Although each individual home financing package has its own variety of features, the concept of a mortgage is really quite simple: a mortgage is a loan made to help you finance a home. Your lender advances you a certain amount of money, which you repay over a specified period.
Rates, points, and loan fees
The total cost of your mortgage is determined by a number of different factors, most notably the interest rate, discount points, and loan fees.
Interest rate refers to the percentage of your outstanding loan balance that you pay the lender each month as part of the cost of borrowing money. Your interest rate will be based on the current overall rate environment, as well as your financial profile and the specific features of your loan.
Discount points allow you to “buy down” your interest rate at closing. One point equals 1% of your loan amount, and the more points you pay, the lower your interest rate will be, and the less you will have to pay each month. If you wanted to lower your closing expenses, you could also accept a slightly higher rate and pay no points.
Loan fees are up-front charges to cover the cost of originating, processing, and closing your loan, among other things. An origination point is a loan fee that equals 1% of your loan amount.
When considering loan pricing, keep in mind that rates, points and fees should be considered together. The interest rate alone only tells part of the story. The expenses that contribute to the cost of your loan can be expressed as the annual percentage rate (APR).
Selecting The Right Mortgage
Selecting the right mortgage is central to the homebuying process–that's why it's so important to understand your options. You'll need to consider two things at the outset: which loan type best meets your homebuying needs, and which loan term offers the ideal repayment schedule.
Most home loans fall into one of two general categories: fixed-rate mortgages and adjustable-rate mortgages (ARMs).
Fixed-rate mortgages have interest rates that stay the same for the entire life of the loan.
You will have predictable monthly payments throughout the life of the loan.
You'll be protected from rising rates, so your principal and interest payments will never increase, no matter how high interest rates rise.
Adjustable-rate mortgages have interest rates that adjust periodically based on market conditions.
The initial rate is fixed for an introductory period (usually one to ten years) and is typically lower than for a fixed-rate mortgage. After that, the rate adjusts annually based on a market index, but can't go above a predetermined adjustment cap.
Because of the lower initial rate, some borrowers may be eligible for a larger loan amount with an ARM than with a fixed-rate mortgage.
The "term" of a loan is the period of time you will spend repaying it. The most common loan term is 30 years, but other options are also available. A 40-year term is available for buyers who want lower monthly payments than those available from a 30-year term. There are also 20-, 15- and 10-year mortgages for those who want to repay their loans faster.
Whether you'd be better off with a longer loan term or a shorter one depends on a number of factors, most notably your monthly income and long-term financial goals.
Longer mortgage terms offer lower monthly payments, and are a good option if you're on a tight budget or would prefer to direct your monthly cash flow toward other investments or expenses.
Shorter mortgage terms mean higher monthly payments but allow you to repay the loan faster and save money on interest.
A preapproval is your lender's written commitment to finance your home purchase up to a specific amount. Getting preapproved is a smart move for serious homebuyers because it shows sellers that you come to the negotiating table ready to complete the transaction.
Preapproval vs. prequalification
A preapproval indicates that a lender has taken a detailed look into your financial background and has committed to lend you a certain amount of money, pending specific property details. Because preapproval includes a credit check, it's more powerful than a prequalification letter, which generally only estimates what you can afford based on information you've provided.
What are the advantages of being preapproved?
Preapproval offers a number of advantages over waiting to apply for a mortgage until after you've found a home. It lets you:
Shop for a home with the confidence of knowing exactly how much you can afford.
Take advantage of the preference many home sellers have for preapproved buyers.
Find out about possible qualification problems early in the homebuying process.
Avoid the hectic rush to find the right mortgage loan at the same time that you’ve found a house.
Who can benefit the most from preapproval?
Preapproval is a great advantage for anyone buying a home, but it can be especially useful for buyers looking for their first home and those who are self-employed or work on commission.
First-time homebuyers. Without a record of previous mortgage payments, sellers may see first-time homebuyers as less likely to obtain financing than a similar buyer who's already demonstrated the ability to meet a monthly mortgage payment. A preapproval helps even the field by showing the seller that a lender has already run the numbers and is willing to proceed with the transaction.
Self-employed buyers or commissioned employees. Because their incomes may fluctuate more dramatically, self-employed and commissioned buyers often lack the financial documentation of salaried employees, which can send up a red flag to some sellers. Showing that a lender has already considered these factors will help mitigate this risk.
How does the process work?
Before you begin shopping for a home, submit your financial information to a mortgage lender for review. Your application will be considered, if you qualify, you will be provided a written preapproval for a certain mortgage amount, down payment, and interest rate, subject to the terms of the commitment letter. The loan commitment letter can be finalized after information about the property, including an appraisal, is submitted.
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