Dear Young Earners, What is a mortgage? A mortgage acts as a financial tool used when buying real estate. Because I think that real estate is a great asset to include in your portfolio, I am going to discuss this tool. No matter what your main source of income is, it is best not to put all of your income eggs into one basket. I am fond of putting some income eggs into real estate. If you, too, plan to have a real estate income basket, it is important to know what a mortgage is.
What is a Mortgage?
Basically, a mortgage is the basis of a long-term relationship with a lender. A mortgage is a loan used to buy real estate. Mortgages and other loans differ in that mortgages are specifically used to buy real estate. Furthermore, mortgages are typically the largest and longest loans that people ever take out.
There are three main aspects of a mortgage.
First, is the principal. The principal is the amount that you have borrowed.
Next, the second aspect is the interest that you pay, which is the cost of borrowing the principal.
Last, the third aspect of a mortgage is the term, which is the length of time that you have to complete the loan. For instance, 15 or 30 years are common terms.
Overview of How Mortgages Work
There are three parts to the application process.
- The preapproval involves filling out some paperwork and submitting information and documents (like employment history, paystubs, and W-2s) to determine how much you can afford to borrow. The goal at this point? It’s receiving a preapproval letter from the lender, which will tell you how much they approve you for.
- Afterward, you find a property, and you give the lender more information, including information about the property. This is the actual application for the mortgage. The lender will do more research on you and have an appraisal report done on the property.
- Finally, if everything is given to the underwriter, he or she is the one who says yes or no regarding whether you are approved. So, the third part of the application process is the approval.
Mortgage Down Payments
When you purchase a house, a down payment is out of pocket money that you must put down. Specifically, it is money that the lender requires you to put down. It will be determined based on a percentage of the purchase price. The percentage that you put down varies, depending on the lender, the type of mortgage, and the situation. For instance, a rental property in which you are not going to live typically would require a higher percentage of the purchase price than a house in which you plan to live.
Down payments are required to help protect the lender’s investment. It is thought that people are less likely to default on their mortgage when they have their own money at stake.
Importantly, you should not automatically go for the lowest down payment because it will typically require you to pay for mortgage insurance, which is an extra fee. Mortgage insurance is designed to protect the lender, not the purchaser. Also, the less of a down payment that you pay, the more you need to borrow in the mortgage. The bigger your mortgage, the higher your monthly payments will be.
Monthly Payments
Mortgages are paid back in the form of monthly installments. Each month, you hand over a chunk of your hard-earned cash to your lender, which feels a bit like paying rent, but with the added twist of eventually owning the place.
These payments are made monthly and typically consist of several components:
- The principal, which is a portion of the loan amount being repaid.
- Interest, which is the cost of borrowing the money.
- Taxes, which are the property taxes charged by your town.
- Insurance, which is the required homeowner’s insurance.
The money for the taxes and insurance are collected by the lender and placed into an escrow account.
The acronym for the four components of the mortgage payments is PITI.
In the beginning, a larger portion of each payment goes toward the interest and a smaller portion goes toward repaying the principal. Over time, the larger portion of the payment goes toward the principal and a smaller portion goes toward paying the interest. The more you pay, the more you chip away at the principal.
Types of Mortgages
Two common types of mortgages are fixed-rate mortgages and adjustable-rate mortgages.
Fixed-Rate Mortgage
A fixed-rate mortgage is a type of home loan where the interest rate remains constant throughout the life of the loan, which is typically 15 or 30 years. (Loans of 10 or 15 years are considered short-term mortgages.) Fixed-rate means your monthly payments for principal and interest will not change, making it easier to budget and plan for the future. (Note that your overall payment can change if the cost of your real estate taxes and homeowner insurance change.)
Adjustable-Rate Mortgage
Unlike a fixed-rate mortgage, an adjustable-rate mortgage (ARM), has an interest rate that can change periodically based on market conditions. Initially, ARMs often come with a lower interest rate compared to fixed-rate mortgages. This can lead to lower initial monthly payments. However, after an introductory period, the rate adjusts periodically, which can result in higher payments. The variability creates a level of uncertainty and risk. But, if rates remain low or decrease, it can also offer potential savings. Be very careful with ARMs. I personallly, would not use them.
Beyond Fixed and Adjustable-Rate Mortgages
There are other types of mortgages designed to cater to different financial situations. For example, FHA loans are backed by the Federal Housing Administration and are ideal for first-time homebuyers with smaller down payments and lower credit scores. VA loans are guaranteed by the Department of Veterans Affairs, and are available to eligible veterans. They often require no down payment. USDA loans can help rural homebuyers.
The various types of mortgages fit various financial situations and homeownership goals. So, be sure to investigate the various options that may be available to you.
Bonus: Common Mortgage Mistakes to Avoid
Avoid overextending yourself. In other words, don’t borrow more than you can afford.
Don’t skip the pre-approval process. It is important to get a pre-approval before house hunting.
Do not forget or ignore additional costs. Buying and owning real estate comes with extra costs such as closing costs and maintenance.
What is a Mortgage? Key Takeaways
- A mortgage is a loan used to buy real estate.
- There are 3 parts to the application process: Pre-approval, Application, and Approval.
- A down payment is out of pocket money that you must put down when purchasing a house.
- Mortgages are paid back in the form of monthly installments.
- The four typical parts of a mortgage payment include: Principal, Interest, Taxes, and Insurance (PITI).
- Two common types of mortgages are fixed-rate mortgages and adjustable-rate mortgages.
- The various types of mortgages fit various financial situations and homeownership goals.
- Don’t borrow more than you can afford.
- Don’t skip the pre-approval process.
- Do not forget or ignore additional costs.
There you have it…the basics of mortgages.
Unless you have a stack of green lying around, you will need to get a mortgage to buy real estate. But, don’t worry. I am confident that you can do it!
Hugs,
Rich Mom
If you would like to read more about buying real estate, check out:
Overcoming Obstacles To Buying Your First Home
Looking to read even more? You can check out these posts:
SMART Financial Goals: Stay On Target
Diversify Your Portfolio: The Early Stages
The Best Ever Birthday Present That You Can Buy Yourself
If you want to check out a cool tool, check out this mortgage calculator:
Who is Rich Mom?
If you stumbled upon this post and you are wondering who Rich Mom is, check out my “About Rich Mom” page.
Also, please note: I am not an investment advisor. Always do your own due diligence and research before investing. Check with your own investment advisor.
Also, remember that past performance is not a guarantee of future performance.
The information shared here is not intended as financial advice, just entertainment and education.