How to understand your mortgage (and get the lowest rate you can)
You pay back a mortgage in monthly installments over an agreed-upon period of time, typically 30 or 15 years.
Mortgages are secured loans, meaning you need to put up an asset — in this case, your house — as collateral.
If you want to live the American dream of being a homeowner, you’re most likely going to need a mortgage.
A home loan is a major responsibility. So, before buying or refinancing a home, you need to understand several basics about mortgages: how they work, the types that are available, and what you can do to make sure you’ll get the best mortgage rate possible.
How does a mortgage work?
When you take out a mortgage, you agree to repay the loan, with interest, under the condition that if you don’t, your house could be taken away — foreclosed on, in real estate lingo.
The many documents you sign at a mortgage closing include your mortgage note, which is a legal contract confirming your promise to pay back your loan, with interest, within the agreed-upon term.
Your monthly mortgage payments cover a variety of costs, including:
1. Principal. The principal balance on your mortgage is the amount you still have left to pay; it’s the value of your original loan minus your down payment and any monthly payments you’ve made so far.
Each monthly payment you make toward your mortgage reduces your principal and the amount of interest you owe.
Most mortgage payment schedules start with a larger portion of your monthly payment going toward interest. As you near the end of the loan term, this distribution will shift — and the bulk of your payment will go toward your principal.
Your payments stay the same, but the mix of interest and principal changes — through a process called amortization.
2. Interest. The interest rate on your mortgage is the annual cost of borrowing the money, expressed as a percentage of your loan.
There are two main options when it comes to mortgage interest: fixed rate or adjustable rate.
- With a fixed-rate mortgage, your interest rate will hold steady for the life of your loan. Fixed-rate mortgages are a good option if your income is stable and you’re planning to stay in your house for the long haul; your monthly payments will remain the same and you won’t have to worry about any surprise rate increases.
- With an adjustable-rate mortgage, or ARM, you’ll pay a fixed rate for the first part of your loan term, and then your interest rate can go up or down based on the movement of a benchmark, such as the prime rate.
“An ARM is an attractive program for someone who is planning on living in their home for less than 10 years,” says Alan Rosenbaum, founder and CEO of GuardHill Financial, a mortgage banking and brokerage firm in New York. “It comes with a lower rate than a fixed-rate mortgage and is locked in for a stable period of five to 10 years before it can adjust up or down.”
“An ARM with an interest-only option is ideal for homeowners whose income fluctuates, since they have the option of how much principal they want to pay each month,” Rosenbaum says.
3. Mortgage insurance. Mortgage insurance protects lenders against the risk of borrowers defaulting on their loans.
Most mortgage lenders will require you to buy private mortgage insurance, or PMI, if your down payment is less than 20% of your home’s purchase price, or if you’re refinancing and your equity is less than 20% of your home’s value.
If you’re paying PMI and your equity reaches 20% of your home’s purchase price, your lender may be willing to cancel your PMI.
For loans backed by the Federal Housing Administration, or FHA, you can make a down payment of as little as 3.5%, but you must pay a mortgage insurance premium, or MIP. You make a MIP payment upfront, at closing, and then pay annual premiums spread across your monthly mortgage payments.
If your down payment on an FHA loan is less than 10% of your home’s purchase price, you’ll be required to pay your MIP for the entire term of your loan. If you put more than 10% down, you’ll pay MIP for only 11 years.
4. Taxes. In addition to your mortgage payment, your lender might collect property taxes and keep the money in an escrow account until your property tax bill is due, then pay it on your behalf.
But it’s possible you may have to pay your property taxes on your own, so you should get this issue nailed down with your lender — so you won’t miss a payment.
5. Homeowners insurance. Some lenders may require you to pay for home insurance, which covers damage to your house caused by weather, accidents and natural disasters. Rates for home insurance have been going up, so be sure to shop around and compare premiums.
As with property taxes, your lender might collect your homeowners insurance premiums as part of your mortgage payments and keep the funds in an escrow account until it’s time to pay your bill. It’s a good idea to confirm this with your financial institution, just to make sure.
The different types of mortgages
Most mortgages are made up of the same core elements — principal, interest, monthly payments, and so on — but different types of home loans have their own unique conditions you should know about.
1. Conventional mortgages. These are the most common mortgages taken out by U.S. homebuyers and homeowners.
The requirements for getting a conventional mortgage are stricter than for a government-sponsored loan, such as an FHA mortgage.
Conventional mortgages are typically available only to people with good credit. The minimum credit score to qualify for a conventional loan is typically around 620.
These mortgages require private mortgage insurance if the down payment amount is less than 20% of the home’s purchase price.
There are two main types of conventional loans: conforming and nonconforming.
