How Do Mortgages Work?
The Essential Home Mortgage Guide to Get a Home Loan for First-Time Buyers
You've run the numbers and decided that owning a home beats renting. Now comes the hard part: getting a home loan, or mortgage. One of the most common questions homebuyers ask is "how do mortgages work?"
Think of this home mortgage guide as a blueprint for homebuying, with step-by-step instructions to get you from pre-qualification to the closing table. Here's what we'll cover.
We'll start by walking you through the pre-approval process.
- Week 1 covers choosing a mortgage and applying for a loan.
- Week 2 focuses on the home inspection and locking your interest rate.
- Week 3 dives into appraising and insuring your new home.
- Week 4 wraps things up with the closing process.
You don’t have to follow all of the steps in this order, as every homebuyer’s experience is different, but it’s helpful to understand how the overall mortgage process works, through a structured timeline. The goal is to help you feel educated and empowered so you can get a mortgage with confidence.
Financially, there's a lot more to owning a home than renting.
"The first big challenge for renters who are buying their first home is to think beyond the initial purchasing costs,” says Jennifer Fitzgerald, CEO and co-founder of PolicyGenius, a digital insurance company.
According to Fitzgerald, first-time buyers spend a lot of time budgeting for their down payment, mortgage, closing costs and taxes. But they overlook the longer-term costs of owning, which can be higher than you might think.
Asking these questions can help you gauge whether you're ready for a home mortgage.
How much home can I afford?
Many homebuyers have no clue what they can realistically spend. Not fully understanding how much you can home you can afford may make you “house poor,” which means you’re spending way too much on your mortgage.
Add up your income and monthly expenses. How much is your rent? What about utilities or maintenance?
Think about your debt-to-income ratio or DTI. That's how much of your income goes to debt repayment each month. We recommend keeping this number at 45% or less, although we can go up to 50% if you have a stronger application. For example, having a higher credit score or hefty amount of cash in your savings account could help offset a higher DTI.
Figuring out your DTI can give you an idea of how much home you can afford. Here's an example.
If you make $5,000 a month, 45% of that would be $2,250. If you pay $300 to student loans, $350 for a car loan and $100 to credit cards, you'd have $1,500 to spend on a home ($2,250 - $750 = $1,500).
How much to put for the down payment?
The best way to answer this is to think about how much home you’re hoping to buy and how much you can realistically save for a down payment. A 20% down payment can help you avoid private mortgage insurance, also referred to as PMI (it reimburses the lender if you default on your home), but this isn't realistic for every buyer.
Some home mortgages let you buy with less cash upfront. An FHA home loan, for example, only requires 3.5% down. A USDA or VA loan requires no down payment.
One way to get around private mortgage insurance without a 20% down payment is to piggyback your mortgages. This involves taking out a first home loan and a 2nd mortgage when you buy. A Reali loan advisor can help you decide if piggybacking makes sense.
What mortgage can I afford?
Your home mortgage is more than the purchase price. It also includes things like escrow for homeowners insurance and property taxes, and private mortgage insurance if you're putting less than 20% down.
These extra costs can push your monthly home loan payment higher. If your budget says you can afford to spend $1,500 a month on housing, you need to know how much of that is going to the principal (the actual loan amount) and how much is going to the extra, rolled-in costs.
A mortgage payment calculator can help with running the numbers. Checking your credit score is also important. You can check it for free on sites like Credit Sesame or Credit Karma.
Home mortgage rates are influenced by your credit score. The higher your score, the better your chances of qualifying for the best mortgage rates. If you're thinking of going with a shorter loan term, remember that 15-year mortgage rates are typically higher than rates for a 30-year loan.
What mortgage can I afford on $100,000?
Assuming the 45% DTI that Reali uses, you could afford to spend $3,750 a month on debt. If your debt payments are low, that could be more than enough to buy a comfortable home.
What other costs do I need to consider?
Insurance is another big expense to budget for as you plan to buy a home.
"As a renter, you're only concerned about protecting your possessions in your home and insuring those against loss. As a homeowner, you have to insure those possessions plus the actual structure of the home,” Fitzgerald says.
