What Is a Mortage and How Does It Work?
A mortgage is an agreement between a lender and a borrower (buyer), that allows the buyer to take ownership of the home, while making monthly payments to the lender. Mortgage loans are used to buy a home or to borrow money against the value of a home you already own. There are numerous types of loans available, with a variety of options related to the associated fees, interest rates, terms, programs and more.
There are seven primary things to look for in a mortgage:
- The interest rate and any associated fees
- The closing costs of the loan, including the lender's fees
- The Annual Percentage Rate (APR)
- The type of interest rate and whether it can change (is it fixed or adjustable?)
- The loan term, or how long you have to repay the loan
- Whether the loan has other risky features, such as a pre-payment penalty, a balloon clause, an interest-only feature, or negative amortization
- Discount Points (the cost associated with obtaining a lower interest rate or “buy-down”)
Focus on a mortgage that is affordable for you given your other priorities, not the maximum amount for which you qualify.
Lenders will tell you how much you are qualified to borrow - that is, how much they are willing to lend you. There are numerous online calculators that allow you to compare your income and debts and come up with similar answers. But how much you could borrow is very different from how much you can afford to repay without stretching your budget for other important items. Lenders do not consider all your family and financial circumstances. To know how much you can afford to repay, you'll need to take a hard look at your family's income, expenses and savings priorities to see what fits comfortably within your budget.
Don't forget other costs when coming up with your ideal payment.
Costs such as homeowner's insurance, property taxes, and private mortgage insurance are typically added to your monthly mortgage payment, so be sure to include these costs when calculating how much you can afford. You can get estimates from your local tax assessor, insurance agent and lender. Knowing how much you can comfortably pay each month will also help you estimate a reasonable price range for your new home.
Learn more about all the costs associated with getting a mortgage
Mortgages are complex and getting a better deal on one part of the mortgage often means paying more elsewhere. For example, one mortgage may have a lower interest rate, but higher closing costs than another offer.
Consider your choices for paying for these costs
All mortgage loans include some costs that you pay upfront, at the time of closing, and some you pay over time, in your monthly payment. You have some choices for how much you pay, and when:
- If you want to lower your interest rate, you can pay discount points. Points, as they are often referred to, are money you pay upfront to your lender in exchange for a lower interest rate. Points increase your closing costs and are typically only a good idea if you plan on staying in the home for many years.
- If you want to reduce your closing costs, you can ask to receive lender credits. Lender credits are money you receive from the lender to offset your closing costs. You agree to pay a higher interest rate in exchange for an upfront rebate that is applied to your closing costs.
- You can do neither. You pay all of your closing costs out-of-pocket up front and get an unadjusted interest rate.
Points and credits let you make tradeoffs between paying more upfront or paying more in your monthly payments
What’s right for you depends on your situation, how long you expect to be in the home, how much cash you have available for closing, and the lender's specific rates.
You can always shop lenders and compare closing costs (and you should)
Comparison shopping for loan offers can help you save money at closing and every month. Be sure to get prequalified before you start looking for a home, so that you’ll know how much home you can afford and to be ready to act quickly when that perfect home comes along. Here are a few important considerations:
- The Annual Percentage Rate (APR) helps you compare options. The APR is a helpful tool for comparing loan options with different interest rates and fees. It takes into account both the interest rate and fees, so you can see which loan is less expensive over the full loan term.
- You may see a "no closing cost loan" advertised, but that doesn't mean the closing costs are free. In most cases, you still pay for the closing costs in a “no closing cost” loan. Typically, you pay in one of two ways, and either option may be worth considering if you’re short on cash for closing:
- The costs are rolled into the loan amount or sales price, increasing the total loan amount to cover the closing costs. The larger loan means you pay more interest charges over time. In some cases, the increased loan amount can mean you pay a higher interest rate as well.
- The costs are rolled into the interest rate. The lender is providing a rebate, known as a lender credit, to cover the closing costs. You pay a higher interest rate for a loan with credits than for a loan without credits.
Sometimes, the seller may offer to pay some of your closing costs
You would need to negotiate directly with the seller – not the lender – for the seller to pay some of the closing costs. Depending on the particular market in your area, sellers may be more or less willing to pay for some of your closing costs.