What is a Mortgage? A Complete Guide

A mortgage is the biggest and most important debt that the average American will procure, helping over 7 million consumers to secure sizable assets every year. With an average balance of $202,000, these loans have contributed over $10 trillion to the US national debt crisis—17x more than credit cards and 7x more than student loans. 

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But how easy is it to get a mortgage, what do you need to consider when applying, and how does interest work?

Whether you’re applying for a first mortgage, a second mortgage or just have a few questions about the process, this complete guide to home loans can help.

How to Get a Mortgage: 5 Steps

Looking to acquire a mortgage? Here are a few simple tips to help you on your journey and ensure you get the best rate:

Work on your Credit Score

Check your credit report, make sure it is accurate and dispute anything that doesn’t belong. You will need a score of 620 or higher for a conventional mortgage and the higher it is, the better, so start building that score and improving your chances:

  • Always pay your bills on time.
  • Increase available credit limits (without using them) to improve your credit utilization score (this compares current debt to available credit and accounts for 30% of your score).
  • Increase monthly payments to clear more of the principal and reduce total interest.
  • Don’t close credit cards once they have cleared otherwise your credit utilization will take a hit.
  • Avoid unnecessary inquiries and new accounts.
  • Use a secured credit card or lending circle if you’re struggling to improve your credit.

Check Your Debt-to-Income Ratio

Your debt-to-income ratio (DTI) doesn’t have a direct impact on your credit score but it will be used by a prospective lender to determine your creditworthiness. You can learn more about calculating this ratio on our Debt to Income Ratio Calculator, but in simple terms, it is a percentage figure that represents how much of your gross income is spent on debt.

As an example, if you have an income of $5,000 and spend $1,000 on credit card and loan payments, you have a DTI of 20%. Lenders often accept scores of less than 43%, but lower is always better and it’s preferable to remain under 30%.

Start Saving

A 20% down payment will allow you to avoid private mortgage insurance, which can be very costly and will greatly inflate your monthly payments. A down payment will also reduce the loan required (a $200,000 house will require a $160,000 loan as opposed to the $193,000 needed for a 3.5% deposit), which will significantly decrease your interest payments.

If you’re currently living with family and not paying rent, use a mortgage calculator to determine how much your monthly payment would be and then save at least that amount every month. Not only are you proving to yourself that you can make those payments when the time comes, but you’re also saving towards your down payment.

Don’t stop when you reach that 20% sum, either. Moving to a new house is expensive and there are a lot of hidden fees to cover. It also helps to have a rainy-day fund you can tap into during an emergency (medical bills, broken appliances, etc.,) and ensure your affordability won’t be affected.

Look for a House

You don’t need to actively view houses, but you should start scanning local realtors to see what’s available and to get an idea of what sort of budget you will need. The average first-time buyer spends at least 6 months searching for a house and some spend several years, because the houses they want are out of their budget and this stark realization doesn’t hit until they’re ready to buy.

Be realistic about what you can afford, compare it to what you need, and decide if you’ll be ready when planned or if you’ll need to save more money and improve your credit score.

Get Pre-Approved

Once you have a stable income and a solid credit score, you’re ready to get pre-approved for a mortgage. There are no commitments here and you won’t be given the home, you’re just allowing mortgage companies to run some checks to make sure you qualify. Once they do—and providing your credit score or employment doesn’t change significantly—you’ll be ready for a quick and easy mortgage application when the time comes.

Choose your Mortgage  

It’s time to start shopping around with banks, credit unions, and mortgage lenders. Don’t accept the first offer you receive, don’t rush in, and give yourself plenty of time to compare and contrast. 

There will be a lot of paperwork and an equal amount of frustration. You may also receive a few setbacks, but eventually, you’ll get what you need and when you do you’ll be ready to purchase a new home!

Mortgage Interest

Depending on who you ask and when you ask them, the average credit card interest falls somewhere between 17% and 20% while personal loans are between 9% and 15%. The average mortgage rate, however, is between 3% and 4%.

A 3% interest rate on a loan of $100,000 means you’ll pay $103,000 in total. Or it would if interest calculations were simple. But they’re not.

Mortgages are fully amortized loans. This means that the amount you pay every month will remain the same, but the ratio of interest/principal will change. There are generally four different parts of a mortgage payment:

  • Principal: The original balance. Once this has cleared then the debt has been repaid. On a $200,000 mortgage, the principal will be $200,000. The principal payments also start small and then gradually increase, with more of your total mortgage payment being allocated to that $200,000 balance.
  • Interest: A sum of money added to the principal and paid to the lender. This incentivizes them to loan you money. The higher the interest rate and the longer the term, the greater this sum will be. Most of your initial mortgage payments comprise of interest payments and these decrease over time.
  • Taxes: Property taxes are levied to cover public services and education. These are calculated annually but can be added to your monthly payment. Taxes are paid to the lender, which then holds them in Escrow before releasing them to the government when due.
  • Insurance: Insurance payments are also levied every month and then held in Escrow until the due date. All insurance payments include coverage for property insurance, protecting the home from fire, damage, and theft. If the mortgage originated with a down payment of less than 20%, then Private Mortgage Insurance (PMI) is also required. This insurance type covers the lender in the event the borrower can’t meet their obligation.

