Fixed-rate or adjustable-rate mortgage? To escrow or not to escrow? Pre-qualification vs. pre-approval? Mortgage financing can seem confusing, but it doesn’t have to be. There are a few key things to understand, and the more you know, the more prepared you’ll be.
What's a mortgage?
- Type of loan that is secured by real estate (i.e., the home you purchase). Unless you are paying cash for the home, you'll need a mortgage.
- You promise to pay back the lender (usually in monthly payments) in exchange for the money used to purchase the home. If you stop paying, you'll go into default, which means you've failed to meet the terms of the loan and the lender can take back the property (foreclosure).
What's included in my monthly payment?
Your mortgage payment typically includes PITI:
- Principal – What you borrowed (also referred to as "amount financed");
- Interest – What the lender charges you to borrow the money used to purchase or refinance the home;
- Taxes – What you pay in property taxes to your local city/municipality and sometimes county; and
- Insurance – What you pay to insure your home from damages (fire, natural disasters, etc.). There is also Private Mortgage Insurance (PMI) which is usually required on most loans when your down payment is less than 20%. PMI is paid monthly until you reach the 20% equity threshold.
NOTE: in some cases, your monthly payment might also include the fees paid to a homeowner's association on your property (HOA fees).
What is an escrow account?
Taxes and insurance are usually held in an escrow account and paid by the mortgage company when they are due (a portion of your monthly payment goes to fund the escrow account). This can be beneficial—especially for first-time buyers or buyers without significant savings—as you set aside a small amount each month instead of having a large, semi-annual or annual out-of-pocket expense. But, it does increase your mortgage payment and reduce your cash flow each month.
Some lenders require an escrow account and some let the homeowner pay their insurance and taxes directly. Always check with your lender to see what's covered in your monthly payment.
What are the types of loans?
Each lender/financial institution has their own mortgage products, but they usually fall into these categories:
- Fixed-rate mortgage – Interest rate remains the same for the life of the loan providing you with a stable and predictable monthly payment.
- Adjustable-rate mortgage – Interest rate is flexible and subject to adjustments—either on specific dates (3-, 5-, 7-year adjustments) or based on market conditions. An adjustable rate mortgage may provide you with a lower rate in the beginning of the loan; however, the payment may increase over time.
- Government guaranteed mortgages – Both the Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) offer loans to help homeowners with income restrictions or those who are currently in the military or a veteran respectively. Typically these loans have lower down payment requirements and less restrictive qualifying guidelines, but they do require you to meet certain criteria. Always check with the FHA or VA for complete details and if you think you may qualify for this type of loan, inform your lender.
- Lower initial rate which may be locked for an introductory period or set timeframe
- Rate adjusts on pre-determined dates (e.g., annual, 3-, 5-, 7-year terms)
- Good choice if interest rates are high and/or if you only plan to stay in the home for a short time
- Interest rate remains the same over the life of the loan
- Predictable monthly payments—even if interest rates rise, your payment doesn't change
- Good choice if interest rates are low and/or you plan to remain in the home for a long time
Pre-qualification vs. pre-approval?
Sometimes these terms are used interchangeably, but they're actually very different:
This involves providing your lender with some basic information—what income you make, what you owe, what assets you have, etc. They'll look at your overall financial situation and be able to provide you with a preliminary estimate of what loan terms for which you may qualify.
When you get pre-qualified, the lender doesn't review your credit report or make any determination if you can qualify for a mortgage—they'll just provide the mortgage amount for which you may qualify. Pre-qualifying can help you have an idea of your financing amount (and the process is usually quick and free), but you won't know if you actually qualify for a mortgage until you get pre-approved.
This involves completing a mortgage application and providing the lender with your income documentation and personal records. You’ll usually have to pay an application fee, and the lender pulls and reviews your credit. A pre-approval takes longer than a pre-qualification as it’s a more extensive review of your finances and credit worthiness.
Pre-approval is a bigger step but a better commitment from the lender. If you qualify for a mortgage, the lender will be able to provide: the amount of financing; potential interest rate (you might even be able to lock-in the rate); and you'll be able to see an estimate of your monthly payment (before taxes and insurance because you haven't found a property yet).
Why get pre-approved? It saves you time by letting you search for homes within your pre-approved, affordable price range. Also, you're letting sellers know you're a serious and qualified buyer. Often, if there's competition for a home, buyers who have their financing in place are preferred because it shows the seller you can afford the home and are ready to purchase. We'll also go through the pre-approval process a bit more in the next section.
What's an APR?
Most homebuyers only think about the interest rate, but your lender will typically use APR (Annual Percentage Rate) when reviewing and quoting your financing. The interest rate is what the lender charges you to borrow money. The APR includes the interest rate as well as other fees that will be included over the life of the loan (closing costs, fees, etc) and shows your total annual cost of borrowing. As a result, the APR is higher than the simple interest of the mortgage. That’s why it’s always important when comparing lenders to look at the APRs quoted and not just the interest rate. In addition, all lenders, by federal law, have to follow the same rules when calculating the APR to ensure accuracy and consistency.
What are Points?
One point is equal to one percent of the total principal amount of your mortgage. For example, if your mortgage amount is going to be $125,000, then one point would equal $1,250 (or 1% of the amount financed). It's important to ask about the interest rate, APR, closing costs and points as these can all vary by lender. Lenders frequently charge points to cover loan closing costs—and the points are usually collected at the loan closing and may be paid by the borrower (homebuyer) or home seller, or may be split between the buyer and seller. This may depend on your local and state regulations as well as requirements by your lender. Be sure to ask if there are points on your loan, how much they are and who will pay the points.
What's a Pre-Payment Penalty?
Be sure to ask if your mortgage contains a pre-payment penalty. A pre-payment penalty means you can be charged a fee if you pay off your mortgage early (i.e., pay off the loan before the loan term expires).
What Forms are Standard?
When you apply for a mortgage, your lender will likely use a standard form called a Uniform Residential Mortgage Application, Form Number 1003. Sometimes it's just referred to as a "1003." The lender uses this form to record relevant financial information about an applicant who applies for a conventional one- to four-family mortgage. It's important to provide accurate information on this form. The form includes your personal information, the purpose of the loan, your income and assets and other information needed during the qualification process.
After you give the lender six pieces of information – your name, your income, your social security number to obtain a credit report, the property address, an estimate of the value of the property, and the size of the loan you want – your lender must give or send you a Loan Estimate within three days. The Loan Estimate will outline the projected closing costs and loan terms (i.e., loan type, interest rate, estimated monthly mortgage payments) you discussed with your lender. Carefully review the estimate to be sure the terms meet your expectations. If anything appears different, ask your lender to explain why and to make any necessary corrections.
Lenders are required to provide you with a written disclosure of all closing conditions three business days before your scheduled closing date. Use that time to thoroughly review details of the Closing Disclosure and to question anything that doesn’t match your Loan Estimate (i. e, closing costs, loan amount, interest rate, monthly mortgage payment, estimated taxes and insurance outside of escrow). If there are significant changes, another three-day disclosure period may be needed.