How Mortgages Work: What to Know Before Buying a Home

Buying a home is an exciting milestone. It’s natural to picture the holiday gatherings you’ll host, the family you may grow and the memories you’ll make in a place that is truly your own. But before you start touring homes, it helps to understand how mortgages work, what is included in a mortgage payment and what steps are involved in buying a home. We’re here to break down the basics so you can feel more prepared before you apply for a mortgage or talk with a lender.

What is a mortgage and how does it work?

A mortgage loan is used to purchase a home or refinance an existing home loan. Like other loans, you agree to make monthly payments to the lender for a set number of years, referred to as the term of the loan, until the borrowed amount is paid off. In exchange for borrowing the funds, you pledge the home as collateral for the loan and pay interest on the amount borrowed. If you’re interested in buying your first house, understanding mortgage financing options and the mortgage application process is important.

Are there different types of mortgage loans?

Yes, various mortgage loan products are available to homeowners. The right fit often depends on your financial situation, how long you plan to stay in the home and how much you have saved for a down payment and closing costs.

What are the different types of mortgages?

There are many loan options available to homebuyers, including but not limited to:

Fixed-rate vs. adjustable-rate mortgage (ARM)

If you choose a fixed-rate mortgage loan, the interest rate remains the same for the term of the loan.  An adjustable-rate mortgage (ARM) has an initial fixed-rate period, typically three, five, seven or ten years, and thereafter, the interest rate may adjust periodically, typically once a year.  The interest rate adjustment will be based on a market index, such as the one-year US Treasury, plus a margin, such as 2.00%, and subject to adjustment caps which limit how much the interest rate can increase or decrease when adjusted.

A fixed-rate mortgage loan typically has a higher interest rate than initial interest rate for an ARM, but can be a good choice for homebuyers who plan on staying in their home long-term and want a consistent, predictable monthly payment. An ARM may be a good option for borrowers who do not anticipate keeping the loan beyond the initial fixed-rate period and have the financial ability to make payments if they still own the home during the adjustable-rate period and the interest rate increases.

Conventional mortgage loan

A conventional mortgage is one that is not part of a specific government-backed program.  There are two types of conventional mortgages.  Conforming, meaning they comply with Fannie Mae or Freddie Mac maximum loan amounts and other rules, and non-conforming, meaning maximum loan amount and features are established by the lender.

Jumbo Mortgage Loan

Jumbo loans are similar to conventional loans, but the loan amount is larger than the conforming loan limit. Qualifying for a jumbo loan usually requires lower debt-to-income ratios, higher down payments and higher credit scores than a conventional mortgage.

If you want to purchase a home that requires a loan amount larger than the current conforming loan limit, you will most likely need a jumbo loan.

Portfolio Mortgage Loan

A portfolio loan is designed by the lender and retained rather than sold to another lender or Fannie Mae or Freddie Mac (referred to as the “secondary mortgage market”). Because the lender retains the loan, it may have more flexibility to evaluate borrowers or properties that do not fit standard conventional guidelines. Portfolio loans may be an option for borrowers with unique financial situations, non-traditional income or a property that requires a more customized lending approach.

Since portfolio loans are held by the lender, terms, qualification requirements, interest rates and fees can vary by institution. Borrowers should talk with their mortgage banker to understand whether a portfolio loan is available and how it compares with other mortgage options.

Construction loan

A construction loan is a short-term loan that finances the construction or renovation of a home. At SouthState, our construction loans allow you to finance up to 90% of the construction or home value (whichever is lower). You only pay interest during the construction of the home and can take advantage of flexible and quick disbursements during the home building process to cover materials and labor.

Because construction loans are short-term, your loan will be converted from the construction loan to a permanent mortgage loan (such as a fixed-rate mortgage or an ARM) after the custom build of your home is complete.

Government-backed mortgage loans

Homebuyers who do not meet the qualifications for a conventional mortgage may be eligible for a government-backed mortgage.  These loans allow for more flexible qualification criteria such as a lower credit score, lower debt-to-income requirements, and down payment assistance. There are a variety of government mortgage programs available aimed at helping make homeownership more accessible.

