Most people can’t afford to buy a house or property outright, which is where a mortgage comes into play. But what is a mortgage, and how does it differ from a loan?
A mortgage can come from a bank, credit union, or other financial institution, and although mortgages are a type of loan, not all loans are mortgages. Mortgage is a term used specifically to describe borrowing money to purchase property, whereas a loan can be for any number of uses.
Before taking out a mortgage, it’s important to understand the options available to homebuyers and how the mortgage process works. Typically, to qualify for a mortgage, borrowers need to have a down payment, or percentage of the home’s purchase price that they pay upfront, which can be as low as 0% depending on the type of mortgage loan. The more a buyer puts toward a down payment, the lower their monthly mortgage payments will be.
Each monthly payment goes toward the mortgage loan’s principal and the interest on the amount of money borrowed. Interest rates for a mortgage can vary based on a number of factors, including credit history and the current market.
Lenders view mortgage loans as relatively safe because the property can be used as collateral if a borrower defaults on the loan. Knowing about the different types of mortgages, how rates work, and the steps to get a mortgage can help homebuyers get the best deal when shopping for a home loan.
Common Types of Mortgages
There are several different types of mortgage loans available, and each has its pros and cons. Here’s an explanation of the most common types of mortgages people use when they need to borrow money to purchase a property:
FHA loan
FHA loans are government-backed loans guaranteed by the Federal Housing Administration. This means that if a borrower defaults on the loan, the FHA will repay the loan balance. Most mortgage lenders offer an FHA home loan with as little as 3.5% down.
Homebuyers can also qualify for a mortgage through the FHA with credit scores as low as 580. A credit score that’s lower than 580 will require a larger down payment of at least 10%. These loans are meant to help those with low income become homeowners.
Conventional loan
Conventional loans are any mortgage not backed by a government agency. Mortgage lenders typically prefer borrowers to put 20% down when they take out a conventional loan. However, borrowers can get a conventional loan with just 3% down, but this will require private mortgage insurance (PMI).
PMI will add to the monthly mortgage payment, but it means borrowers can get into a home sooner because they don’t have to save money for a large down payment.
VA loan
VA loans are available to active-duty military members, veterans and surviving spouses, eligible members of the National Guard, and eligible reservists. As a benefit for their service, military personnel can apply for a VA loan with 0% down.
With no money down, these loans do have a funding fee that’s required upfront. This funding fee can be built into the loan, acting as PMI that will increase the monthly mortgage payment. VA loans are backed by the Department of Veterans Affairs.
USDA loan
With USDA loans, borrowers can get a mortgage loan for a property in a qualifying rural area. Mortgage lenders will allow a 0% down payment on USDA loans, but to qualify, borrowers can’t exceed 115% of the area’s median income.
This type of loan has guarantee fees that are meant to cover losses if a borrower defaults, as well as administrative costs.
Uncommon Types of Mortgages
A mortgage lender may also recommend one of the following uncommon types of mortgages if borrowers don’t qualify for any of the more common ones:
Jumbo and interest-only mortgages
A jumbo loan is a mortgage for an amount that exceeds conforming loan limits set by the Federal Housing Finance Agency. For 2023, conforming loans are any loan amount of $715,000 or, in higher-cost housing areas, $1,073,000.
So borrowers who need more than these conforming limits must take out a jumbo loan. This means that a mortgage broker will look closely at a person’s finances to ensure they have the means to make their loan payments.
Borrowers who opt for an interest-only jumbo mortgage will make payments on the interest portion of the loan for a specific term, such as 10 years. After this period, the loan will be amortized, and the borrower will make payments on the remainder of the loan balance, plus interest for the life of the loan. Typically, to qualify for a jumbo loan, the borrower’s debt-to-income ratio can’t exceed 43%, and they should have a credit score of 700 or higher.
Reverse mortgage
A reverse mortgage is less common because it typically only applies to homeowners over the age of 62 who own their home outright or have a very low mortgage balance. Taking out a reverse mortgage means borrowing against the equity of a home, so as the loan balance increases, the home’s equity decreases.
Borrowers won’t have a monthly payment on a reverse mortgage. Instead, the balance of the loan and its interest are due at the time the borrower no longer lives in the home. Reverse mortgages are usually paid off when the home is sold.
With a reverse mortgage, the homeowner still has to pay property taxes and homeowners insurance. A home in disrepair won’t qualify for a reverse mortgage, and the home must be the borrower’s primary residence.
Blanket and wraparound mortgages
Blanket and wraparound mortgages aren’t the same thing. A blanket mortgage is often used when an investor or someone who owns multiple properties wants to combine their mortgage payments into one loan. It may be harder to qualify for a blanket mortgage due to the risk involved for the lender.
With blanket mortgages, borrowers may have to make a balloon payment, meaning a large lump sum, after a set number of years. Investors often consider a blanket mortgage if they plan to sell the property before a balloon payment is due.
Wraparound mortgages require working with a seller, usually because a buyer doesn’t qualify for a traditional mortgage. The seller takes on the role of a lender, meaning the buyer makes their monthly payments to the seller, who keeps making their original mortgage payments.
Here, the seller wants to receive a monthly payment that exceeds their current mortgage loan. The buyer becomes the owner of the property and pays their monthly payment to the seller, who can set the interest rate and loan term. In most cases, the seller will set the mortgage interest at a higher rate than the current annual percentage rate they’re paying so they come out ahead.
