A mortgage is a type of loan used to finance the purchase of real estate, usually a house or other residential property. It allows borrowers to buy a home without having to pay the full purchase price upfront. Mortgages are one of the most common types of credit used by consumers.
What Makes a Mortgage a Type of Credit?
Mortgages share several key features with other forms of credit:
- Borrowed funds: Like other loans, a mortgage involves borrowed money that must be repaid over time. The lender provides an upfront sum of money to the borrower.
- Interest: Mortgages charge interest on the borrowed amount. This interest accrues over the life of the loan and factors into the borrower’s regular payments.
- Collateral: The home purchased with the mortgage serves as collateral for the loan. If the borrower defaults, the lender can foreclose and take possession of the home.
- Credit checks: To qualify for a mortgage, borrowers must have a sufficient credit score and credit history. Lenders check applicants’ credit reports.
- Repayment terms: Mortgages have set repayment periods, often 15 or 30 years. Borrowers must repay the loan principal plus interest in regular installment payments.
- Impact on credit: Mortgage payments are reported to the credit bureaus. Making on-time payments can improve your credit score over time. Missed payments hurt your credit.
So in these essential ways, mortgages function like other common types of credit such as auto loans, student loans, and credit cards. The key difference is that mortgages are secured by real property while other loans may be unsecured.
READ ALSO: How to Easily Refinance Your Mortgage Online
Common Types of Mortgage Loans
There are several mortgage structures to choose from:
Fixed-Rate Mortgages
The interest rate remains constant for the entire loan term. Because payments are predictable, fixed-rate mortgages are popular with borrowers who value stability.
Adjustable-Rate Mortgages (ARMs)
The interest rate fluctuates over the life of the loan, often starting lower and rising over time. ARMs usually have caps limiting rate hikes at periodic adjustments. The lower initial payments make ARM loans appealing, but the tradeoff is interest rate risk.
Government-Backed Mortgages
These include FHA loans, USDA loans, and VA loans. They are insured or guaranteed by government agencies and have more flexible underwriting standards than conventional mortgages. These programs aim to promote homeownership.
Jumbo Mortgages
Jumbo mortgages are for loan amounts exceeding conforming loan limits. Because they cannot be purchased by Fannie Mae or Freddie Mac, jumbos are considered riskier. Requirements like down payments and credit scores are higher.
Construction Loans
Also called build loans, construction mortgages provide financing to builders or homeowners looking to build a residence rather than buy an existing home. Disbursements are made in stages based on completion of the project.
Mortgage Loan Process
Obtaining a mortgage loan involves several steps:
1. Prequalification – Getting prequalified provides an estimate of what you can afford and may qualify for based on a cursory review of your finances.
2. Loan application – Your full loan application authorizes the lender to verify your employment, income, assets, debts, and credit history. Supporting documentation is required.
3. Underwriting – Lenders analyze your loan application in depth during the underwriting process. Your debt-to-income ratio and loan-to-value ratio are calculated at this step.
4. Appraisal – The lender will order an appraisal to confirm the property is worth at least the loan amount.
5. Closing disclosure – This outlines the terms of your loan, monthly payment, fees, and other closing costs.
6. Closing – You’ll sign the final loan documents and mortgage note at closing. Keys are exchanged after funds change hands.
READ ALSO: The First Time Homebuyer’s Guide to FHA Loans
Mortgage Loan Requirements
To qualify for a mortgage, you must meet certain credit, income, and down payment requirements:
Credit – Most lenders want a minimum credit score of 620-640 for conventional loans. Government programs can be more flexible. Your history of repaying debts is reviewed.
Income – Your income must be steady and sufficient to cover the monthly mortgage payment, taxes, insurance, and other regular debts. Alternate documentation options are available for self-employed buyers.
Down payment – Conventional loans call for a 20% down payment to avoid private mortgage insurance (PMI). Government loans allow down payments as low as 3.5%.
Meeting the requirements results in better loan terms. Borrowers with higher credit scores and down payments typically get lower mortgage rates.
Mortgage Costs and Fees
Beyond the home price, mortgage borrowers pay costs including:
- Interest – Interest charges are based on your loan amount, rate, and term. Rates vary by applicant.
- Closing costs – This includes lender fees, appraisal fee, title insurance, etc. Closing costs range from 2-5% of the loan amount.
- Property taxes & insurance – Lenders require homeowners insurance and escrow payments for property taxes. Monthly payments cover these costs.