Before Week 1: Getting Pre-approved With Reali
Next comes mortgage pre-approval -- what does this mean?
In simple terms, it means we've checked your credit and financials to figure out how much home you can afford. One important point (since we get this question a lot): You don't need to wait until you're pre-approved to start looking for a home. Getting pre-approved early on, however, gives you a better idea of how much home you can afford.
Reali CEO Jason van den Brand strongly recommends getting pre-approved and explains, “This is about affordability and putting you and your family in a position of strength. The last thing anyone wants to be is ‘house rich, and cash poor’ and that's exactly what a pre-approval helps you discover. In other words, just because you qualify for $500,000, doesn't mean you should buy that much.”
How home loan pre-approval works
The mortgage pre-approval is simple and involves filling out a home loan application and information about your income and assets. We review those details, including your debt-to-income ratio and credit score.
If your application looks good, we'll make a conditional offer for a specific loan amount. You then use that amount to guide your home search.
However, if your financial situation changes suddenly -- let’s say you applied for some new credit cards (which means your credit score probably went down) or lost your job, the amount you’re approved for could also change.
Why get pre-approved?
Mostly, it keeps you from wasting time looking at homes that don’t fit your budget.
It also sends the message to sellers that you’re serious about buying. If you're going up against another buyer for the same house, a seller might take your offer more seriously if you've got a loan pre-approval in hand.
That doesn’t mean, however, that you’re “locked” into a particular loan if you’re pre-approved. You can still get a loan elsewhere.
Week 1: Applying for a home mortgage
Your offer has been accepted. Now the real work of getting a home mortgage begins. So what comes next?
Applying for a home loan
Applying for a loan is a lot like the pre-approval process.
At this stage, you'll fill out a full loan application. You'll also provide all the documents needed to send your loan through underwriting -- which means we take a deeper look at your financials to decide whether you're approved for the loan, how much you can borrow and what interest rate you qualify for.
We'll need some documents from you to process your application. To save time, start gathering:
- Your pay stubs
- Previous tax returns
- Most recent bank statments
If you're self-employed, you'll need a recent profit and loss statement.
How long is the the loan application?
Reali's loan application is pretty streamlined, so once you submit it, we’ll review the details and get back to you within one business day.
How to choose the right home loan
Home loans are all a bit different. The mortgage that's right for you is the one that fits your budget and offers the best interest rate.
For some, that may be a fixed rate loan. With a fixed rate loan, your rate never changes, which means you know upfront how much you'll pay in interest and what your monthly payments will be.
A 15-year loan could be the right choice for you if you’d like to get rid of your debt faster. A 30-year loan might be better if you need smaller payments. Just remember to compare 15-year mortgage rates against 30-year fixed mortgage rates.
An adjustable rate mortgage or ARM is another option. These loans work a little differently.
Typically, you pay one rate for the first five to seven years, then the rate changes. The rate can go up or down over time, based on the index that it's tied to. Reali doesn’t currently offer adjustable rate mortgages but we have plans to add them in the future.
Debunking the biggest home mortgage myths
Sometimes the stuff you hear from your friends or on TV can confuse you about buying a home. The following are four common myths we’d like to dispel about home buying.
Myth: You must have a 20% down payment to buy.
Reality: You can put less than 20%.
Putting 20% down on a home can help you avoid private mortgage insurance (PMI) but there’s no rule that says you absolutely must have 20% in cash for the down payment.
Tip: There are programs from the Federal Housing Administration to help with your loan. If you qualify for an FHA loan, you can put as little as 3.5% down.
Myth: Buying a home is as easy as it looks on HGTV’s “House Hunters.”
Reality: It's not.
“House Hunters” is entertaining but only scratches the surface of what home buying is really like. The episodes are packaged nicely in 30 minutes, showing home shoppers browsing through three choices of homes, and picking one at the end of the show. They almost always get their offer accepted, which is not always the case in a seller’s market.
Then the show fast forwards to a few months later when the homeowners are moved into their new home with new furniture, new upgrades to the kitchen -- everything is perfect!
While the show reveals how much each home costs, it doesn’t give you details of all the work that goes on behind the scenes, like how much the buyers saved (in cash) to purchase the home, what their credit score looks like, what type of mortgage they chose plus the interest rate, or how long the entire process took to purchase the home.
