What is a Home Loan?
A home loan (or mortgage) is a contract between a borrower and a lender that allows someone to borrow money to buy a house, apartment, condo, or other livable property. A home loan is typically paid back over a term of 10, 15 or 30 years.
How Does a Home Loan Work?
For most people, purchasing a home is the biggest financial decision they will ever make. And with homes often costing hundreds of thousands -- and in some cases millions -- of dollars, most people can't afford to pay cash for the entire property up front. As a result, they need to take out a home loan (i.e. borrow) from a bank, credit union, or specialized mortgage lender for borrowers with lower budgets (such as the USDA, FHA, or VA).
There are several types of home loans available on the market, but each home loan is typically defined by four main factors:
- The Principal, or the amount of money you're borrowing. This amount is typically the purchase price minus your down payment, minus closing costs and other related fees.
- The Term, or how long you have to repay the entire loan. The term of a home loan can range between five to 30 years.
- The Interest Rate, or the annual amount you need to pay the lender to borrow the money, shown as a percentage of the current principal balance.
- The Repayment Frequency, or how often you make payments. Borrowers usually pay back their mortgages on a monthly or bi-weekly basis.
Here's an example of how a home loan works. Let's say I'm attempting to buy a $400,000 home. After paying $80,000 of my own money as a down payment on a new home, I need to borrow $320,000 to pay for the rest of the house.
After shopping around and submitting my financial information for approval, a lender offers me a home loan for $320,000 (the principal) with a fixed term of 30 years (the term) at a rate of 5% (the interest rate), to be repaid in monthly installments (the repayment frequency).
(Note: This amount does not include property taxes, private mortgage insurance, or property insurance, which can differ by the home's property tax rates and the individual borrower's coverage needs. Your official mortgage payment will include these amounts.)
What different types of home loans are offered by mortgage lenders?
Home loans are designed to suit a variety of borrower needs and budgets, and thus can come in several different forms. Here are three of the most common types of home loans.
- Fixed-Rate Mortgages:
The most common type of home loan is the fixed-rate mortgage, which requires a borrower to repay the principal over a "fixed term" (an unchanging length of time) with a "fixed rate" (an interest rate that never fluctuates over that time period). Borrowers looking for steady and predictable mortgage payments often take out 30-, 15-, or 10-year fixed-rate mortgages. Generally, the shorter the term of the fixed-rate mortgage, the lower the interest rate the borrower can get.
- Adjustable-Rate Mortgages (ARMs):
Unlike a fixed-rate mortgage with its static interest rates, adjustable-rate mortgages (ARMs) have variable interest rates that can move up or down over the course of the loan. To entice buyers with smaller budgets, lenders frequently offer one-year ARMs with a more affordable introductory interest rate for the first year (often with interest rates that are significantly lower than a comparable fixed-rate mortgage). The interest rate can then increase in the following years if market interest rates go up. As you might imagine, this can become costly for a borrower if the Federal Reserve raises interest rates over time, as the borrower's monthly ARM payments would also increase.
- Hybrid, Adjustable-Rate Mortgages:
A cross between a fixed-rate mortgage and an ARM, the hybrid mortgage offers a fixed rate for a set term (usually fewer than 10 years) and then allows the interest rate to adjust up or down much like an ARM loan would. For example, a 5/1 hybrid mortgage, or 5/1 ARM, offers a borrower a fixed interest rate for 5 years before switching to an adjustable rate (with the rate adjusting once per year) for the remainder of the home loan's term. As the "goldilocks" option among home loans, hybrid mortgages typically offer interest rates that are lower than fixed-rate mortgages and higher than ARMs.
Why Does a Home Loan Matter?
Home loans make buying a home a reality for people who want to own property. Getting a home loan often takes a substantial investment (closing costs, down payment, time to apply), but these upfront costs can be recouped by a homeowner over time if their property value appreciates. Given the upside potential, it's little wonder why homeownership rates in the United States have historically averaged more than 60% since the 1950s.
FREQUENTLY ASKED QUESTIONS (FAQ):
What is the difference between pre-qualification and pre-approval for a home loan?
