A Beginner’s Guide to Home Loans

Many homebuyers jump into the market without really understanding how the mortgage process works. They may have a hazy idea of going to a bank and taking out a loan (monthly payments figure in somewhere), but the details escape them. Borrower confusion is one of the reasons so many took out risky loans leading up to the housing crash.

Avoid making rash decisions by learning the basics behind home loans before you start shopping for a mortgage. Home loans work very much like other loans: You secure credit from a lender, and pay back the loan over time with interest added on as a payment to the lender. However, some of the mortgage language and processes can be confusing for beginners. Knowing what commonly used terms mean is a great starting place.

Basic Terms

Mortgage: A mortgage and home loan are essentially the same thing. The word mortgage is mostly used when people buy property, while using that property as collateral.

Collateral: Collateral is an asset that “backs up” the mortgage, something of value which the lender can take if the mortgage fails. One predominant quality of a mortgage is that the purchased property is used as collateral, which is why people can lose their homes when they stop paying the mortgage.

Borrower/Lender: The borrower is the person who wants the loan to buy a house. The lender is the organization that creates the mortgage, gives out funds, and receives payments. You are the borrower. Many lenders are banks, but other financial institutions can lend money for home loans, too.

Down Payment: The down payment is usually 15 to 20 percent of the total loan amount and is paid immediately when the loan is first made. This indicates to the lender that the borrower is able to handle the rest of the mortgage. Some programs, such as FHA loans, decrease the down payment to only a few percentage points.

Interest and Interest Rates: Interest is what you pay the lender for making the loan, beyond the funds you use to purchase the house. It is based on an interest rate, a percentage that is applied to the remaining loan amount, typically on a monthly basis.

Points: Interest point programs allow you to pay extra fees at the start of loan to lower the interest rate, thus paying less interest in monthly payments.

Principal: The mortgage principal is the remaining portion of the loan you have to pay. It decreases through the life of the loan.

Underwriting: Underwriting is the process of reviewing your financial information so lenders can judge the risk of lending you money. The lender and any organization insuring the lender must accept this risk during the underwriting process. This can determine what type of mortgage you qualify for, among other details.

Title and Escrow: Title and escrow companies handle the legal side of the mortgage, assuring all parties that ownership is officially changed and regulations have been followed.

Prime and Subprime: A prime loan is a loan made to an ideal borrower with average, acceptable risk. A subprime loan is made to a much riskier borrower with less income and more debt.

Foreclosure: Owners face foreclosure after failing to make monthly mortgage payments. At first you are warned, then the mortgage defaults, then the lender moves to foreclose, or stop the mortgage and seize your house. Foreclosures work differently in different states.

Mortgage Pitfalls and How to Avoid Them

Never feel pressured to buy a loan. Lenders cannot force you to do anything until you sign a contract, so shop across a number of lenders to get an idea of what interest rates and mortgage “terms” or contract details you can expect. Predatory lending seeks to take advantage of ignorance, so always take time to look around before making a decision.

Likewise, watch interest rates carefully. There are many different mortgage rate structures. Variable rates can shift over time, and may make your monthly payments surprisingly high, especially if the market is in a growth phase. Fixed rates stay the same and are much more predictable, though they start higher.

Also pay attention to mortgage fees. Lenders and escrow companies charge fees for application, appraisal, underwriting, documentation…nearly every step of the process has a fee. These can quickly add up to several thousand dollars and take many homebuyers by surprise. Watch for hidden fees in your loan package and search for a low fee arrangement.

More Information on Home Loans

Daily Interest: Steps in the Mortgage Process

Freddie Mac: The Mortgage Process

Federal Reserve Board: Home Mortgages

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