Mortgage Rates
The two most common types of mortgage interest rates are fixed and adjustable. Borrowers need to understand the difference between these types of interest when they fill out a mortgage application. Let’s explore the differences in more detail:
Fixed-rate mortgage vs. adjustable-rate mortgage
Having a fixed-rate mortgage means borrowers pay a set amount of interest over the life of the mortgage loan. Mortgage payments won’t change as long as the borrower owns the property.
An adjustable-rate mortgage (ARM), also known as a floating- or variable-rate mortgage, has an interest rate that can go up or down. The movement of the interest is determined by an index, sometimes referred to as a benchmark rate. The benchmark, such as the prime rate, is chosen by the lender. The change in interest means a variable mortgage payment.
The terms for interest rates on ARMs are expressed as two numbers—the first is the years the introductory rate is locked in, and the second is how often the rate adjusts. For example, the most common ARMs are expressed as 5/1, 7/1, or 10/1. An ARM expressed as 5/1 means the loan has a fixed rate for five years, and then it adjusts every year going forward.
Both types of mortgage rates have advantages and disadvantages. The benefit of an ARM is that it can be cheaper than a fixed-rate mortgage and often comes with a lower monthly payment initially. However, payments rise and fall, depending on where the index rate is after the introductory period.
Related: Fixed-Rate vs. Adjustable Rate Mortgages: What’s the Difference?
Some lenders place caps on how low or high interest rates can go. An ARM might make sense over a fixed-rate mortgage if the buyer plans to move or refinance before the introductory period is over, or if they believe interest rates will fall.
For some investors, fixed-rate mortgages are preferred because of their predictability. The payments on a fixed-interest mortgage never change, so it can be easier to budget the monthly payments. Discussing investment goals with a financial advisor can help borrowers understand which type of interest rate will suit their needs best.
How to Calculate Your Mortgage Payment
There are several factors that go into calculating mortgage payments:
- Loan amount
- Interest rate
- Loan term
- Mortgage insurance
- Property taxes
- Homeowners insurance
- Homeowners association fees, if applicable
The formula mortgage lenders use to calculate monthly mortgage payments is:
M = P [ I(1 + I)^N ] / [ (1 + I)^N ? 1]
Using this formula, “M” is the monthly payment, “P” is the principal amount, “N” is the number of payments, and “I” is the interest rate. However, it may be easier to use a mortgage calculator that allows borrowers to plug the numbers in and get the results quickly.
How to Get a Mortgage
Getting a loan to buy real estate involves more than simply filling out a mortgage application. Following these steps can ensure the mortgage process goes smoothly and borrowers get a mortgage that fits their budget:
Preapproval
Before starting the search for a home, borrowers should get a mortgage preapproval letter. This means a lender reviews a borrower’s information and determines how much they are willing to lend them to purchase property.
Related: Pre-Qualifying vs. Pre-Approved: Know the Difference or Lose the Deal
Figuring out how much of a mortgage the borrower can afford is based on the borrower’s other obligations and annual income. Lenders will verify income and ask for a credit report. A better credit score generally translates into a better interest rate—borrowers with a high likelihood of repayment will be offered the best rates.
With a preapproval letter, buyers are viewed as more credible by both lenders and sellers. Preapproval means a bank has determined that a potential buyer can borrow up to a specified amount of money.
After getting preapproved, borrowers can move to the next step.
Find a house, make an offer
Once a buyer knows how much house they can afford, they can start the home search process. This begins with looking at homes, potentially using a real estate agent or broker, to find those that fit within the price range of their preapproval.
When the buyer finds a home that meets their needs and budget, they can make an offer on the home. Often, the offer can be below the asking price, but this may not be the case in a hot real estate market.
Apply for the loan
In this step, the potential borrower fills out a mortgage application for the specific house they want to buy. The application must include all the information about the borrower and the home they’re looking to purchase.
Lenders want to ensure the home is valued at the selling price and that a borrower has the means to make their payments. Although a buyer goes through preapproval, the application step may dig deeper into their finances so a lender understands the risk involved.
Mortgage is processed
Next, a mortgage processor will gather and verify all the necessary information needed to finalize the loan. This can include bank statements, credit reports, and home appraisals.
Sellers may be required to make improvements or repairs to a home before a mortgage can be processed. If an appraisal comes in below the selling price, a lender is unlikely to complete the loan. The buyer can either make a lower offer or search for another home.
Underwriting
The underwriter looks at all the information and makes a decision on whether the loan should be approved or denied. The underwriter might request additional information. If approved, pre-closing happens, which includes ordering title insurance and scheduling a closing.
Closing
The closing is the finalization of the deal, where the buyer signs the loan documents. This is also when closing costs are due, which might be paid by the seller, the buyer, or both.
Keys are handed over to the property’s new owner, and the lender releases the funds to the seller. The borrower can choose to set up an escrow account for property taxes, where the lender will put part of the mortgage payment that is used to pay the taxes when they’re due.
Which Mortgage Is Best for Real Estate Investors?
The best mortgage for real estate investors will depend on a variety of factors, including credit score, down payment amount, and the current interest rate. Many investors prefer a conventional loan because it has the least restrictions, but these loans can come at a higher upfront cost because of the higher down payment requirement or need for private mortgage insurance.
An FHA loan might be beneficial for first-time buyers who don’t have much money saved for a down payment, but this type of loan is only available to buyers who haven’t purchased another home within the last three years. VA and USDA mortgages also have restrictions that can limit an investor’s ability to buy multiple properties. Investors who already own several properties may want to use a blanket loan to consolidate their payments.
Discussing mortgage options with a financial advisor is the best way to get a loan that meets a real estate investor’s needs.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
