Understanding Mortgages and How They Work
Buying a home is an exciting milestone in your life.It’s exciting to think about the holiday gatherings you will host, the family you will grow, and the memories that will be made in a place that is truly all yours. However, understanding what all is involved in a mortgage can be confusing, leaving homebuyers feeling overwhelmed and searching for answers. The good news is Nicole Reeves, one of our SouthState mortgage bankers, is here to break down the different types of mortgage loans, how they work, and how to determine which option might be better for you.
What is a mortgage?A mortgage is a loan used to purchase a home or to refinance an existing home loan. Like other loans, you agree to make monthly payments to the lender until the mortgage is paid off after a set number of years. In exchange for borrowing the funds, you will be required to sign a contract agreeing the home will be used as collateral for the loan.
What are the different types of mortgages?There are many loan options available to homebuyers, including but not limited to:
Fixed-rate mortgageA fixed-rate mortgage is a home loan in which your interest rate will remain the same over the entirety of the 30-year or 15-year mortgage term. Regardless of market conditions, your interest rate will not fluctuate. This mortgage is a good choice for homebuyers who plan on staying in their home long-term and who want a consistent, predictable monthly payment.
If you choose a 30-year fixed-rate mortgage, your payments will often be significantly lower than with a 15-year fixed-rate mortgage because they are spread out over a longer time period. However, 15-year fixed-rate mortgages typically come with lower interest rates since the lender will get their money back sooner.
Adjustable-rate mortgage (ARM)An adjustable-rate mortgage (ARM) is a type of mortgage in which the interest rate applied on the remaining balance will vary throughout the life of the loan based on market conditions. Initially, the borrower will receive a fixed interest rate for a period of time. After that, the interest rate may periodically change at yearly or even monthly intervals.
Adjustable-rate mortgages often come with rate caps that place limits on how much your interest rate can fluctuate year after year, as well as throughout the life of the loan. This mortgage is a good option for borrowers planning to keep the loan for a limited time to take advantage of the up-front low interest rate, and who have the financial ability to make the mortgage payments if they still own the home should the interest rate increase.
Government-backed mortgagesHomebuyers who do not meet the qualifications for a conventional mortgage may choose to consider a government-backed mortgage due to more flexible qualification criteria such as lower credit score requirements, 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 Association (FHA) The FHA offers government-backed mortgages allowing 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.
Jumbo mortgageJumbo mortgages are very similar to conventional loans; however, the maximum loan amount is larger and qualifying for a jumbo mortgage usually requires lower debt-to-income ratios, higher down payments and has higher FICO scores than a conventional mortgage.
In 2022, the nationwide limit for a conventional loan is $625,000, but in some high-cost areas this limit can be higher. If you want to purchase a home that requires a loan amount larger than this limit, you will most likely need a jumbo mortgage.
Construction loanA 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.
What are the loan terms for a mortgage?Your mortgage loan term refers to the amount of time you have to pay back the loan in its entirety. The two most common loan terms are 15 years and 30 years but loan terms can range between 10 years and 30 years. As a general rule of thumb, the longer your loan term is, the lower your monthly payment will be. However, a shorter loan term can mean a savings in how much interest you pay.
What costs are included in a mortgage payment?Your mortgage payment is the amount you pay each month towards your loan. Your payment will include an amount paid to the principal balance as well as the amount of interest owed for that period. Most mortgage payments will also include an amount that is escrowed to pay property taxes and insurance.
PrincipalThe principal refers to the amount of money you borrowed from the lender. This money does not include interest or fees. Every time you make a payment, this balance will decrease. For example, if you borrow $100,000 and over a period of time the portion of your monthly payments applied to principal equals $10,000, then your principal balance is reduced to $90,000.
InterestThe interest rate is an amount the lender charges, in addition to the principal, for the use of the money loaned. The interest rate is based on a borrower’s credit profile and is expressed as a percentage of the outstanding loan amount. The interest rate is a percentage of the total amount borrowed and is based primarily on the borrower’s credit profile. The Annual Percentage Rate (APR) provides a more comprehensive look at the overall costs of borrowing money. The APR includes the interest paid in addition to other charges and fees assessed by the lender such as loan origination fees, and mortgage insurance.
Taxes & InsuranceEvery 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.
Homeowner’s insurance is required for any homeowner who owes a mortgage balance on their home. It provides a home with insurance coverage in the case of damage from theft, fire, or other disasters. The price varies depending on the city and neighborhood you live in. According to Bankrate.com, the cost of the average annual homeowner’s insurance policy is $1,312 for a $250,000 dwelling.
An escrow account is a dedicated account the lender sets up to hold the funds collected each month. Funds are disbursed from the account 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 a month will be added to your monthly mortgage payment. Your lender will take the $500 and hold it in the 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.