Mortgage Lending 101
what is a mortgage
Mortgages are often referred to as a loan made by lenders for purpose of buying a home.
Note that the term "mortgage" actually refers to a contractual agreement that gives the lender the right to possess your home if you fail to pay back your loan obligations.
What are the Loan Obligations
There are three part to a mortgage contract:
the original amount that you borrow with an obligation to repay the amount over a set term.
a percentage amount that you agree to pay the lender for use of the principal amount until the full amount is repaid.
the length of time (generally in months) to repay the loan amount .
the lender gives a home buyer $100,000 (principal) to buy a home. The buyer agrees to pay 10% annually (interest) on the loan balance until the entire amount has been repaid.
If the buyer pays interest-only payments, s/he will pay the lender $10,000 each year for use of the loan:
(calculated as: $100,000 X 10% = $10,000)
However, the buyer wants to repay the loan over a length of time (term),
so s/he will make additional payments over the required interest payment to reduce the principal amount to zero.
There is a mathematical formula that displays in an amortization schedule the monthly amount the buyer must pay in order to reduce the loan to zero over a certain period; i.e., 30 years.
All amortization schedules use a term: the most common term is 30 years (360 months). But other terms may include 10, 15, 20 and 25 years; there are even 40-year and 50-year mortgages in some markets.
During the first few years of the repayment schedule, the monthly payment will almost entirely be of interest with a little amount left over to repay the principal.
But as time goes on, more of the payment will repay the principal amount and less on the interest. Below is an illustration of a 360-month amortization schedule for $100,000 borrowed at 10%:
Note: the 10% rate is for example only. Current mortgage interest may differ. View current rates.
Mortgage Lending Components
The Purchase Price:
This is the agreed upon purchase price of the home between the seller and buyer.
The Down Payment:
The down payment is an amount that you pay out of your own pocket on the purchase price of the home. The remaining portion is the amount borrowed from the lender.
Most lending institutions require that you pay at least 20% percent of the home purchase price.
- Any down payment that is less than 20% of the purchase price may require Private Mortgage Insurance (PMI).
PMI protects the bank against potential losses in the event of a loan default or foreclosure. PMI adds to your total monthly payment. Since PMI is not tax deductible, it is in your advantage to put down 20% or more to avoid PMI.
For more information about PMI: click here
- Relatives can help with the down payment by "gifting" some of the money.
You will be required to report the gift when applying for a mortgage loan. If you are obligated to repay the "gift", this obligation may impact your debt-to-income ratios (or PITI ratio).
For more information about ratios: click here
The Home Loan:
If your qualify, your lending institution will give you a loan that pays the seller for the purchase price of the home minus your down payment.
The type of loan the lender gives you depends on the your qualifications and how you want to repay the loan.
When you sign a mortgage agreement, you agree to repay monthly the amount you borrowed (the principal) plus the interest that the lender charges for the borrowed amount.
See mortgage loan calculation for estimating your mortgage monthly payment.
Lenders use an amortization schedule to figure your monthly mortgage payments. Most amortization schedules use a 30-year repayment period; however, you can get a 10-, 15-, 20-, or 25-year repayment schedule.
The amortization schedule first calculates the interest charges for the month on the amount you borrowed and then adds an amount to repay the loan based on a 30- or 15-year repayment schedule.
You can download our Loan Amortization worksheet to analyze your own numbers (Excel worksheet):
download loan amortization worksheet
The First Mortgage:
Generally referred to as the first loan on the home. It is the mortgage loan that purchased your home.
The Second Mortgage:
Any second loans on the home are referred to as second mortgages. Lenders will lend money secured by the equity in your home for making home improvements, consolidating debts, sending your child to college, etc.
You can calculate equity by subtracting your home's market value from the amount you owe on your first mortgage.
The equity value in most new home purchases is the down payment. Some lenders will allow you to borrow against your down payment.
The escrow is a depository account that the bank manages.
Part of your total monthly payment includes bank collections for property taxes, hazardous insurance, PMI, and other expenses related to your home. These collections are held in escrow until payments are due.
These escrow charges can add to your total monthly payment: see our information on escrow charges and to estimate your monthly escrow payment.
Points are prepaid interest that lenders charge for the cost of borrowing money. A point equals 1% of the amount you borrow. Charging points is a standard practice among mortgage lenders.
Points can raise your APR. One point is roughly equivalent to one-eighth raise in your initial rate on a 30-year mortgage. Example, a 30-year mortgage rate at 9% and 2 points is roughly equivalent to an APR of 9.25%.
For more information about APR: see rate notes
Closing costs are fees for professional appraisals, surveys, title searches, loan documentation, inspections, points, and other services required by law and your lender that are related to the purchase of your home.
