The majority of homeowners in the U.S. will use a mortgage loan to finance the purchase of their homes. The home is typically the largest asset a family owns, and the corresponding mortgage loan is usually the largest debt.
Financially, understanding how the mortgage loan process works is absolutely critical. This overview is your starting point to learning the essential information on mortgage loans.
What are mortgage loans?
Mortgage loans are the primary tool homebuyers use to pay for their home. Mortgage loans can also be used to buy some investment properties and vacation homes, although they're most commonly known for their use in financing a primary residence.
Homebuyers will pay a down payment on the home, and the remainder of the financing will come from the mortgage. As a rule of thumb, a mortgage will pay for 80% of the price of the home, although there are specialized programs that can allow a mortgage to pay for a higher percentage of the purchase. Some programs will even provide for 100% financing. Mortgages for investment properties and second homes will generally require a larger down payment.
After the home is purchased, the homeowner makes monthly payments of both principal and interest to pay off the loan over time. Most mortgage loans in the U.S. are repaid over a 30-year period.
How do you get a mortgage loan?
To get a mortgage loan, a prospective borrower must apply through a bank, a credit union, or another lender. Mortgage brokers can also be used. These individuals or companies will present your loan request to a variety of lenders and present you with the best deal available. Sometimes working with a broker can be very helpful, and other times the broker may charge extra fees, making the loan unnecessarily expensive.
When applying for the loan, the lender will want to fully examine the applicant's financial situation. That can be an unpleasant process for many individuals. The lender will take into consideration the applicant's credit score, income, debts, net worth, and down payment. The exact requirements for each of those considerations will vary from lender to lender.
Once a borrower is approved for the loan, the lender will order an appraisal of the property to ensure that the value of the house is accurate. Typically, the borrower will be required to pay for the appraisal, even though the bank orders it.
Borrowers should expect to pay an origination fee, miscellaneous taxes and filing fees, any mortgage points, and a handful of other fees that will vary from lender to lender. These payments are required to be paid up front, while the interest on the loan will be paid over time with each payment. The exact details of all costs will be presented to the borrower during the application process, as required by law.
Important mortgage loan concepts
To help prepare you for the bank jargon used in the mortgage loan process, here are some helpful definitions you'll need to know.
APR or APY: Annual percentage rate or annual percentage yield. This number represents the actual annual interest cost to you on your mortgage, including the fees the lender is charging you.
Loan term: The term of the loan is the length of time before the entire loan amount is to be paid in full. In most cases in the U.S., the term will be 30 years.
Credit score: A credit score is a number calculated by one of the three credit reporting agencies that represents a borrower's credit history and that person's likelihood of repaying future debts. The credit score takes into account past payment history, current debt levels, the type of debt (credit card vs mortgage, for example), and more. Credit scores range from 300 to 850, with a higher score representing a better score. Under most circumstances, a credit score of 650 or higher is sufficient to qualify for a mortgage.
Loan-to-value ratio: This is the ratio the bank calculates to show how much of a down payment is being paid. The ratio is calculated by dividing the loan amount into the appraised value of the property. A loan-to-value ratio of 80% is most common for mortgage loans, but there are special programs that can allow the ratio to rise to 90% to 100%.
Debt-to-income ratio: This is the ratio banks use to calculate a borrower's monthly cash flow. Mortgage lenders will typically use two versions of this ratio. First, they will divide the borrower's total monthly debt obligations into his or her total monthly income before taxes. Lenders want to see this ratio at about 40% or less. Second, the lender will do the same calculation, but instead of using all the debt payments, the lender will just use the total monthly mortgage payment. This ratio should generally be 30% or less.