If you were to have your sights set on a new house, but you learned that in order to buy it, a special "death pledge" was part of the deal, you’d probably run far, far away in the other direction.
Just the words "death pledge" can send shivers down your spine. It sounds like some sort of pact with the devil, a sale of your soul to Satan in exchange for a 3-bedroom bungalow. It conjures up all sorts of imagery, like haunted houses, or cursed properties built on top of sacred burial grounds or situated on a sinkhole. The house with the death pledge on it is the one trick or treaters are too afraid to go near on Halloween. A house is a place you’re supposed to pledge to live in, not die.
But what if we were to tell you that a death pledge is just another term for a good old fashioned mortgage loan?
Mortgage contains "mort," the French word for death, and the word "mortgage" itself has its origins in Old French and Latin, literally meaning death pledge. In this case, when you borrow money to buy a home, you make a pledge to pay your lender back, and when the loan is paid off, the pledge dies.
Obscure references aside, how well do you really know the rest of your home loan basics? It’s important to know the ins and outs of the lending process, the difference between fixed and variable, principal and interest, prequalification and preapproval. What about insurance, and taxes?
Going into the home buying process uninformed may lead you to make the wrong decisions with negative financial repercussions. So, with that, we prepared this basic primer on mortgages and home loans.
What is a mortgage, exactly?
A mortgage is a home loan. When you select a house you’d like to buy, you’re allowed to pay down a portion of the price of the home (your down payment) while the lender -- a bank, credit union or other entity -- lets you borrow the rest of the money. You’re then permitted to move into the house and live there while you pay back the money over the course of several years, usually on a 15- or 30-year schedule.
Why is this process in place? Well, if you’re wealthy enough to afford a house in cash, a mortgage doesn’t need to be a part of your financial vernacular. But homes can be expensive, and most people can’t afford $200,000 (or $300,000, or $1 million) up front, so it would be unfeasible to make you pay off a home before you’re allowed to move in. That would leave entire neighborhoods of houses sitting empty and entire populations of people homeless (or, at the very least, renting/leasing for eternity).
Like most loans, a mortgage is a trust between you and your lender -- they’ve entrusted you with money and are trusting you to repay it. Should you not, a safeguard is put into place. Until you pay back the loan in full, the house is not yours; you’re just living there. During this time, the home is considered collateral -- it’s a piece of security with monetary value that your lender can take away from you if you stop making your loan payments for whatever reason. This is called foreclosure, and it’s all part of the agreement.
The principal and interest of things
Mortgages are like other loans. You’ll never borrow one lump sum and owe the exact amount lent to you. Two concepts come into play: principal and interest.
Principal is the primary amount borrowed from your lender after making your down payment. So, if you put down 10 percent on a $150,000 house -- $15,000 -- the principal amount the bank grants you is $135,000.
How nice it would be to take 30 years to pay that money back and not a penny more, but then, lenders wouldn’t make any money off of lending money, and thus, have no incentive to work with you. That’s why they charge interest: an extra, ongoing cost charged to you for the opportunity to borrow money, which can raise your monthly mortgage payments and make your purchase more expensive in the long run.
If your interest rate is 7 percent, for example, you’ll pay 7 percent extra of the $135,000 you initially borrowed -- that is, sometimes. There are two types of mortgage loans, both defined by a different interest rate structure.
Types of mortgage loans
Fixed-rate mortgages (FRMs) have an interest rate that stays the same, or in a fixed position, for the life of the loan. Conventionally, mortgages are offered in 15-year or 30-year repayment terms, so if you obtain that 7-percent fixed-rate loan, you’ll be paying the same 7 percent without change, regardless if interest rates in the broader economy rise or fall over time (which they will).
Adjustable-rate mortgages (ARMs) come with an interest rate that fluctuates or varies over time according to market changes. So, you might start off with 7 percent, but in a few years you might be paying 5.9 percent, or 3.7 percent, or 12.1 percent.
