What Is a Mortgage?
A mortgage is a loan used to buy a house or other real estate. In other words, it’s a fancy term for “home loan.” Most people get a mortgage from the bank, but it may also come from other financial institutions. The property is used as collateral, meaning if you fail to make your loan payments in a timely manner, the bank will foreclose—i.e. take your house and resell it. Monthly mortgage payments include a portion that is applied to the principal amount of the loan—reducing the amount due—while the other portion goes toward interest.
Mortgages are used to boost home ownership. Most individuals or families don’t have the cash available to purchase a home outright. Mortgages allow homebuyers to put down a portion of cash—the down payment, which can be as low as 3% with an FHA loan—and finance the rest. On the lender side, it’s a relatively safe way to make money, with the loan backed by an asset that can’t be hidden or easily moved.
Requirements for a Mortgage
To get a mortgage, borrowers generally need a stable income, relatively strong credit score, and a down payment (typically 20%). The higher the credit score, the lower the interest rate charged by the bank. Conventional mortgages—any mortgage not secured or offered by a government entity—will require private mortgage insurance (PMI). This type of insurance is meant to protect the lender against default and is typically between 0.5% and 1% of the mortgage amount.
During the first few years, mortgage payments mostly go toward interest. Over time, more of the mortgage payment goes toward the principal. At any time during your mortgage, there are two key numbers: the debt you owe the bank (remaining mortgage balance) and the portion of your home you own (the equity). As you pay down your mortgage, the equity number rises. The equity can also increase as the value of the home appreciates.
While not required, one option when searching for a mortgage is to use a mortgage broker. Mortgage brokers are go-betweens for borrowers and lenders. They are akin to mortgage matchmakers, pairing an individual with a bank or lender willing to provide the mortgage.
The Mortgage Process
Broadly, there are six steps in the mortgage process:
Finding a house, making an offer
Applying for a loan
Processing the mortgage
Before starting the search for a home, it’s recommended to get a mortgage pre-approval. This involves the lender reviewing the borrower’s information and determining how much they are willing to lend.
Figuring out how much of a mortgage the borrower can afford is based on the borrower’s other obligations and income. Lenders will verify income, as well as pull credit reports and scores. A better credit score generally translates into a better interest rate. That is, borrowers with a high likelihood of repayment will be offered the best rates.
Find a House, Make an Offer
After getting pre-approved, the potential borrower moves to the home search process, looking at homes and potentially using a real estate agent or broker to find homes within the price range of their pre-approval. Once found, the individual can make an offer on the home.
Apply for the Loan
In this step, the potential borrower fills out an application for the house. The application includes all the information about the borrower and the home they’re looking to purchase.
Mortgage Is Processed
Here a mortgage processor will gather and verify the necessary information, such as bank statements, credit reports, and appraisals.
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.
The closing is the finalization of the deal. Closing is where the money and keys are exchanged. The lender releases the funds to the seller at closing, and the buyer signs the loan documents.
Types of Mortgages
There are many types of mortgages, with the most popular types being fixed- and adjustable-rate mortgages. A fixed-rate mortgage has a set interest rate and payment for the entire duration of the loan. They are good choices for borrowers who want to lock in a rate and/or avoid the risk of rising interest rates. Fixed-rate mortgage terms are typically 15 or 30 years, but it is possible to get a term in any five-year increment between 15 and 40 years.
Fixed-Rate Mortgage vs. Adjustable-Rate Mortgage
An adjustable-rate mortgage (ARM), also known as a floating- or variable-rate mortgage, has an interest rate that is tied to a benchmark rate, meaning the rate can go up or down depending on the movement of this benchmark rate. The benchmark, such as the prime rate, is chosen by the lender. The ultimate rate for an ARM is the benchmark rate plus a margin (e.g. 1%, 2%, etc.).
The terms for interest rates on ARMs are expressed as two numbers—the first is the years the introductory rate is locked in for, and the second is how often the rate adjusts. For example, the most common ARMs are 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.
The benefit of an ARM is that it can be cheaper than a fixed-rate mortgage, with initial payments being lower. Payments may rise or fall, depending on where the index rate is after the introductory period. 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.