These programs include:

• Veterans Association (VA) The VA offers loans to veterans meeting specific service requirements. These loans have limited closing costs, competitively low interest rates, and grant the ability to purchase a home with no money down.

• Federal Housing Administration (FHA) FHA loans are government-backed mortgages that may allow qualified borrowers to get into a home for as little as 3.5 percent down.

• United States Department of Agriculture (USDA) The USDA offers loans to qualified borrowers to purchase homes in designated rural areas with no down payment required.

First-time homebuyer checklist: what do I need to do to buy a house?

If you’re wondering how to prepare to buy a house, start by reviewing your budget, checking your credit, estimating how much to save for a house and gathering the documents you may need for your mortgage application. A simple first-time homebuyer checklist may include recent pay stubs, bank statements, tax returns, credit information and an estimate of funds available for your down payment and closing costs. You may also want to make a list of questions to ask your mortgage banker, such as what loan options you may qualify for, downpayment expectations, estimated closing costs and whether there are any prepayment penalties if you pay off the loan early.

Closing costs vs. down payment: what’s the difference?

Your down payment is the amount of money you pay out of pocket to purchase a home, with the reminder of the purchase price paid with the proceeds of your mortgage loan. Closing costs are separate expenses paid at or before closing and may include lender fees, title fees, appraisal fees, prepaid taxes, insurance and other costs associated with finalizing the home loan. When deciding how much to save for a house, consider both your down payment and your estimated closing costs so you have a clearer picture of the total cash needed to buy a home.

Principal, Interest and APR

Principal refers to the amount of money you borrowed from the lender. Every time you make a payment, part of that payment may go toward reducing your principal balance. For example, if you borrow $100,000 and, over time, the portion of your monthly payments applied to principal equals $10,000, then your principal balance is reduced to $90,000.

Interest is the amount the lender charges for the use of the money loaned. The interest rate is based on factors such as the borrower’s credit profile and is expressed as a percentage of the outstanding loan amount. The Annual Percentage Rate (APR) represents the overall cost of borrowing money because it includes interest as well as certain lender charges and fees, such as loan origination fees and mortgage insurance.

What is included in a mortgage payment?

Your monthly mortgage payment will include principal and interest, and many also include an escrow payment amount.

What is the purpose of an escrow payment?

Every homeowner pays property taxes, which are based on the value of the home and the tax rates applied by the state, county, city and school district in which they live. Tax rates can vary significantly depending on the location and value of the home.

Mortgage lenders require homeowners obtain an insurance policy to coverage the cost  of damage from theft, fire, or other disasters. The annual premium for insurance varies depending on the location and value of the home. According to Bankrate.com, the cost of the average annual homeowner’s insurance policy is $1,312 for a $250,000 dwelling.  If the home is located in a Special Flood Hazard Area, a separate flood insurance policy must also be obtained. 

An escrow account is established by the lender to hold the funds collected each month from the borrower to pay real estate taxes and insurance policy premiums.  Funds are disbursed from the account by the lender to pay insurance premiums and property tax when due. For example, instead of paying $6,000 in property taxes in a lump sum once a year, $500  will be added to your monthly mortgage payment and placed in your escrow account  until the property tax bill is due.

In some instances the lender may allow the borrower the choice to pay taxes and insurance on their own rather than utilize an escrow account, however, for certain loan program such as government-backed mortgages, funds are required to be escrowed. Flood insurance is required by law to be escrowed.

How do I apply for a mortgage?

When beginning the mortgage process, preparation is key. Use our mortgage application checklist to see what information may be required to complete your application. By gathering documents such as pay stubs, bank statements and tax returns ahead of time, you will likely experience a more streamlined process. When you’re ready to apply, you can contact one of our local Mortgage Bankers or use our quick and convenient online application. If you have questions before you begin your application, your local SouthState mortgage banker is available to discuss the homebuying process.

Should I get pre-qualified before I start shopping for a home?

Getting pre-qualified is an excellent way to begin the mortgage process. By getting pre-qualified before you start shopping for a home, you can receive an estimate of how much you may be able to borrow, which can help you understand your price range and make the application process easier. A mortgage pre-qualification can also give you additional leverage with a seller in negotiating the best possible terms of the sale. Contact your local SouthState mortgage banker and we can help you get started today.