortgage for your home.
First, a borrower must do their due diligence and find a lender they are comfortable working with. Then, the borrower will apply for a mortgage through the lender of their choice. To qualify for a mortgage, a borrower must meet the standards of the lender, which include the amount of debt the borrower currently holds, their income, and their credit score. The lender will also need to know how much a borrower has for a down payment, which will impact their monthly payment and interest rate.
Down Payment
The down payment is the amount of money the borrower will pay upfront for the home. In the late 1800s, the down payment amount required was 50%. However, today that requirement has been lifted and borrowers can put a down payment that is much less. The amount required for a down payment will depend on the type of mortgage you obtain, which we will visit later.
Here’s an example of how much you will need for a down payment of 20% on a conventional mortgage. If the average home in 2022 is $428,700, and you will put down 20%, then your down payment amount is $85,740. This means the amount of money you will borrow from your lender is $342,960. Your loan amount, interest rate, and monthly mortgage payments will all be based on the $342,960 loan amount.
Interest Rate
The average rate on a 30-year fixed mortgage rate today is 5.817%. The rate you receive may defer depending on the type of mortgage you obtain, your financial background, loan amount, and the type of home you are purchasing. It is important to shop around for the best rate to help keep more of your money in your pockets.
It’s important to understand how interest on a mortgage is calculated. The rate you receive, assuming it is fixed, will be applied to the outstanding amount of your mortgage every month. This means that for the entire term of your mortgage, whether it’s 15 years or 30, you will be charged interest every month on the outstanding portion of your mortgage until your home is paid off. Mortgages follow what is known as an amortization schedule for the life of the loan, which is comprised of the amount of principal and interest you pay towards your loan each month.
To better understand how mortgage payments are calculated and estimate your monthly mortgage payment, I recommend using a mortgage calculator.
Adjustable Rate Mortgages (ARMs)
Adjustable-rate mortgages (ARMs) offer interest rates that will fluctuate throughout the term of the loan. In most cases, the initial interest rate will be lower than the rate on a fixed-rate mortgage. ARMs have a fixed term where the interest rate remains constant, usually the first few years of the loan. Then, after the fixed term expires, the rate will fluctuate based on the current market rate.
In some cases, your initial interest rate may be higher than the current interest rate and your monthly payments will decrease. In other cases, your initial interest rate may be lower than the current interest rate and your monthly payment will increase. Your rate will adjust at specified times throughout the term of the loan, which will have an impact on your monthly mortgage payment.
An ARM is more complicated than a fixed-rate mortgage, where your initial rate remains fixed throughout the term of the loan. As with any mortgage decision, it is important to speak with a qualified lender before deciding which product is best for you.
Terms and Type of Mortgages
There are many types of mortgages and terms associated with them. Some lenders can get very creative to help you reach your home buying goals. For this article, I am focusing on the most common terms and types of mortgages I encounter. I suggest contacting a mortgage lender to find out what type of mortgage works best for you.
Term of Mortgage
There are two terms that most buyers will encounter when applying for a mortgage. The first is a 15-year mortgage and the second is a 30-year mortgage. This simply means that your monthly payment will be lower or higher depending on when how long your term will last. The longer the term, the lower your monthly payments will be. However, this also means you will be paying more in interest throughout the life of the loan.
Two things account for the difference in mortgage payments depending on your term. The first is that your interest rate will be different depending on your mortgage term. For instance, we said that at the time this article was written, the average interest rate on a 30-year fixed mortgage is 5.817%. However, the average interest rate on a 15-year fixed mortgage is 4.631%. The shorter your term is, the better your rate will be.
The second difference between the two terms is the amount your mortgage payment will be every month. It would be easy to assume that a lower interest rate means a lower monthly payment. However, because the term to repay the mortgage is also shorter, your mortgage payment will be higher on a 15-year mortgage than it is on a 30-year mortgage. Let’s take a look at an example by comparing the monthly payment on a $342,960 loan amount using today’s average mortgage rates for a 15-year mortgage and a 30-year mortgage:
Your mortgage payment on a 15-year mortgage using a 4.631% interest rate and a loan amount of $342,960, will be about $2,647 per month.