FRM pros and cons:
+Peace of mind that your interest rate stays locked in over the life of the loan
+Monthly mortgage payments remain the same
-If rates fall, you’ll be stuck with your original APR unless you refinance your loan
-Fixed rates tend to be higher than adjustable rates for the convenience of having an APR that won’t change
ARM pros and cons:
+APRs on many ARMs may be lower compared to fixed-rate home loans, at least at first
+A wide variety of adjustable rate loans are available -- for instance, a 3/1 ARM has a fixed rate for the first 36 months, adjustable thereafter; a 5/1 ARM, fixed for 60 months, adjustable afterwards; a 7/1 ARM, fixed for 84 months, adjustable after
-While your interest rate could drop depending on interest rate conditions, it could rise, too, making monthly loan payments more expensive than hoped
How is your APR determined? That all depends on your credit score, a 3-digit representation of your credit health. Credit scores usually range between 300 to 850 on the FICO scale, from poor to excellent, calculated by three major credit bureaus (TransUnion, Experian and Equifax). Keeping your credit free and clear of debt and taking the steps to improve your credit score can qualify you for the best mortgage rates, fixed or adjustable.
The difference between mortgage prequalification and mortgage preapproval
You may have heard of the terms prequalification and preapproval and assumed they were one and the same. They both share similarities in that being successfully prequalified and preapproved gets your foot in the door of that new house, but there are some differences.
Providing some basic financial information to a real estate agent as you shop around for a house, like your credit score, current income, any debt you may have, and the amount of savings you may have can prequalify you for a loan -- basically a way of earmarking you in advance for a low-rate loan before you’ve applied for it. In some cases, this may be preferred by agents and brokers, since they want to see if you’d be able to afford any of the new homes they have listed before they begin working with you.
Prequalification is a simple, early step in the mortgage process and doesn’t involve a hard check of your credit report, so your score won’t be affected.
Preapproval comes after you’ve been prequalified, but before you’ve found a house. It’s a way of prioritizing you for a loan over others bidding for the same property, based on the strength of your finances, so when you do pursue the purchase of a house, most of the financial work is done. Preapproval is a preliminary step in the mortgage process, and does not guarantee that you’ll ultimately be approved for the loan.
In the preapproval process, your prospective lender does all the deep digging and checking into your financial background, like your credit report, to verify the type of loan you could receive, plus the interest rate you’d qualify for. By the end of the process, you should know exactly how much money the lender is willing to let you borrow, plus an idea of what your mortgage schedule will look like.
What kind of a credit score do you need in order to get approved for a mortgage? There’s no hard and fast number, but the general rule of thumb is that a very good to excellent credit score will secure you the best, most competitive interest rates. Mortgage applicants with a score higher than 700 are best poised for approval, though having a lower credit score won’t immediately disqualify you from obtaining a loan. Cleaning up your credit will remove any doubt that you’ll be approved for the right loan at the right rates.
Mortgage fees and other factors
Once you’ve been approved for a mortgage, handed the keys to your new house, moved in and started repaying your loan, there are some other things to keep in mind.
Some homeowners will need to pay private mortgage insurance, or PMI, if they fail to produce at least a 20 percent down payment on their new home. Your PMI is also a sort of collateral; the extra money your pay in insurance (on top of your principal and interest) is to make sure your lender gets paid if you ever default on your loan. To avoid paying PMI or being perceived as a risky borrower, only purchase a house you can afford, and aim to have at least 20 percent down before borrowing the rest.
Then there are other fees and taxes involved during and after you’ve signed on the mortgage dotted line. First, you’ll be responsible for commissions and surcharges paid towards your broker or real estate agent. Then there’ll be closing costs, paid when the mortgage process "closes" and loan repayment begins. Closing costs can get costly, for lack of a better word, so brace yourself; they can range between 2 to 5 percent of a home’s purchase price.
Buying a new home is one of the biggest expenses anyone will incur in their lifetime, so understanding some of the ins and outs of the mortgage process can help you come closer to reaching your goal while staying financially sensible.
Mortgages exist in an entirely different dimension than the average apartment lease, so if you’re looking to make the transition from renting to buying, get to know your home lending basics, and more, to to remove all doubt and proceed with confidence as part of the homeowners club.