You will be obligated to pay these costs before taking ownership of your home: view our closing cost checklit below
Upon completion of your application, you will receive a "Good Faith" estimate that itemizes your projected closing costs. This is an estimate only and does not signify the true amount of your closing costs. Costs may vary by area.
Some mortgage lenders charge pre-payment fees. If you pre-pay your mortgage loan prior to a specified date. Check with your lender on pre-payment penalties.
You want want to avoid prepayment clauses if you plan to pay down your mortgage early or to refinance it at a later time.
Combo Home Mortgage / Home Equity Closing:
Some homeowners who are looking to borrow against their down payment and will close a home equity loan or home equity line of credit in addition to their home mortgage loan.
The advantage is that all the paper work required for closing your mortgage can be used to close your home equity.
Homeowners will use this extra borrowing to make home improvements, buy furniture, landscape the yard, or fix-up their home purchase.
- You need to request from your mortgage lender information
about closing a home equity along with your mortgage loan. For more information about home equities, click to visit our affiliate site at: www.YourEquity.com
Understanding Mortgage Loan Programs
are mortgage loans provided by lenders
and not by government-sponsored loans (FHA, VA or RHS). There are many loan
types to select from. Categories include:
- fixed rate loans
- adjustable rate loans (ARMs)
- combination (hybrid) fixed-ARM loans
- balloon mortgages and pledge asset loans
- jumbo / construction loans
- reversible mortgage
Conforming loans are conventional loans that meet terms and conditions set forth by Fannie Mae and Freddie Mac.
These two stock-holding companies that purchase mortgage loans from lending institutions and secure them for resale to the investment community. Buying back mortgage loans allow these agencies to provide a continuous flow of affordable funding to banks who reinvest their money back into more mortgage loans.
Fannie Mae and Freddie Mac establish maximum loan amounts, income requirements, down payment requirements, and type of suitable properties.
Loans that do not conform to these guidelines are referred to as non-conforming loans.
Link to the Fannie Mae and Freddie Mac web sites for more information:
Jumbo Mortgage Loans:
These are loans that are above the maximum loan amounts established by Fannie Mae and Freddie Mac.
Rates on jumbo loans are generally a little higher than conforming loans. Jumbo loans are used to purchase expensive and high-end custom construction homes.
Loans that do not meet the credit requirements of Fannie Mae and Freddie Mac are referred to as B, C and D paper loans. Loans of this type are made to applicants that have filed for bankruptcy, foreclosure and who generally have bad credit.
These loans are temporary loans until the applicant can qualify for conforming "A" loans. The interest rate on B/C loans varies, but are generally higher than conforming "A" loans.
FHA loans have lower down payment requirements and are easier to qualify for than conventional loans. FHA loans are administered by the Federal Housing Administration, which is part of the U.S. Department of Housing and Urban Development.
Link to the FHA web site for more detailed information: www.hud.gov
These loans are sponsored by the U.S. Department of Veteran Affairs. They guarantee loans for eligible veterans, active-duty personnel, and surviving spouses. These loans offer competitive rates, lower or no down payments, and minimum income requirement.
Link to the VA web site for more detailed information: www.homeloans.va.gov
RHS Loan Programs:
Affordable housing for low- to moderate-income level rural residents to purchase, construct, repair, or relocate rural-related facilities. Lower or no down payment is required in most cases.
These loans are guaranteed by the U.S. Department of Agriculture.
Link to the RHS web site for more detailed information: www.rurdev.usda.gov
Who Are the Players
There are four major players that participate in the mortgage lending business:
Lenders of Money:
This would include Commercial Banks, Savings & Loans, Credit Unions, Mortgage Bankers, and others that lend money to prospective borrowers.
Commercial banks, S&Ls, and Credit Unions generally use collected deposits as sources of loans. Mortgage Bankers get loan money from investors or public issued debt.
It doesn't matter where you get the money its all the same. But some lenders (like most Mortgage Bankers) originate mortgage loans and then sell them off.
There are stock-holding companies that buy mortgages for investment reasons. This allows for a continuous source of money into the system so that new loans can be made.
For example, a bank may securitize a percentage of their mortgage loans this means that they take a certain portion of their mortgage loans and sell them to an outside investor.
The money the bank gets from the sale usually goes back into issuing more loans.
The investor now collects a return on their portfolio of mortgage loans, which could be quite attractive considering the interest rates on mortgage loans.
Agencies include the Federal Government, State Agencies, the Veterans Administration, and others.
These agencies do not lend money rather they guarantee loans allowing the lenders to extend credit to low-to-moderate income borrowers, home buyers who have little down payment, and others.
This includes mortgage brokers, real estate agents, lending web sites, etc.
These players act as middlemen who help prospective borrowers find the right mortgage product among multiple lenders.
Loan brokers can be considered as a distribution network (retailer) of mortgage loans from the banks (manufacturers) to the borrower (consumer).