Your mortgage payment on a 30-year mortgage using a 5.817% interest rate and a loan amount of $342,960, will be about $2,016 per month.
As you can see from this example, the lower interest rate results in a higher payment because of the shorter mortgage term.
Your monthly expenses before accounting for your mortgage payment will determine how much your monthly house payment should be. Speak to a lender of your choice for a better understanding of how much you can afford.
Types of Mortgages
Conventional
A conventional mortgage is a loan that is available through a private lender, such as a bank, credit union, or mortgage company. Because a conventional mortgage is offered by a private lender, they are not secured by a government entity. For this reason, conventional mortgages usually have stricter standards to qualify than a loan secured by a government entity. This includes, but is not limited to, down payment amounts, credit scores, and debt to income ratios.
Although a conventional mortgage is not secured by a government entity, they usually meet the requirements for Fannie Mae or Freddie Mac, government-sponsored enterprises. Fannie Mae and Freddie Mac purchase most mortgages from lenders and sell them to investors.
Loan guarantees from Fannie Mae and Freddie Mac reduce risk for lenders who make loans and investors who might purchase them. This makes loans more affordable and contributes to the availability of 30-year fixed-rate loans. Loans that are not eligible for Fannie Mae or Freddie Mac guarantees are typically more expensive.
Conventional mortgages usually have a term of 15-30 years. The interest rate associated with a conventional mortgage is determined by the term of the loan, the borrower’s finances, and the type of property being purchased. The monthly principal and interest payment on a fixed-rate mortgage remains the same throughout the life of the loan. A conventional mortgage also gives you the option of an adjustable-rate mortgage (ARM) With an ARM, your rate will fluctuate throughout the life of the loan depending on market conditions.
Federal Housing Administration
A Federal Housing Administration (FHA) mortgage is issued by a private lender and is regulated and insured by the Federal Housing Administration, a government entity. FHA mortgages allow for a lower down payment (usually as low as 3.5%), lower credit scores than a conventional mortgage, and usually have a maximum loan amount.
Congress created the FHA in 1934 during the Great Depression. At that time, the housing industry was in trouble: Default and foreclosure rates had skyrocketed, 50% down payments were commonly required, and the mortgage terms were impossible for ordinary wage earners to meet. As a result, the U.S. was primarily a nation of renters, and only one in 10 households owned their homes. The government created the FHA to reduce the risk to lenders and make it easier for borrowers to qualify for home loans.
FHA mortgages have two loan terms, either 15 years or 30 years. The rate on an FHA mortgage is always a fixed rate throughout the term of the loan.
Veterans Affairs
A Veterans Affairs (VA) loan is issued through the Department of Veterans Affairs. With a VA loan, veterans, service members, and their surviving spouses can purchase homes with low to no down payments and receive a competitive interest rate.
VA loans help active service members, veterans, and their surviving spouses become homeowners. They provide up to 100% financing on the value of a home. Eligible borrowers can use a VA loan to purchase or build a home, improve and repair a home, or refinance a mortgage.
VA Loans offer loan terms of either 15 or 30 years. Similar to a conventional mortgage, a VA loan offers a fixed rate or an adjustable-rate mortgage. VA loans are only available to veterans, service members, and their surviving spouses.
Conclusion
According to the National Association of Realtors, 87% of recent buyers financed their home purchase. If you will need a mortgage to purchase your next home, then it’s in your best interest to speak with a lender as soon as possible so you know exactly how much home you can afford. The last thing you want to happen is to fall in love with a home that you think you can afford, but your lender thinks otherwise.
When purchasing a home with a mortgage, it’s just as important to receive the best financing as it is to get the best price for your home. I highly recommend all buyers shop around for the best mortgage rate and terms they can receive for their home purchase. You may be surprised to find out that lenders will give you a better rate if they know you are shopping their offer around.
I have covered the three most common types of mortgages. The mortgage industry is always changing and the types of products and terms available can change as well. It’s important to speak with a qualified lender who can go over your options in greater detail before you begin your home journey. Your lender will find the best product available to you based on your individual needs and circumstances.