Government, Jumbo and Interest-Only Mortgages
Other, less common, types of mortgages include interest-only mortgages, jumbo mortgages, and government loans, such as VA and FHA loans. An interest-only mortgage allows you to pay only the interest portion of the payment for a set period. These mortgages tend to cost more over the life of the loan, but the payments are lower.
Jumbo mortgages are for borrowers that need large amounts of money, notably an amount that exceeds Fannie Mae and Freddie Mac loan-servicing limits, which is $484,350 for a single-family home in the majority of markets. Jumbo mortgages can be fixed- or adjustable-rate mortgages, but they typically have a higher interest rate, require a higher down payment, and have stricter underwriting standards than a conventional loan.
The government loans, backed by the FHA or VA, have features that help low-income and first-time home buyers. FHA loans offer lower down payments than conventional loans, while VA loans can offer up to 100% financing and lower rates.
Mortgage vs. Reverse Mortgage
A reverse mortgage is the opposite of a mortgage. With a mortgage, the lender will give you money to buy a home. With a reverse mortgage, the lender gives you money against the equity you have built up in the home. The lender will pay the borrower in monthly payments, a lump sum, or as a line of credit. Unlike a mortgage or a home equity loan, a reverse mortgage doesn’t require steady payback—it’s paid back when the owner sells the home, moves out, or dies.
One catch with reverse mortgages is that you have to be over 62 years old. Some lenders will require the borrower own the home outright, while others will require at least 50% equity in the home. While there are no required payments, if the borrower fails to make required home insurance or property tax payments, the lender can foreclose on the home. As well, interest on a reverse mortgage is not tax deductible. Who uses reverse mortgages? Generally, it’s retirees looking for extra capital or whose retirement funds have fallen short.
Mortgages vs. Hard Money Loans
Hard money loans are generally short-term real estate loans. Unlike mortgages, hard money loans are offered by individuals or groups of individuals. Hard money lenders focus less on the borrower’s ability to repay and instead focus on the value of the property. Repayment length for hard money loans are generally one to five years, and they have higher interest rates and fees (origination, closing, etc.) when compared to mortgages.
Investing in Mortgages
Real estate investors can invest in mortgages, specifically mortgage notes. The mortgage note is the promissory note attached to a mortgage. This note lays out the terms of the loan. Investing in these mortgage notes, sometimes called real estate notes, means buying the right to the mortgage payments. The investor doesn’t own the property, however. Basically, you become the de facto bank when buying mortgage notes.
The investor gets monthly passive income. Investing in mortgage notes is a unique way to diversify a portfolio, while gaining exposure to the real estate market. Buying mortgage notes can be done via online platforms, lending institutions and investment companies, among other options.
To learn more about investing in notes, check out our Real Estate Note Investing book.
Pros and Cons of Mortgages
Compared to using all cash to purchase a home, here are the pros of using a mortgage:
A mortgage allows you to put down less cash (e.g. 20% or less), leaving you money to invest in other properties or assets, or allowing people without the required cash to purchase a home.
Being able to take out a mortgage also allows buyers to qualify for a more expensive home than they would otherwise be able to afford if paying in cash.
Mortgages can magnify your home value appreciation by providing leverage.
Mortgages can boost your credit score, assuming you make payments on time.
Mortgages are tax deductible. That is, mortgage interest paid on the first $750,000 of the mortgage debt can reduce your tax liability. However, in order to get this deduction, the borrower must itemize their deductions instead of taking the standard deduction.
Paying all cash eliminates paying interest, where interest charges increase the cost of your home. For example, the total cost of a mortgage—including interest but excluding taxes, insurance and other fees—for a $250,000, 30-year fixed rate loan at 4% interest, with a 20% down payment is just over $402,000.
Cash buyers can be viewed as more appealing to sellers, where the threat of a deal falling through due to denied financing is eliminated.
Buying with all cash can also make it easier to resell the property, as you don’t have to worry about satisfying the mortgage debt.
To learn more about home loans, including the ins and out of mortgage options and how they work, be sure to read our Ultimate Beginners Guide to Home Loans.