It is possible to pay only principal and interest, but the borrower will then be responsible for paying taxes and insurance.

How Much of a Mortgage Payment is Interest?

The older a mortgage is, the more of the principal you will repay every month. As an example, let’s assume you have borrowed $200,000 over 30-years with a 4% fixed interest. Every month your bill will come to $954.83 without taxes and insurance. In the first month, just $288.16 of that will go towards the principal while $666.67 will cover the interest.

For your second payment, $1.04 will be taken from the interest and added to the principal. This gradual change will continue every month for the term of the loan until, in the final year, just $40.43 of your $954.83 will go towards interest while $914.40 will cover the principal.

For each of those 30 years, your repayments and balance will look like this:

Year

Principal

Interest

Monthly Payment

Yearly Payment

Balance End of Year

1

$3.522.04

$7.935.92

$954.83

$11.457.96

$196.477.96

2

$3.665.55

$7.792.41

$954.83

$11.457.96

$192.812.41

3

$3.814.89

$7.643.07

$954.83

$11.457.96

$188.997.52

4

$3.970.32

$7.487.64

$954.83

$11.457.96

$185.027.20

5

$4.132.06

$7.325.90

$954.83

$11.457.96

$180.895.14

6

$4.300.43

$7.157.53

$954.83

$11.457.96

$176.594.71

7

$4.475.63

$6.982.33

$954.83

$11.457.96

$172.119.08

8

$4.657.98

$6.799.98

$954.83

$11.457.96

$167.461.10

9

$4.847.76

$6.610.20

$954.83

$11.457.96

$162.613.34

10

$5.045.26

$6.412.70

$954.83

$11.457.96

$157.568.08

11

$5.250.80

$6.207.16

$954.83

$11.457.96

$152.317.28

12

$5.464.74

$5.993.22

$954.83

$11.457.96

$146.852.54

13

$5.687.39

$5.770.57

$954.83

$11.457.96

$141.165.15

14

$5.919.09

$5.538.87

$954.83

$11.457.96

$135.246.06

15

$6.160.24

$5.297.72

$954.83

$11.457.96

$129.085.82

16

$6.411.21

$5.046.75

$954.83

$11.457.96

$122.674.61

17

$6.672.40

$4.785.56

$954.83

$11.457.96

$116.002.21

18

$6.944.27

$4.513.69

$954.83

$11.457.96

$109.057.94

19

$7.227.18

$4.230.78

$954.83

$11.457.96

$101.830.76

20

$7.521.64

$3.936.32

$954.83

$11.457.96

$94.309.12

21

$7.828.08

$3.629.88

$954.83

$11.457.96

$86.481.04

22

$8.146.99

$3.310.97

$954.83

$11.457.96

$78.334.05

23

$8.478.94

$2.979.02

$954.83

$11.457.96

$69.855.11

24

$8.824.37

$2.633.59

$954.83

$11.457.96

$61.030.74

25

$9.183.88

$2.274.08

$954.83

$11.457.96

$51.846.86

26

$9.558.06

$1.899.90

$954.83

$11.457.96

$42.288.80

27

$9.947.46

$1.510.50

$954.83

$11.457.96

$32.341.34

28

$10.352.76

$1.105.20

$954.83

$11.457.96

$21.988.58

29

$10.774.52

$683.44

$954.83

$11.457.96

$11.214.06

30

$11.214.06

$244.48

$955.41

$11.458.54

$0.00

 

You will make 360 payments during the term of this land and repay a total of $343.739.39, of which $143.739.39 is interest.

When Do Mortgage Payments Begin?

Your first mortgage payment is due a month after the purchase and is always paid in arrears, which means you pay on the first of December to cover the funds due in November. As an example, if you close the sale on November 1st, your first payment will be due exactly 1 month later on December 1st. However, if it begins on October 20, then your first payment, which will include the fees accrued for the remainder of October as well as all of November, will due December 1st.

Why the Interest Rate is so Important

There are two main types of interest rate: Fixed and Variable. A fixed interest rate is set at the beginning of the mortgage while a variable rate is subject to change. Interest rates are generally very low with mortgages and you could be forgiven for thinking that there wasn’t a great difference between 3% or 4%, or even 3.4% and 3.5%. But over the term of the loan, this can amount to a considerable sum of money.