2. Conforming mortgages follow specific dollar-amount limits set by Fannie Mae and Freddie Mac, two government-sponsored agencies that buy mortgages from lenders and sell them as investments while guaranteeing the underlying loans.
The limits for single-unit homes in 2020 are:
- $510,400 for most states.
- $765,600 in high-cost areas, plus Alaska, Hawaii, Guam, and the U.S. Virgin Islands.
3. Nonconforming mortgages, or jumbo loans, are larger loans that go beyond the limits.
Without the blessings of Fannie Mae and Freddie Mac, conforming loans are considered higher risk and often come with higher interest rates and require larger down payments, usually 20% of the purchase price or more.
4. FHA loans. FHA loans are guaranteed by the Federal Housing Administration and are designed to benefit first-time homebuyers and those with lower or middle incomes.
The guidelines for FHA loans are less strict than for conventional loans: They require a lower minimum credit score to qualify — usually around 580.
The minimum down payment for an FHA loan is 3.5% of the loan amount. But again, any down payment under 10% of the purchase price will require you to pay a mortgage insurance premium (MIP) for the entire life of the loan, which can get pricey depending on the length of your term.
5. VA loans. VA loans are guaranteed by Department of Veterans Affairs and are available to active service members, veterans, and some surviving military spouses.
VA loans offer major benefits. They require no down payment or mortgage insurance, but borrowers do pay an upfront funding fee.
The fee typically ranges from 1.25% to 3.6% of the total amount of the loan, depending on your down payment amount and whether it’s your first VA loan.
6. USDA loans. USDA loans are mortgages for rural and suburban homeowners that are guaranteed by the United States Department of Agriculture and require no down payment and no private mortgage insurance.
You’ll have to pay an upfront guarantee fee of 1% of the loan amount and an annual fee of 0.35%, but these costs are generally more affordable than paying for mortgage insurance.
There are income limits to qualify, so you won’t be able to take out a USDA loan if your household earns too much.
The current income limits in most parts of the U.S. are $86,850 for one- to four-member households and $114,650 for five- to eight-member households, but the thresholds may be higher if you live in a county with a steeper-than-average cost of living.
7. Second mortgage. A second mortgage, also known as a home equity line of credit (HELOC), is a loan on a home that already has a primary mortgage.
It allows you to tap the equity, or value, you’ve built up in your home to cover expenses such as home improvements or your kid’s college tuition.
If you can’t make your mortgage payments, your lender will be able to foreclose on your home and sell it to recoup the company’s losses.
A second mortgage must be paid off after your first mortgage, so if you stop making payments your second lender won’t be paid until your primary lender has been fully reimbursed.
How to get a mortgage at the lowest interest rate
Now that you’re up to speed on the basics of mortgages, here’s the part that you’ve been waiting for: how to get a loan at the lowest interest possible. Maybe one of today’s 30-year mortgages with rates under 3%.
The key is to make yourself as appealing as possible to a lender.
1. Boost your credit score. When you have a higher credit score, you’ll be seen as less risky — and will be rewarded with a better interest rate.
Credit scores are determined by information in your credit reports, including your payment history, the balance-to-limit ratios on your credit cards, the length of your credit history, and your current amount of debt.
The easiest way to increase your credit score is to pay your bills on time and keep your credit card balances low.
If you’re not sure about the current status of your credit score, get a free score online to find out.
2. Lower your debt-to-income ratio. Your debt-to-income ratio compares your monthly debt payments to your monthly gross income, and keeping it down can be a great way to get a better rate on your mortgage.
A lower ratio demonstrates to your lender that you have enough money to comfortably make your mortgage payments every month.
The ideal ratio is 36% or less, which signals that you’re managing debt well and have money left over after paying your monthly bills.
If your ratio is higher than 50%, that means you’re stuck spending a substantial portion of your monthly income on debt — not a good look if you’re applying for a mortgage.
The two primary ways to lower your debt-to-income ratio are to increase your income — maybe by taking on a part-time job or asking your boss for a raise — and to pay off your debt.
If you can get your debt fully paid off, maybe with the help of a debt consolidation loan, your ratio will drop down to 0% — which is a level that any lender will find very appealing.
3. Make a larger down payment. Another strategy for scoring a low mortgage rate is to make a larger down payment when you buy a home.
If you’re planning to take out a conventional loan, aim for a down payment of 20% or more of the purchase price so you can avoid that pesky private mortgage insurance.
If you qualify for an FHA loan, try to make a down payment of at least 10% of the price of your home to avoid getting locked into a mortgage insurance premium for your entire mortgage term.
Although having to make a larger down payment will put more of a strain on your bank account, the long-term savings that come when you land an ultra-low mortgage rate will be worth it.