Getting a home loan doesn’t have to be intimidating – especially when you understand the basics like options, features and costs of a home loan. Of course, your mortgage banker is available anytime to answer your questions and make the process a lot easier.
Types of Home Loans
Every home loan has two parts: principal and interest. The principal is the amount you borrow, and the interest is what you pay to borrow the money. Different types of home loans give you choices on how to structure your interest payments to meet your specific financial needs.
When shopping for a home loan, there are two major types of loans that you can choose from: a fixed-rate mortgage or an adjustable-rate mortgage (ARM).
The main features of a fixed-rate mortgage are:
- The interest rate doesn’t change on your loan.
- Your monthly mortgage payment (principal and interest) will always be the same amount
- As a tradeoff for the security of knowing your monthly payment will never increase, the interest rate will be slightly higher than the rate on an adjustable-rate mortgage
The main features of an ARM are:
- The initial interest rate will be lower than the rate on a fixed-rate loan.
- The interest rate adjusts periodically after the initial term expires (anywhere from 1 to 10 years), depending on movements in market interest rates.
- Your monthly mortgage payment could increase or decrease in the future, based on the annual adjustments to the interest rate on the loan
Tip: If you are considering an ARM, it is a good idea to ask your mortgage banker what your monthly payment would be if interest rates rise 1, 3 or 5 percentage points in the future, so you can get a sense for how much more you may be required to pay in the future.
Government loan programs offered by the Federal Housing Authority (FHA) are also popular and are available in both fixed-rate and adjustable-rate structures. In general, government loan programs are easier to qualify for and have lower down payment requirements as well as more flexible credit requirements. However, like conventional loan programs, FHA loans have specific fees and payments associated with each of them.
Prequalified and Preapproved
Before you start looking for a home, you will need to know how much you can afford, and the best way to do that is to get prequalified for your loan. Many real estate agents want you to be prequalified so they can show you homes in your price range.
To get prequalified, you just need to provide some financial information to your mortgage banker, such as your income and the amount of savings and investments you have. Your mortgage banker will use this information to estimate how much they can lend you. You can also use our Affordability Calculator to see the price range of homes you should be looking at.
You can also get preapproved for your mortgage, which may involve providing your financial documents (W-2 statements, paycheck stubs, bank account statements, etc.) so your lender can verify your financial status and credit. Preapproval gives you “cash-buyer confidence” when you’re ready to make an offer, and it helps your seller take in your offer seriously because they know you can get the money you need to buy their home.
The term is the number of years that you will make payments on your home loan. The longer the term, the lower your monthly payment will be. With a longer term, you will also pay more in interest over the life of the loan.
The interest rate is used to calculate your monthly mortgage payment. The higher the interest rate on a particular loan, the higher your monthly payment will be, and vice versa. With a fixed-rate mortgage, the interest rate on your loan will never change. With an ARM, however, the interest rate is linked to an index of interest rates published by a third-party, such as the federal government. As this index changes over time, so will the interest rate used to calculate your monthly mortgage payment.
If you are comparing particular loans across lenders, you want to be sure to look at your Loan Estimate and the Annual Percentage Rate (APR) of each loan. The APR tells you the estimated cost of your loan, which includes the interest rate and other upfront fees that you pay for the loan (such as discount points and origination fees). Comparing APRs will help you understand which loan is actually the best value for you when all costs are considered.
One popular home-loan strategy is to negotiate discount points. These are fees you can choose to pay the lender to reduce your interest rate. Generally, each point you purchase will lower your rate by 0.25% (for example, a 6.50% interest rate would be lowered to 6.25%). This, however, depends on the term of the loan. The cost of buying one point is equal to 1% of the loan amount. For a $100,000 loan, a point would cost you $1,000. For a $200,000 loan, a point would cost $2,000. Buying discount points can be smart for those who know they’ll be in their home for a long time, as it saves money over the life of the loan.
Interest rates can change in the time it takes to complete the home loan application process. To protect yourself against a potential rise in interest rates, you can ask your lender to lock in the rate you have been quoted for a specific period of time, usually 30-60 days (some lenders may charge a fee for locking in the rate). If you decide to lock in the rate, be sure to get the agreement in writing and make sure it covers the length of time needed to complete your home purchase or refinance your mortgage. Other borrowers prefer to take the chance that interest rates will decrease while the loan is processed and let the rate on their loan “float.” The rate can then be locked in at any time until the day before your loan closes.
Buying a home or refinancing a mortgage requires the help of a lot of different people (the lender for processing the loan, the title company for verifying ownership of the property, the appraiser for assessing the value of the home, etc.). Don’t worry about finding all of these people; your mortgage banker and real estate agent can handle all of that for you. All of the fees from these services are collectively called closing costs. These fees commonly total about 2-3% of the loan amount, but they can be higher in certain situations. Some of these costs are controlled by the lender, while the rest are controlled by other firms that are involved in your loan process. The closing costs can either be paid up-front, or in some situations, the lender will add them to the amount you are borrowing. Your lender will outline these costs in a Loan Estimate, so you can get a sense for how much you will need to pay when the loan closes. Your mortgage banker will send you a GFE within three days of finishing your application and help you to understand what you are paying for.
Monthly Mortgage Payment
Generally, your monthly mortgage payment includes principal and interest. Property taxes and homeowner’s insurance may also be collected by the lender through your monthly mortgage payment, held in an escrow account, and then paid on your behalf when the payments are due. Your property taxes and homeowner’s insurance may be reassessed each year during an annual escrow reassessment period. Your home loan servicer (described in the section below) will recalculate what your new monthly payments will be and let you know how much you owe. These payments will be put into escrow and paid on your behalf.
Use a mortgage payment calculator to estimate your monthly mortgage payment.
Home Loan Originator vs. Home Loan Servicer
Don’t be surprised if you are asked to send your monthly mortgage payments to a company that is different from the one that lent you the money to buy your home. A home loan originator works with you during the mortgage process and provides the money for your loan. Once your loan closes, a different firm called a home loan servicer may then be responsible for managing your account, collecting your monthly payments and paying your property taxes and insurance (when applicable).