The show is fun to watch, but would be more insightful if it gave deeper insight to each home buyer’s financial situation so viewers could learn what it takes to buy a home.
Myth: You’re not allowed to pay more than the minimum payment on your monthly mortgage payment.
Reality: You can prepay your mortgage -- but watch out for penalties.
Paying extra on your home loan can help you become debt-free faster and save money on interest, but some lenders actually charge a penalty when you pay off a mortgage early. If this is part of your debt payoff plan, you should find out from your lender ahead of time.
Myth: You have to have a realtor or agent to get started.
Reality: You don’t need an agent to get a mortgage.
An agent is good to have for negotiating a deal on a home but you don't need one to apply for a mortgage. Keep in mind real estate agents charge a percentage (typically 6-7% or more) of the total sales price of the home.
Home mortgage mistakes that cost you time and money
- Not checking your credit. Knowing what’s in your credit report can help you understand your chances of getting approved. It’s also a good way to see if there are any reporting mistakes made on your credit profile (for example, it said you paid your credit card late when you didn’t) so you can quickly fix them. If your score is low, you should start making improvements right away.
- Skipping pre-approval. Being pre-approved helps you understand how much home you can afford and which loan is best. Keep in mind these aren’t guarantees you’ll be approved for a mortgage.
- Not comparing your loan options. You most likely compare prices when making big purchases, like a laptop or washing machine, so why would you ignore comparing loans? Choose the loan that fits your income and budget, but make sure you know what options are out there before you pick.
Week 2: Home inspections and rate locks
Before you can finalize your home purchase, you need to get a home inspection.
What does a home inspection do?
This inspection makes sure that the home is in good shape and there aren't any major lurking problems.
Some sellers will get their own inspection. If you trust the seller, you can use their inspection. If you'd rather get a second opinion, you can hire your own inspector to look at the house. Your agent may be able to recommend someone as well.
The inspector will look at the following parts of the house and make sure it’s solid and in working condition (like the fireplace and chimney):
- Heating and air system
- Wiring and the plumbing
- Basement and the attic for mildew and draining problems
An inspection costs anywhere from $300 to $700 so add that into your budget. You should also set money aside for septic and pest inspections, since those aren't included in the home inspection.
What if there's a problem?
If your inspection turns up a problem, there are a few ways to handle it. First, you can ask the seller to fix the problem. Or, you could ask them to give you a credit at closing and then make the repairs yourself.
If there's something seriously wrong with the home, the third option is to cut your losses and cancel the sale.
Understanding your mortgage rate
When buying a home, the interest rate is super important because it ultimately determines how much your loan costs over the long term.
Mortgage expert Stephen Moye explains, "The most misunderstood part of the mortgage process is how mortgage rates are determined and what factors (out of the loan officers' control in most cases) affect mortgage rates.
If math is not your strong suit, ask Reali’s home loan advisors to help you understand this fully. We can’t stress this enough -- your interest rate (even a few points difference) can mean the difference of thousands of dollars over the life of your loan.
How mortgage interest rates work
You're probably wondering where Realis rates come from. Like all mortgage lenders, our rates are calculated based on the 10-Year Treasury market rate, plus a spread.
Rates aren't fixed. In fact, they can change daily. That's why you want to lock your rate as soon as possible. We'll explain how rate locks work a little later on.
Your interest rate is linked to your credit rating. The better your credit, the better your rate. If you don't have great credit, you may be able to get a lower rate by purchasing discount points. The question is, should you do it?
When you buy points, you're really prepaying the interest on your loan. Each point you buy lowers your interest rate. One point is worth 1 percent of your mortgage. So for every $100,000 you borrow, a point would cost $1,000.
An easy way to decide if you should buy discount points is to plug the numbers into a mortgage calculator. Figure out what your mortgage would cost with points and without them.
If you'd save a lot on interest over the life of the loan, then buying points upfront might make sense. If buying points wouldn’t lower your rate enough to make a huge difference, you may be better off saving the cash instead.
Are mortgage interest rates going up?