Now who is PickMyMortgage.com: consider us an instructor of the mortgage lending business. Our goal is to educate consumers so that they can negotiate the right product and price.
We also manage a network of loan brokers and lenders. You can submit your application through our network and receive up to four competing offers.
Don't Forget Closing Costs
Expect to pay a number of fees when you close on your home.
Closing is when you formally buy the home and transfer the title from the seller to the buyer. There are two categories of closing costs:
- lender closing costs
- independent 3rd party closing costs
Some closing costs are negotiable.
You are more likely to negotiate lender closing costs. In some "buyers market" where home sales are not as strong, you can often negotiate with the seller to pick up a portion of the closing costs.
Closing costs can average around 7% of the home purchase price.
These costs can vary widely from 3% to 10% depending on your location and whether you pay points. Closing costs are typically paid at the time of closing and can be a significant portion of your home savings. So budget and plan wisely.
For a survey of selected closing fees and charges for home mortgages: click here
What Makes-up Closing Costs:
Upon completion of your application, you will receive a "Good Faith" estimate that itemizes your projected closing costs. This is an estimate of costs only and does not signify the true amount of your closing costs. Costs may vary by area.
Listed below are the most common closing costs with their related range of fees. Please note that fees will differ by location and circumstances:
- Application Fee:
some lenders may charge an application fee to process and finalize your mortgage application. This is generally a flat fee ranging from $75 to $300. Other lenders may charge a percentage of the mortgage loan amount (avoid these lenders).
You should check with your lenders before submitting your application. Some lenders will refund the fee if fail to qualify.
Money Saving Tip:
there is zero cost to submit your mortgage application through our financial network. It is entirely FREE. Lenders will compete for your business and provide an estimate of their terms if they can verify the information that you submitted.
If you choose to work with one particular lender, they may require you to complete a more thorough application where they may charge an application fee.
Negotiate with the lender to waive the fee since much of the information they need to approve your mortgage was provided by our network.
- Appraisal Fee:
lenders must appraise the property to verify its value. Fees can range from $200-500. You can negotiate this fee with the lender on selecting an less expensive appraiser.
- Attorney's Fees:
your attorney (or closing agent) will prepare and review the closing documents. These fees can range from $200-$500.
Some lenders may also charge fees for the lender's attorney services in connection to your mortgage. This is a fee you can negotiate down with the lender.
- Credit Report Fee:
lenders will pull your credit report to qualify you for a loan. This fee is generally passed onto you once your application has been approved. The fee can range from $45-75.
- Escrow Fees:
in most cases, lenders will setup an escrow account to collect fees for paying taxes, homeowners insurance, and other required collections: see escrow account discussion
You will be required at closing in most cases to prepay from 6 months to 1 year of taxes and homeowners insurance. These fees will be placed in escrow and used when tax assessment and insurance premiums are due.
Pre-paid taxes and insurance can range from $1,500 to $4,000, depending on your area and tax assessment.
There is not room for negotiation of prepaid taxes and insurance.
- Loan Origination
these are the points that you pay the lender for extending you a loan. A point equates to 1% of the mortgage loan balance; e.g., $100,000 at 2 points equals $2,000.
Points can be the most significant portion of your closing costs. This is an area where you can negotiate.
view our notes on points
- Lock-in Fee:
if you lock-in your rate at a certain time prior to closing, the lender may charge you a rate lock-in fee.
This fee can range from 0.5% to 1.0% of the mortgage loan amount. Negotiate this fee with your lender prior to locking in your rate.
- Mortgage Insurance:
There may be two types of mortgage insurance:
mortgage default insurance:
private mortgage insurance (PMI) that protects the lender in the event you default on your loan. PMI is required for home buyers whose down payment is less than 20%. Costs may vary.
see our notes on PMI
mortgage life insurance:
insurance that names the lender as the beneficiary in the event of your death. This insurance may or may not be required as part of your closing and may be negotiable.
Recording, Survey Fees:
these are mandatory fees often required by local governments.
The notary fee guarantees the signatures to the document. This fee can range about $50 or less.
Recording fee pays for the recording of closing documents into the county records. This fee is about $50.
Survey fees pays the surveyor to show the exact boundary, location, and legal description. The cost can range from $200-$400 and may be paid by the seller in some areas.
- Title Search and
title search is where the lender (and you) ensure that the property purchase is free and clear of all obligations. This means that no party has a claim on the house because of unpaid dues, legal suits, and other.
Title search will be completed by an attorney or title company. However, some claims on your house can be missed during search. That is why the lender and you want Title Insurance, which protects your home from any claims that may pop-up in the future. Title Insurance is a one-time fee that you pay at closing.
Both the Title Search and Title Insurance are combined into one fee that can range from $400-$700.
Mortgage Lending Options
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