In the above example, we looked at a 30-year, 4% mortgage of $200,000, which paid $143,739.39 in total and $954.83 a month. If we decrease that rate to 3%, the monthly payment drops to $843.21 and the total interest to $103.554.53. If we increase it to 5%, the monthly payment climbs above $1.070 and the total interest above $184.000.

The difference between 3.4% and 3.5% on a home loan of $200,000, is more than $4.000 over the loan term and around $12 a month.

In other words, every digit counts and you should fight for the lowest interest rate that you can get, whether that means spending more time shopping around, or devoting some time to improving your credit score.

Private Lender vs Bank: When it the Right Time to Buy?

In 1960, the average first-time buyer was 24, married, and in full-time employment. They saw their first home as a permanent residence, a place to settle down, remain and then pass onto their children. Fast forward to today, and things are a little different.

The cost of living has increased in relation to the average wage, couples are not tying the knot until their late 20s/early 30s (the average is 28), and they’re devoting more of their 20s to education. As a result, the average age of a first-time buyer is 34 (although it’s not all doom and gloom, because contrary to what you might think, it’s actually lower than it was in 2000).

Times are changing, Americans no longer feel the need to rush and are more willing to rent, and that’s a good thing. This is a long-term commitment—the biggest loan you will ever get. It’s not something to be taken lightly.

There is an argument to suggest that it’s better to buy sooner rather than later, especially if you’re currently paying rent. But if you rush in when you can’t afford it, your options will be limited, and what you save in rent you could lose with higher rates.

Private Mortgage Insurance is around 1% of the loan amount on average and it’s charged every year. Based on the average US mortgage, it could cost you an extra $200 to $250 a month. Private mortgages also charge higher interest rates, sometimes twice as high as a conventional bank.

If your options are to wait, spend a few more years paying rent, save for a down payment and build your credit, or rush in, get a private mortgage and grab that asset, it’s nearly always better to opt for the former. Assuming that down payment will come and you have a respectable credit score (see our guide to What Credit Score is Needed to Buy a House) this is a much cheaper and more sustainable option.

What Happens if You Don’t Make Payments?

Contrary to popular belief, banks are not hellbent on foreclosure. It’s actually a very costly process, with legal fees, maintenance, and a cut-price eventual sale that leads to a loss of at least $50,000. Still, they can be very ruthless and it’s imperative that you meet your monthly obligations to avoid the following process:

Penalty Fee

If you don’t meet your monthly payment then you may be charged a penalty fee after 10 or 15 days, depending on the length of the grace period. Details of this period and the late fees will be included in the mortgage documents but it is usually around 5% of the overdue payment.

If your mortgage payment is $1,000, for instance, your late fee will be $50, creating a total overdue payment of $1,050. These fees will increase if you don’t pay the overdue balance.

Default and Inspection

If you still don’t make the payment, your home loan will enter a state of “default” after 30 days and the lender may exercise its rights to initiate a property inspection, which they will charge for. An inspection may be ordered as soon as the loan defaults.

Credit Score Drop

The lender reports all information to the three credit bureaus and at this point a derogatory mark will appear on your report, reducing your credit score in the process. This occurs after the 30 period, when one overdue payment runs into another.

Foreclosure Begins

Foreclosure is initiated once the payment is 120 days overdue. This process differs from state to state, but generally, the borrower will be hit with foreclosure fees and the process will begin, with the lender seeking to sell the house and recover their costs.

Getting Help with Payments

To avoid the foreclosure process and the chaos that precedes it, you need to act quickly and face the consequences. It’s important not to bury your head in the sand, because unlike some unsecured debts, this is not something that will simply disappear in time.

Here’s what you should do if you find yourself struggling to make payments:

Forbearance Plan

In the first instance, you should contact your lender and discuss this process with them. As mentioned above, they’re not in any rush to foreclose and will generally do what it takes to avoid this process. If that means creating a refinance plan, known as a forbearance plan, and making your payments more manageable, they’ll be more than happy to do it.

They may also put your payments on hold. However, this is only a temporary solution to help you through difficult times.

A Deed-in-Lieu of Foreclosure

You hand over the deed to your property and in exchange, they will forgive some or all of your debt. This will prevent the foreclosure process, saving you the hassle and reducing some of the costs for the lender.

Repayment Plan

If you miss a few payments, your lender may create a repayment plan, whereby your previous missed payments are added to upcoming ones. This ensures that your debts are paid, after which you can get back on track and prevent further complications.

A Short Sale

A short sale occurs when you sell the property and use the funds to repay the mortgage company. It’s available for any home that has dropped below the total value of the mortgage. 

Summary: A Lifetime Commitment

A mortgage is a lifetime commitment and not something that should be taken lightly. Take your time, understand the process, the costs, and the potential pitfalls, and make sure you’re fully prepared before making the commitment.

If you need any more tips on buying a home, improving your credit score or managing your other debts, check out our many other guides to personal finance issues.