Mortgages: What You Need to Know

Because people often don't have enough cash to purchase a home outright, they usually take out a loan when buying real estate. A bank or mortgage lender agrees to provide the funds, and the borrower agrees to pay it back over a specific period, say 30 years.

Read on if you're shopping for a new home and planning on taking out a loan to finance the purchase.

What Is the Difference Between a Promissory Note, Mortgage, and Deed of Trust?

Depending on where you live, you'll likely either sign a mortgage or deed of trust when you take out a loan to purchase your home. This document provides security for the loan evidenced by a promissory note, and creates a lien on the property.

Some states use mortgages, while others use deeds of trust or a similarly-named document. The mortgage or deed of trust gives the loan owner the right to sell the secured property through the foreclosure process if you don't make the payments or breach the loan contract in another way.

While most people call a home loan a "mortgage" or "mortgage loan," it's actually the promissory note that contains the promise to repay the amount borrowed.

Different Types of Mortgage Loans: FHA, VA, Conventional

Most mortgage borrowers get an FHA, VA, or conventional loan.

What Is an FHA-Insured Loan?

The Federal Housing Administration (FHA) insures some home loans. If you default on the loan and your house isn't worth enough to fully repay the debt through a foreclosure sale, the FHA will compensate the lender for the loss.

A borrower with a low credit score might want to consider an FHA-insured loan because other loans usually aren't available to those with bad credit.

What Is a VA-Guaranteed Loan?

As you might guess, a VA-guaranteed loan is a loan that the U.S. Department of Veterans Affairs (VA) guarantees. This type of loan is only available to specific borrowers through VA-approved lenders. The guarantee means the lender is protected against loss if the borrower fails to repay the loan.

A current or former military servicemember might want to consider getting a VA-guaranteed loan, which could be the least expensive of all three loan types.

What Is a Conventional Loan?

Conventional loans aren't insured or guaranteed by the federal government. So, unlike federally insured loans, conventional loans carry no guarantees for the lender if you fail to repay the loan.

What's the Difference Between Being Pre-Qualified and Pre-Approved for a Mortgage Loan?

Homebuyers sometimes think that if a lender pre-qualifies them for a mortgage loan, they've been pre-approved for a home loan. But the terms "pre-qualified" and "pre-approved" have very different definitions.

Getting Pre-Qualified for a Mortgage Loan

Pre-qualifying for a loan is the first step in the mortgage process. Typically, it's a pretty easy one.

You can pre-qualify quickly for a loan over the phone or Internet (at no cost) by providing the lender with an overview of your finances, including your income, assets, and debts. The lender then reviews the information—based on your word—and gives you a figure for the loan amount you can probably get.

The main reason to get pre-qualified for a loan is to get an idea of how much you can afford when shopping for a new home. It's important to understand that the lender makes no assurance that you'll be approved for this amount.

Getting Pre-Approved for a Mortgage Loan

With a pre-approval, you provide the mortgage lender with information on your income, assets, and liabilities, and the lender verifies and analyzes that information. The pre-approval process is a much more involved process than getting pre-qualified for a loan.

Once the lender completes the analysis, you'll receive a conditional commitment in writing. You can then look for a home at or below that price level.

As you might guess, being a pre-approved buyer carries much more weight than being a pre-qualified buyer when it comes to making an offer to purchase a home; once you find the home you want and make an offer, your offer isn't contingent on obtaining financing.

Principal, Interest, Taxes, and Insurance

After taking out a mortgage loan to buy a home, the borrower typically has to make monthly payments of principal and interest, as well as taxes and insurance if the loan is escrowed. Collectively, these items are called "PITI."

• Principal. The "principal" is the amount you borrowed. For example, suppose you're buying a home that costs $300,000. You put 20% of the home's price down ($60,000) so that you can avoid paying private mortgage insurance (PMI), and you borrow $240,000. The principal amount is $240,000. Each month you'll pay back a portion of the principal.
• Interest. The interest you pay is the cost of borrowing the principal. When you take out the home loan, you'll agree to an interest rate, which can be adjustable or fixed. The rate is expressed as a percentage: around 3% to 6% is more or less standard, but the rate you'll get depends on your credit history, your income, assets, and liabilities. Mortgages are set up so that you pay mostly interest at the beginning of the repayment period. Eventually, however, you'll pay mostly principal.
• Taxes. When you own real estate, you have to pay property taxes. These taxes pay for schools, roads, parks, and the like. Sometimes, the lender establishes an escrow account to hold money for paying taxes. The borrower pays a portion of the taxes each month, which the lender places in the escrow account. When the property tax bills are due, the lender pays these bills with money from the escrow account.
• Insurance. The mortgage contract will require you to have homeowners' insurance on the property. Insurance payments are also often escrowed.

