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How do mortgages work?

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Banks provide cash in the form of a mortgage to a home buyer in exchange for interest payments and the home as collateral

They say it’s the “American Dream” to purchase and own a home. Unfortunately though, homes are expensive, and most of us can’t afford to shell out all our cash for our house. This is where home mortgages come in—they’re a cost-effective way to finance and purchase a home.

Before the 1930s, only a few highly privileged families had their own home. People did not have enough cash to pay for a home instantly. In the 1930s, the banks embraced the idea of giving people a loan to buy a home. This loan is what we now call the mortgage.

What is a home mortgage

A mortgage is a loan given to a homebuyer by a bank or mortgage lenders. This loan is meant to help the buyer finance the purchase of the house they desire. When purchasing a home mortgage, it is best to secure one that is no larger than 80% of the home’s value. In exchange for the loan, the house being bought acts as collateral if the buyer cannot clear the loan payments. 

A mortgage payment has four key components, normally abbreviated as PITI. These payments are usually made every month to your lender or bank. Depending on the mortgage you get, it could be a combination of any or all of these components. For example, an “interest only” mortgage is where the buyer pays only the interest portion of their mortgage to the bank.

Why get a mortgage

There are many reasons why people consider purchasing a home mortgage instead of paying for the house upfront. The first and foremost reason is that they can purchase a bigger home. Since a homebuyer has to put up only a fraction of the cost of the home (around 20%), they can “finance” the rest by paying it off over time. Imagine how much larger of a property you can buy if you finance it over 30 years.

Also notable is that mortgage interest rates are much lower than other loan interests – usually 2% to 15%. These rates are low because the house being purchased already acts as collateral. Therefore, the bank or mortgage lender can take the property you have purchased and sell it to someone else if something happens and hinders you from making the monthly payments. 

The government has various programs like FHA and HUD Homes, which aims to help people purchase their first home. Some government programs offer loans to seniors who do not have to pay for the loan as long as they live. The loan payment is made once the homeowner passes on, moves out, or sells their home. These loans are known as reverse mortgages. They allow the homeowner to convert a portion of their equity to cash without selling their home or pay extra bills.

Since it’s common for a mortgage to be the largest debt anyone could have, its payment is spread over several years – even 30. Doing this makes the home more affordable and the payments manageable. For this reason, a lot of people will opt for a mortgage instead of instant full payment that may be costly.

How mortgage works

When purchasing a home mortgage, you will be required to give a down payment that must be paid upfront. This payment is a lump sum amount, which reduces the mortgage (i.e., the money you will be given as a loan). Most banks, or mortgage lenders, normally require 20% down, but special programs exist that offer mortgages with a down payment of 3-5%. All else being equal, your monthly mortgage bills will be lower if your down payment is large, and if your down payment is small, your monthly payments will be higher.

If you have a fixed-rate mortgage, this means your monthly payments may be the same for the life of the mortgage. However, there may be a few monthly or annual changes on top of the mortgage payment that account for the loan’s principal and the lender’s interest. This gradual payment of the loan and interest charged is known as amortization. It is very advantageous as it helps clear the loan’s interest and keeps the borrower from making a lump sum payment at the end of the mortgage period.

Mortgage costs

When purchasing a home mortgage, you must be aware of the payment components: Principle, interest, taxes, and insurance (PITI). 

  • The principle is the overall cash amount that you will receive from the lender after the deduction of your down payment.
  • Interest is a percentage of the total amount that the lender will charge you for the loan. 
  • Taxes are money meant for the payment of property taxes. They are often deposited into an escrow account and held by a third party until the property taxes are due. 
  • Homeowner’s insurance is a type of insurance meant to protect against hazardous incidents such as fires, floods, theft, etc. This payment is very beneficial as it will help pay for the damage if any of these incidents occur.

Mortgage pros and cons

A home mortgage has many advantages. They are:

  • Aid in buying a home
  • Cost-effective borrowing (lower interest rate than most other loans)
  • Allows you to purchase more property than you could afford today if you had to pay with cash

Though purchasing a home mortgage has many advantages, it has disadvantages as well. They are:

  • Pay more for the same asset (because of PITI costs)
  • Long-term debt
  • Risk of repossession
  • Constant changes in interest rates

Securing a home mortgage is a big financial decision for most of us. It’s important to weigh all the advantages and disadvantages before proceeding.

The home mortgage purchase process

Just like other loan applications, purchasing a home mortgage has a process. For you to get the loan, you must:

  1. Decide on the source of the mortgage. Could be a bank, the government, or a mortgage broker/lender.
  2. Select a mortgage that is suitable for your needs.
  3. Prepare, sign, and submit in the documents needed for the mortgage loan.
  4. Search for a house that fits your budget and agree on the best purchase price with the seller.
  5. Get home inspection services to audit the condition of the house and its quality.
  6. Secure the home by paying a deposit and agree with the seller about the timeline for making the payments.
  7. After completing the survey, you can own the property and begin the mortgage payments and extra taxes.

Once you are done with this process, you are free to move into your property or rent it out whenever you wish.

Documents required in a mortgage application

When applying for a mortgage, there are various documents that you must have. Failure to hand in these documents may lead to the disqualification of the mortgage loan. This means that you will not be given the loan and will have to either apply again or find other finance sources. These documents include:

  • Personal identification documents
  • Proof that you are creditworthy (bank statements, tax returns documents for the last three years)
  • Proof of mortgage affordability (utility bills, cash flow statements, etc.)
  • Proof of legitimate residence in the US

Conclusion

Purchasing a home mortgage has helped many people and can help you acquire a home as well. However, you must be well-informed on the mortgage options available and requirements and payment details. Ensure that you are ready to make this investment to avoid future loss of your home. Get a mortgage, get your dream home!