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.
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.
Don’t let your desire to upgrade your home downgrade your home’s market value. Before you make a renovation fantasy a reality, consider whether the project will pay off when you’re ready to sell. Plenty of home improvements add value, but others — like these five — can hurt it.
1. A chef-quality kitchen
If you love to cook, a high-end kitchen could be the ultimate gift — for you. But if you think a massive overhaul will majorly impact resale value, you might be in for a surprise. An upscale kitchen renovation recoups just 54% of its cost in added value, according to Remodeling magazine’s 2020 Cost vs. Value report.
“If you do marble countertops and high-end appliances, you could spend $100,000, and it doesn’t necessarily mean your house is worth an extra $100,000,” says Beatrice de Jong, a consumer trends expert for Opendoor, a San Francisco-based direct home buyer and seller.
Smaller kitchen upgrades could yield a bigger payoff. Chris Arienti, broker and owner of Remax Executive Realty near Boston, suggests keeping updates reasonable: Think granite rather than marble, and GE instead of Sub-Zero.
2. DIY painting
A bold statement wall can say the wrong thing to potential buyers if the workmanship is questionable. Streaky, chipped or low-quality paint can knock $1,700 off a home’s sale price, according to Opendoor data that looked at home offers made from June 2018 to June 2019.
“A good paint job is not easy,” says Sarah Cunningham, a real estate agent with Ethos Design + Remodel in Boise, Idaho. “It is all in the prep work, and most people don’t want to do the prep work.” Hiring a professional to paint can help ensure a more attractive result.
3. An expanded master suite
Knocking down a wall to create an oversize master bedroom or stealing closet space to build out a spa-style bathroom may sound dreamy. But how about as a selling point? “If you go from five bedrooms to four, and you can make it work, no big deal,” Arienti says. But he cautions that losing a bedroom in a smaller house could mean a lower selling price.
As for cutting into closet space, residential building codes don’t mandate that bedrooms have closets. But, Arienti says, “Once you take the closet out of a bedroom, to a buyer, that no longer looks like a bedroom.”
4. Plush wall-to-wall carpeting
Carpet can be especially unattractive to first-time home buyers, who may be used to landlords updating carpet between renters, de Jong says.
“In general, people are grossed out by [carpeting]. It can make a room look a little bit dated.”
It can also ding your sale price. Carpet as the primary flooring in a house drops the value by $3,900 — and carpeting in the master bedroom causes a $3,800 plunge, according to Opendoor. Conversely, a 2019 report from the National Association of Realtors estimated that sellers could recoup the entire cost of refinishing hardwood floors. New wood flooring could actually add value, with sellers getting $1.06 for every dollar spent according to NAR.
5. A swimming pool
It doesn’t matter if it’s infinity edge or above-ground: Any pool can be seen as a drawback by buyers who don’t want to deal with maintenance or insurance. Even in Florida, a pool doesn’t add value, Liede DeValdivielso, a real estate agent with the Keyes Company in Miami-Dade, said via email. If you’re thinking resale, it’s not worth it — you’ll never recoup the cost, DeValdivielso said. But if you’ll use it and enjoy it, put in a pool.
How to decide if a renovation is worth the cost
To ensure you’re making an informed decision:
- Consider your timeline. “If you’re going to be in the home for 30 years, you can do anything, because at that point, your mortgage is paid off,” Arienti says. Looking to sell in the near future? Pay closer attention to whether your choices will appeal to a potential buyer.
- Consult an expert. “Talk to a professional so you aren’t making misinformed choices that are going to work against you in five to 10 years,” Cunningham says. A designer can help you tell fleeting trends from future classics; a contractor can explain what kind of work a proposed renovation would entail.
- Compare home features in your area. De Jong suggests looking at comparable homes for sale near you and going to open houses to make sure your improvements align with the norms for your neighborhood.
- Get an appraisal. A licensed appraiser can do a feasibility study to estimate your home’s current value and its likely value after the improvements.
10 TERMS YOU’LL LIKELY ENCOUNTER IN A REAL ESTATE PURCHASE CONTRACT
Purchase offers are legally binding contracts. Every state has its own real estate laws, and local real estate boards use different standard forms.
Ask your Accredited Buyer’s Representative to give you a copy of the standard contract so you can review it before searching for homes. That way, you can get familiar with the legal terminology and ask questions before you find a home you’d like to purchase.
Here are ten of the most common clauses:
Of all real estate contract terms, the purchase price may be the easiest to understand and the hardest to agree upon. If the seller is asking too much relative to recent comparable sales, your buyer’s rep may suggest attaching a report that helps defend your offer price.
Also, the seller may be willing to accept a lower price if you include other desirable terms in your offer, like a quick closing date or an all-cash purchase.
2. Closing Date
The closing date (also called settlement date) is the proposed date when ownership will be transferred to the buyer.
It’s an essential contract term that keeps both parties on track to meet their respective obligations. That said, unexpected delays may occur from completing inspection repairs or finalizing your financing, for example.