When the Federal Reserve raises the federal funds rate, interest rates on loans and lines of credit move in tandem. The Fed has raised rates twice so far in 2017. While mortgage rates remain near historic lows, they have inched up slightly since the beginning of the year.
What interest rate will you get approved for?
The rate you're approved for depends largely on the following:
- Type of loan you applied for
- Loan amount
- Loan term
- Where the home is located
- Your down payment
- Whether you choose a fixed or adjustable rate loan
Again, this is where a mortgage calculator comes in handy since you can use it to compare rates using different loan scenarios.
Your rate is “locked” -- what does that mean?
After you fill out the online application, you'll see a Loan Estimate that includes the details of your loan terms. Then, your Reali home loan advisor will ask for confirmation that you lock your loan's interest rate. This means we're guaranteeing you a certain rate for a set period of time.
The rate lock is typically good for 30 days, which gives your application time to go through underwriting. Your loan advisor will give you a heads up if your rate is locked for a longer period.
Why lock your rate?
A rate lock keeps you from paying more in interest if rates go up between the time you apply for a loan and the time you close. You can extend a rate lock for longer if you need to, but we may charge a fee.
What to do if your loan isn't approved
There are many reasons why this may happen, and although it’s a setback (and bummer) that you didn’t get approved, use this as a learning opportunity. These are possible reasons:
Your credit score is too low
One of the first things that happens when you apply for a loan is a credit check. (Don't worry, we don't charge a fee for this.)
A poor credit score can be a roadblock to a mortgage (among other things!). Every lender has a minimum credit score to approve borrowers. If your score falls short, you probably won’t get approved.
In that case, you need to work on raising your score. Start with these three steps, in this order.
1. Paying all your bills on time.
Your payment history has the most impact on your score.
2. Pay down your debt.
A big chunk of your score is based on how much of your available credit you're using in relation to your total available credit. This is referred to as your credit utilization ratio.
For example, let’s say you have two credit cards with a maximum limit of $5,000 for each. This means you have $10,000 available credit. Let’s say you used up $5,000. This means your utilization is 50% -- not good in the eyes of lenders.
Basically, the lower your utilization ratio, the better. Try to get it under 10%.
3. Hold off on applying for new credit.
Inquiries for credit can ding your score. Also, don't rush to shut down any credit accounts you're not using. Closing old accounts could work against your score.
Your debt-to-income ratio is too high
We've mentioned debt to income ratio already but it's worth mentioning again. To figure out yours, just add up your monthly debt payments and divide it by your gross monthly income.
For example, if you make $4,500 a month and $1,500 goes to debt, your DTI ratio would be 33%.
Reali likes to see a debt to income ratio of 45% or less. If you're over that number, you'd have to increase your income or pay off some of your debt.
Week 3: Tackling the appraisal & insurance
At this time, you should be ready to schedule an appraisal. This is one of the most important steps in the homebuying process.
What is an appraisal and how does it work?
An appraisal is a professional estimate of how much the home you want to buy is worth. You'll pay for an appraisal about halfway through the loan process with Reali. The fee is non-refundable but we generally don't ask you to order the appraisal unless we're confident that your loan will be approved. Reali uses a preferred Appraisal Management Company (AMC) to ensure it gets completed on time and correctly.
The appraisal serves an important purpose because we use it to make sure we're lending you the right amount of money. An appraisal that's higher than the sales price is good. It means the home is worth more than you're paying for it.
An appraisal that comes in too low, on the other hand, can be a problem. When the sales price and the appraisal value don't match up, one of two things has to happen. Either the seller has to adjust their price to fit the appraisal, or you have to pay the difference out of pocket.
If you think your appraisal was wrong, you could get a second opinion. You'll have to pay for the cost of any other appraisals you order, and there's no guarantee that the end result will be different.
What to expect from the appraiser
The appraisal process is different from getting an inspection. The appraiser is only interested in finding out the home's value, not uncovering any flaws.
The appraisal process can take anywhere from a few minutes to a few hours. The appraiser will look at the outside and inside of the home to the check the condition of doors, windows, floors, plumbing and light fixtures.
They'll take into account the age of the home, the square footage, the lot size, its location and what kind of view it offers. Finally, they'll look at “comps” (comparables) in the area to see the value of similar homes. The appraiser uses everything they learn about the home to create an appraisal report, which you should get a copy of.