Federal Laws Protecting Homeowners

Federal laws protect homeowners who have new and existing mortgages. Under these federal laws, loan servicers have to:

• give borrowers information about their mortgage loans
• promptly credit mortgage payments to borrowers' accounts
• respond quickly to payoff requests from borrowers
• provide options so borrowers can avoid force-placed insurance, and
• quickly resolve errors and respond to information requests from borrowers.

Servicers Must Provide Borrowers With Information

Mortgage servicers must give borrowers certain information about their loan so they're not caught off guard when an interest rate adjusts or they're charged various fees. The law requires servicers to:

Periodic Billing Statements. A servicer must provide a written statement to the borrower each billing cycle, usually monthly. (12 C.F.R. § 1026.41). The statement must show:

• the amount currently due, including how much will be applied to principal, interest, and escrow
• the total of all payments received since the last statement
• how prior payments were applied
• transaction activity
• partial payment information
• fees or other charges to the account
• account information, like the outstanding balance and interest rate
• contact information for the servicer and housing counselors, and
• information about delinquencies, if the borrower is behind on payments.

However, if you have a fixed-rate mortgage and your servicer sends you a book of coupons to send in with your payments, then a monthly statement isn't required.

Interest-Rate Adjustment Notices. If a mortgage loan has an adjustable interest rate, the servicer must provide the borrower with a notice containing the new rate and new payment (or an estimate):

• between 210 and 240 days (7 to 8 months) days prior to the first payment due after the rate first adjusts, and
• between 60 and 120 days (2 to 4 months) before payment at a new level is due when a rate adjustment causes a payment change. (12 C.F.R. § 1026.20).

The creditor or servicer doesn't have to send a rate adjustment notice in the following situations.

• ARMs with terms of one year or less. The creditor or servicer doesn't have to send a notice when the rate initially or subsequently adjusts if the adjustable-rate mortgage has a term of one year or less.
• The first adjusted payment is within 210 days after consummation of the loan. A rate adjustment notice is not required if the first payment at the adjusted level is due within 210 days after consummation of the loan and the creditor disclosed the new interest rate at consummation. ("Consummation" occurs when you become contractually obligated on the loan.)
• You send a cease communication notice to the servicer. If the servicer is subject to the Fair Debt Collection Practices Act (FDCPA), and you send a written notice to the servicer to cease communication with you, it does not have to send ongoing notices of rate adjustments. (It still must send a notice about the initial interest rate adjustment.)

Promptly Credit Mortgage Payments

In most cases, servicers must promptly credit a borrower for the full payment the day it is received. (12 C.F.R. § 1026.36).

If the borrower only makes a partial payment, that amount may be held in a special account (called a "suspense account"), but the servicer must inform the borrower on the monthly statement. Once the suspense account has sufficient funds to make a full payment of principal, interest, and any escrow, the servicer must credit that payment to the account. (12 C.F.R. § 1026.36, 12 C.F.R. § 1026.41).

Respond Quickly to Payoff Requests

The servicer generally must provide an accurate payoff balance to a borrower no later than seven business days after receiving a written request asking how much it will cost to pay off the mortgage. (12 C.F.R. § 1026.36). In some instances, the servicer must provide the statement within a "reasonable time."

Provide Options to Avoid Force-Placed Insurance

Mortgages require homeowners to have adequate homeowners' insurance on the property to protect the lender's interest in case of fire or another casualty. If a borrower lets the insurance lapse, the servicer can buy coverage and add the cost to the loan payment. (12 C.F.R. § 1024.37). This type of coverage is called "force-placed insurance" or "lender-placed insurance."

Under the law, the servicer:

• must send notice at least 45 days before it purchases a force-placed insurance policy, which gives borrowers sufficient time to buy their own policy
• must send notice again at least 30 days later—and at least 15 days before charging the borrower for force-placed insurance coverage—if the servicer has not received proof from the borrower that insurance has been purchased, and
• generally must continue the existing insurance policy if there is an escrow account from which the servicer pays the insurance bill, even if the servicer needs to advance funds to the borrower's escrow account to do so. The servicer may then add this cost to the escrow balance or otherwise seek reimbursement from the borrower for the funds advanced.

If a borrower gives the servicer proof of hazard insurance coverage, the servicer must, within 15 days:

• cancel any force-placed insurance policy and
• refund any premiums paid for overlapping periods in which the borrower's coverage was in place.

Quickly Resolve Errors and Respond to Information Requests

A servicer must, in most cases, acknowledge receiving a written information request or complaint of errors, like if a borrower complains that the servicer misapplied a payment or charged improper fees, within five days (excluding legal public holidays, Saturdays, and Sundays) and respond within 30 days.

The servicer may generally extend the 30-day period for an additional 15 days if the servicer notifies the borrower within the 30-day period of the extension and provides the reasons for the delay in responding. (12 C.F.R. § 1024.35, 12 C.F.R. § 1024.36).

Getting Help

If you need more information about mortgages, are having trouble deciding what loan type is best for your circumstances, or need other home-buying advice, consider contacting a HUD-approved housing counselor, a mortgage lender, or a real estate attorney.