The purchase agreement includes provisions for situations when the buyer or the seller can’t meet the closing date, potentially including penalties. It’s also possible that the sale could be canceled.
Typically, buyers have ten days to conduct a professional home inspection once the sellers accept their offer. Your buyer’s agent can provide recommendations, but it’s your responsibility to hire the inspector.
Depending on the findings in the inspection report, you may need to negotiate repairs with the seller or agree to an adjustment in the purchase price.
Your purchase may be contingent upon securing funding with a mortgage company. This section of the real estate contract spells out the key terms of your mortgage commitment, such as the size of your down payment and the type of loan (for example, FHA or conventional).
Typically, sellers prefer buyers with larger down payments or who have already received pre-approval (which is stronger than being pre-qualified). These differences can be particularly significant in situations where you’re competing with other buyers.
5. Attorney Review
Real estate professionals are not licensed to practice law but are allowed to help home buyers (or sellers) enter into real estate contracts. This is why most real estate contracts include an attorney review clause, which gives both parties time (typically three to five days) to secure an attorney’s review and potentially cancel the contract under specific provisions.
Sellers are required to complete property disclosures that reveal various defects or improvements that may affect the home’s condition. Required disclosures vary by market, but common examples include revealing the presence of lead-based paint (a federal law), asbestos, or other environmental hazards.
Usually, disclosure documents are given to buyers once the seller has accepted your offer. In some cases, you may receive them before submitting a contract. Either way, buyers must sign off on all disclosures.
For sellers, it’s best to reveal everything about a home upfront because the transaction is less likely to fall apart. Also, if you discover after closing that the sellers lied on their disclosure forms, you may be able to take legal action against them.
7. Escrow of Earnest Money
As a buyer, you’ll need to show the sellers that you’re seriously interested in purchasing their home by depositing earnest money (also called a good faith deposit) into an escrow account.
Your buyer’s representative can advise you on local market conventions, but as a rule, the earnest money is 1% to 2% of the total home purchase and is applied to your down payment at closing.
Your purchase contract should stipulate where your escrow deposit will be held (typically a title company or the real estate broker) and how much you’ll be refunded if the transaction fails to close under various conditions.
8. Adjustments at Closing
This section of a purchase contract outlines any modifications to the property’s purchase price to accommodate the payment of property taxes, utilities, municipal assessments, association fees, etc.
For example, if the seller made a semi-annual property tax payment two months before closing, the buyer will need to “reimburse” the seller for the remaining four months.
9. Title Insurance Affidavit
An affidavit of title is a document that proves the seller owns the property and can legally convey ownership to you. It helps ensure that there are no claims against the property, such as a mechanic’s lien, which might happen if the seller hires someone to complete work on the home but doesn’t pay them.
10. Other Addendums
Additional terms and conditions beyond the general forms can be added to a real estate purchase contract as an addendum.
Typically, this is where you’d spell out requests to include personal property, ask for a home warranty, request information about the property’s Homeowners Association, or make other stipulations.
As a buyer, it’s essential to make sure that you clarify all the terms and conditions of your purchase. At the same time, you’ll need to balance these requests against your desire to successfully negotiate a purchase with a seller.
What Exactly Do Closing Costs Cover?
A home costs more than just the sale price. For example, closing costs—which make up about 2% to 5% of the home’s purchase price—are a major added expense. Michael Hyman, a research data specialist at the National Association of REALTORS®, shares the charges that make up closing costs in a post at the association’s Economists’ Outlook blog so that home buyers can be prepared.
Lenders provide a Closing Disclosure at least three business days prior to closing on a mortgage. But buyers will need to budget for these added costs ahead of time to avoid sticker shock days before closing.
Origination fees. This is the fee charged by lenders for processing the application and underwriting it. The fee typically ranges from about 0.5% to 1% of the borrower’s mortgage. Sometimes, it’s higher for smaller loans because “the fixed costs are a higher percentage of a smaller balance,” Hyman notes.
Service charges. These include items such as the appraisal, credit report, flood determination and certificate, tax status, pest inspection, title search and insurance, and survey fees. Appraisals and surveys can cost anywhere between $300 to $500 each. Title services can add up to about $2,000, so buyers may want to shop around for that.
Transfer taxes and recording fees. Transfer taxes vary by state but can run up to 2.7% in parts of New York. “It does not matter if the buyer or seller pays, as long as the transfer tax is paid to the government, so transfer taxes can be negotiated between the buyer and seller,” Hyman writes.
Escrow items. Homeowners insurance, property taxes, and primary mortgage insurance (if applicable) also are added fees. Buyers moving into a homeowners association may need to pay monthly dues for the upkeep of the community.
Hyman offers the following example for how these costs can add up: A buyer is purchasing a $275,100 home with a 5% down payment. The loan amount is $261,345. Closing costs are estimated at 2.5% of the loan value—so $6,533. The buyer made a $2,000 earnest money deposit, so they would need to bring $4,533 in cash at the time of closing. “Altogether, this means that the potential homeowner will need to have access to approximately $18,300 in cash to pay for the down payment and closing cost net of the earnest money deposit,” Hyman says.