What you should know about homeowners insurance
After the appraisal, the next piece of the puzzle is homeowners insurance. Most states don't require you to have homeowners coverage by law. It is, however, a lender requirement if you're using a mortgage to buy a home.
You'll need enough coverage to pay the cost of completely rebuilding and furnishing your home, in the event something awful happens. At a minimum, your policy should cover you against:
- Wind damage and other natural disasters
If you live in a flood or earthquake zone, you'll need separate flood and earthquake coverage.
Don't rush into a decision when buying coverage. Just like the rest of the home mortgage process, take your time, do your research, talk to experts and compare quotes from different insurers. Make sure you know what is and isn’t covered.
Once you choose a policy, you'll need to get roof of coverage from your insurer. You may need to pay your first year’s premiums in advance if you're escrowing your insurance into the loan.
Tip: Ask about bundling your homeowners policy with your car insurance for a discount.
Organize your paperwork
By now, you have collected some paperwork and receipts. Keep it organized and in one place so you can reference it quickly.
Here is a list of documents to keep organized:
- Your application (should be completed by now)
- Your receipts showing payments for home inspections, appraisal and homeowners insurance.
- If you put up an earnest deposit (which is a deposit made to the seller to show that you’re serious about buying the house), you should have documentation showing what you paid.
- You should also have copies of any disclosures we've provided during the loan process.
Week 4: Countdown to closing
We get it, you’re busy and sometimes need to travel and aren’t necessarily at home when it’s time to close your loan. Reali customers often ask if it’s okay to be located in a different state than where the home is being purchased. The answer is yes. We can send a mobile notary to wherever you are to handle the closing.
Once we have everything we need to approve your loan and finalized the terms, you're cleared to close. Ideally, this happens within 15 days of locking your rate, although the timing can vary for different borrowers, depending on your situation.
What you should expect during closing
The closing process itself usually takes an hour or two. You'll meet with a notary or closing attorney to sign all the final loan paperwork and pay your closing costs. Take note -- closing costs are paid by cashier's check.
We want to get you to the signing table within four to five days of being cleared to close. Once you sign off on the Closing Document Package, you're almost done.
The next step is disbursement. We send the loan funds to your escrow company. The funds are divvied up among the involved parties:
- The bank that previously held the mortgage on the home gets their share.
- The sellers get their cut if they made a profit on the sale.
- The agents on both sides collect their fee and any necessary amounts are paid into escrow.
All of this happens as soon as possible after closing. This is when you get to breathe a sigh of relief!
Closing costs and other hidden expenses
Closing costs cover a range of transaction fees and they typically run between 2 and 5% of the purchase price. These fees cover all the costs associated with completing the loan process. This infographic highlights the various fees included in your closing costs and overall mortgage process.
What to do if you have an impound account
An impound or escrow account is used to collect your homeowners insurance or property tax payments. You make payments to your insurance and taxes monthly, with your regular mortgage payment. These payments are held in the impound account. When your homeowners insurance or property taxes are due, the lender takes money out of the account to pay them.
Your property tax and insurance costs will show up on your loan disclosure, even if you're not using an impound account. When these items are due within a certain timeframe from your closing, we require these fees to be paid at closing. This avoids the risk of insurance or taxes going unpaid.
What to have on hand before you close
The closing agent should have all the paperwork ready to go. The main thing you need to bring to closing is a cashier's check for closing costs. You'll also need a photo ID to verify your identity. Reali may ask you to bring copies or original documents of paperwork that we need to complete your file.
So hopefully the question of how do home mortgages work has been answered, and you’re now much more knowledgeable when it comes to buying a home and what’s involved. The biggest advice we can give you is to do your homework and get really clear on what’s involved when applying for a mortgage. Ask lots of questions, Google what you don’t understand and call our awesome home loan advisors at Reali (1-855-846-7334), and never forget that the best part of this experience is getting into your new home!
Note: Reali currently doesn’t operate in all 50 states but we’re working on quickly expanding. Contact us (firstname.lastname@example.org) to find out if Reali operates in your state.