- Mortgage insurance – If your down payment is under 20%, you’ll pay PMI until you reach 20% equity in the home.
- Prepayment penalties – Some mortgages charge fees if you pay off the loan early. Make sure you understand the rules before closing.
Mortgage rates and terms will impact your total cost. Get rate quotes from multiple lenders to find the most favorable deal.
Mortgage Refinancing
Mortgage refinancing involves taking out a new loan to pay off your existing home loan. There are several reasons you might want to refinance:
- To lower your interest rate and monthly payment
- To switch from an ARM to a fixed-rate mortgage
- To tap home equity via a cash-out refinance
- To shorten your loan term to pay it off faster
Refinancing makes sense if you can get a lower rate or better terms. But refinancing too often can increase your costs over time. Shop rates and run the numbers to see if refinancing achieves your goals.
Mortgage Tax Benefits
Owning a home with a mortgage loan comes with tax perks, including:
- Mortgage interest deduction – You can deduct mortgage interest paid throughout the year on your tax return. In 2024, up to $750,000 in mortgage debt is eligible.
- Property tax deduction – If you itemize deductions, you can also deduct property taxes paid to state and local authorities.
These save homeowners money compared to renting. Consult a tax professional to maximize benefits.
Alternatives to Mortgage Loans
Besides traditional mortgages from banks and lenders, some alternatives include:
- Seller financing – The seller provides owner financing by collecting payments directly from the buyer.
- Shared equity – Programs like community land trusts enable affordable homeownership through subsidized loans. Home price appreciation is shared.
- Rent-to-own – This agreement gives renters the option to purchase the home after a specified rental period. Rent paid applies toward the sale price.
- Hard money loans – These short-term, high-interest loans are backed by the property rather than the borrower’s credit. Hard money loans are common for fix-and-flip projects.
- Crowdfunded mortgages – Borrowers receive funds from individual investors rather than an institutional lender.
If you don’t qualify for a traditional mortgage, explore alternative options that may offer more flexibility.
To Recap
For most homebuyers, obtaining a mortgage is the only way to finance such a large purchase. Mortgages make homeownership attainable by providing the funds upfront and allowing repayment with interest over 15 or 30 years.
This long-term installment loan uses the home as collateral. Having a mortgage can build your credit profile as long as payments are made responsibly. Compare multiple lenders to get the best mortgage rates and terms for your situation.
While mortgages are complex financial instruments, the rewards of homeownership outweigh the costs for many borrowers. Partner with a trusted lender and real estate professional to navigate the mortgage process seamlessly.
Frequently Asked Questions About Mortgages and Credit
What credit score do you need to buy a house?
Most lenders want to see a credit score of at least 620-640 to approve a mortgage, but requirements vary. Government-backed loans through the FHA, USDA, and VA are available to borrowers with scores as low as 500 with a larger down payment. The higher your credit score, the better your loan terms will be.
How does a mortgage affect your credit?
Mortgage payments are reported to the credit bureaus each month. Making on-time mortgage payments builds your credit history and can strengthen your credit score over time. However, falling behind on payments or going into default hurts your credit. Too many mortgage applications in a short time can also ding your credit temporarily.
Do mortgages count as a type of credit?
Yes, mortgages are considered a major type of credit. They involve borrowed funds that must be repaid with interest over a set period. Mortgages also influence your credit reports and scores like other credit accounts.
What are the pros and cons of paying off a mortgage early?
Paying off your mortgage early saves you money on total interest costs but has some drawbacks. With no mortgage, you lose the tax deductions for mortgage interest and property taxes. You also lose any opportunity to invest extra funds into higher return assets. Weigh the pros and cons for your situation before making extra payments toward principal.
Is it smart to use home equity to pay off other debts?
This tactic can make sense in some cases, but it’s risky in others. If you can consolidate high-interest credit card balances with a lower-rate home equity loan or line of credit, this can save substantially on interest. However, tapping equity reduces your ownership stake in the home. Get professional advice before using home equity to pay off other debts.
How do you know when to refinance your mortgage?
The primary motivations for refinancing are to lower your interest rate, shorten your loan term, or tap your home equity. Refinancing costs money upfront, so run the numbers to see that you’ll save enough over time to justify the fees. Also consider how long you plan to stay in the home. Shop rates regularly, since refi opportunities arise when rates drop.
In another related article, 2024’s Best Mortgage Rates for First Time Home Buyers