In order to get pre-qualified for a home loan, you typically need to submit some basic personal financial information to the lender, including your household income, employment history, projected down payment amount, and authorization for the lender to pull your credit rating.
If and when you are "pre-qualified" by a lender (which could take as little as one or two days), it means the lender believes, based on a preliminary analysis, that you are eligible to purchase a home up to a specified dollar amount. The lender will sometimes write prequalification letters to help buyers make a more enticing offer to the seller, though the prequalification does not guarantee final approval for a home loan.
Now on to what pre-approval for a home loan means. After a lender has collected and verified a borrower's basic information along with some deeper personal financial information—such as the multi-year history of your annual income, bank account and credit card balances, full copies of recent tax returns, a in-depth list of all current and long-term debt obligations, etc—that will be used to for underwriting (borrowing risk) purposes, they may "pre-approve" the borrower for a home loan. The pre-approval process is much more strenuous than the pre-qualification process, but also shows the borrower more detail on the costs and interest rates they'll be getting on a mortgage if they choose that lender.
How do I become approved for a home loan?
Before qualifying you for a home loan, a lender will usually ask you as a potential borrower to make an immediate "down payment" on the home (usually a cash amount between 3% to 20% of the home's total value) -- which gives them some assurance that you're serious about owning the property.
To gauge how big of risk it's taking to lend money to you, the lender will also ask for personal financial information related to your annual income, employment history, credit score, and any outstanding debt you have (e.g. how much you owe on existing credit card debt or auto loans).
As a final -- and most important -- condition in approving the home loan, the lender will ask for the deed to the property that the potential borrower wants to buy (this makes the home loan a "secured loan"). Owning the deed protects the lender in case the borrower can't repay (i.e. defaults) the home loan, as it allows the lender to legally take back the property and sell it to get some of its money back.
What is the difference between interest rate and annual percentage rate (APR)?
Interest rate is simply the cost you must repay to the lender for the borrowed amount. By contrast, the Annual Percentage Rate (APR) includes the interest rate along with additional loan-related costs such as your origination fee, processing and underwriting fees, points you may purchase from the lender to reduce your interest rate, and/or private mortgage insurance.
Lenders like to quote APR to give borrowers a better way to compare other lenders' quotes on a more apples-to-apples basis that includes the extra costs involved with taking out a mortgage.
What are closing costs?
If you've been approved for a mortgage, a lender will most likely require you to pay "closing costs" -- which can amount to around 1% to 5% of your home's value (Bankrate.com pegs the average closing cost at around $2,100 for a $200,000 mortgage loan) before you receive your funds.
The closing costs include everything from title and appraisal fees to land surveying and government fees. You may also need to pay to have a home inspector and pest control service look at the property.
Borrowers may either pay their closing costs up front in cash (usually the case), or roll them into their mortgage principal and pay the costs over time as part of their mortgage payment.
What is property tax, property insurance, and private mortgage insurance?
Beyond paying your loan's interest and principal, your monthly mortgage payment will include the amount you owe for property tax, property insurance, and private mortgage insurance (if you didn't pay a down payment of 20% or higher of the home's total value) on the home.
For example, let's say my bank charges me $1,070 to pay for the principal and interest payments on my 30-year-fixed, 5% APR, $200,000 mortgage. If the property tax on the home costs $6,000 a year, that would be another $500 added to my mortgage payment ($6,000/12 months). If home insurance costs $1,200 per year, that would add $100 more to it ($1,200/12 months). If I didn't pay 20% down on my home when I applied for the mortgage, I might owe $70 per month in PMI costs.
All said, my mortgage payment would add up to $1,750 ($1,070 + $500 + $100 + $70).
What does "PITI" mean as it relates to my home loan payment?
When the mortgage payment amount includes the monthly ongoing costs we've shown in the example above, lenders and industry experts refer to this monthly amount as your total mortgage payment including principal, interest, taxes, and insurance -- or, mortgage payment (PITI).
What does it mean to refinance a home loan?
If a borrower took out a mortgage in the past with an APR that is significantly higher than they are today, the borrower can "refinance" their mortgage, where they will sign a new agreement at the new lower interest rate by going through the mortgage application process with a lender again.
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