Because people often don’t have enough cash available 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 of time, say 30 years.
If you’re shopping for a new home and planning on taking out a loan to finance the purchase, read on.
While most people call a home loan a “mortgage,” but it is actually the promissory note that contains the promise to repay the amount borrowed. (Learn more about the difference between a mortgage and a promissory note.)
The mortgage—or deed of trust in some places—provides security for the loan that is evidenced by a promissory note and creates a lien on the property. Some states use mortgages, while others use deeds of trust. (Read more about the difference between a mortgage and a deed of trust.)
Still, people usually just refer to a home loan as a "mortgage" or "mortgage loan."
Most mortgage borrowers get a FHA, VA, or a conventional loan.
FHA loans. The Federal Housing Administration (FHA) insures FHA 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 loan because other loans usually aren’t available to those with bad credit.
VA loans. A VA loan is a loan that the Veterans Administration (VA) guarantees. This type of loan is only available to certain borrowers through VA-approved lenders. The guarantee means that 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 loan, which could be the least expensive of all three loan types.
Conventional loans. Conventional loans, on the other hand, are not insured or guaranteed by the federal government. This means that, unlike federally insured loans, conventional loans carry no guarantees for the lender if you fail to repay the loan. (Learn more about the difference between conventional, FHA, and VA loans.)
Home buyers sometimes think that if a lender pre-qualifies them for a mortgage loan this means that they have been pre-approved for a home loan. But the terms “pre-qualified” and “pre-approved” have very different definitions.
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 does a review of the information—based on only your word—and gives you a figure for the loan amount that you can probably get.
The main reason to get pre-qualified for a loan is so that you get an idea in advance 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 actually be approved for this amount.
With a pre-approval, though, 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 that getting pre-qualified for a loan.
Once the lender completes the analysis, you will 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. This is because once you find the home you want and make an offer, your offer is not contingent on obtaining financing.
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 4% 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 at the beginning of the repayment period, you pay mostly interest. Eventually, though, 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 the borrower to have homeowners’ insurance on the property. Payments for insurance are also often escrowed. (Learn more about escrow accounts.)
If you need more information about mortgages, are having trouble deciding what type of loan 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.