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A Guide to How Mortgages Work

October 14, 2020

23 MINUTE READ

You've been running the numbers and know that owning a home beats renting. Now comes the tricky part: getting a home loan or mortgage. One of the most common questions home buyers ask is, "How do mortgages work?" To make things easier we've created this guide, which includes step-by-step instructions to help get you from pre-qualification to close with confidence.

This guide is structured around the journey most of our customers take, but every home buyer is unique, so your experience might be a little different. Here’s an overview:

  • Week 1: Choosing a mortgage and applying for a loan
  • Week 2: Understanding home inspections and locking your interest rate
  • Week 3: Focusing on appraising and insuring your new home
  • Week 4: Providing clear direction on how the closing process works

Whatever your path, our goal is is to educate and empower you to secure a mortgage on your terms, but financially, there’s a lot more responsibility with owning a home than with renting. “The first big challenge for renters who are buying their first home is to think beyond the initial purchasing costs,” says Jennifer Fitzgerald, CEO and co-founder of PolicyGenius, a digital insurance company. According to Fitzgerald, first-time buyers often spend their time budgeting for the down payment, mortgage, closing costs and taxes—but they overlook the longer-term costs of owning, which can be higher than you’d think.

Asking the following questions can help gauge how ready you are for a home mortgage.

What home can I afford?

If you’re like many homebuyers, you might have no clue what you can realistically spend. Not fully understanding how much home you can afford can lead to being “house poor,” which happens when you’re spending too much on your mortgage.

Start by adding up your income and monthly expenses: How much is your current rent? What about utilities or maintenance? Think about your debt-to-income ratio (DTI), which is how much of your income goes to debt repayment each month. At Reali Loans, we recommend keeping this number at 45% or less, although we can go up to 50% if you have a stronger application. In those instances, having a strong credit score or large amount of cash in your savings account can help offset a higher DTI. Quickly calculating your DTI will give you an idea of how much home you can afford.

Here’s an example: If you make $5,000 a month, 45% of that would be $2,250. If you pay $300 to student loans, $350 for a car loan and $100 to credit cards, you’d have $1,500 to spend on a home ($2,250 – $750 = $1,500).

How much should I have for a down payment?

The best way to answer this is to think about what size of home you’re hoping to buy and how much you can realistically save for a down payment. A 20% down payment can help you avoid private mortgage insurance, also referred to as PMI (it reimburses the lender if you default on your home), but this isn’t always realistic for every buyer.

If you have less cash upfront, you can still qualify for certain home mortgages. An FHA home loan, for example, only requires 3.5% down. A USDA or VA loan requires no down payment.

One way to get around private mortgage insurance without a 20% down payment is to piggyback your mortgages, which requires you to take out a first home loan and a second mortgage when you buy. Talk to a Reali Loans loan advisor for help deciding if piggybacking makes sense.

What mortgage can I afford?

Keep in mind that your home mortgage is more than the purchase price. It will also include things like escrow for homeowners insurance and property taxes, along with private mortgage insurance if you’re putting less than 20% down.

These extra costs can mean a higher monthly home loan payment. If you can afford to spend $1,500 a month on housing according to your budget, you need to know how much of that goes to the principal (the actual loan amount) and how much is going to the additional, rolled-in costs.

It’s important to run the numbers using an easy mortgage payment calculator and check your credit score, which you can do for free on Credit Sesame or Credit Karma.

Your credit score influences your home mortgage rates. The higher your score, the better your chances of qualifying for the best mortgage rates. If you’re thinking of going with a shorter loan term, remember that 15-year mortgage rates are typically higher than rates for a 30-year loan.

What mortgage can I afford on a $100,000 salary?

Assuming the 45% DTI that Reali Loans uses, you could afford to spend $3,750 a month on debt. If your debt payments are low, that could be more than enough to buy a comfortable home.

Are there other costs I need to consider?

As you plan to buy a home, insurance is a big expense that will also impact your budget.

“As a renter, you’re only concerned about protecting your possessions in your home and insuring those against loss. As a homeowner, you have to insure those possessions plus the actual structure of the home,” Fitzgerald says.

 

Before You Begin: Getting Pre-Approved

What is mortgage pre-approval?

It simply means that we’ve checked your credit and financials to figure out how much home you can afford. You don’t need to wait until you’re pre-approved to start looking for a home. Getting pre-approved early on, however, gives you a better idea of what price range you should keep in mind.

Reali Loans Chief Loan Officer, Jason van den Brand, strongly recommends getting pre-approved: “This is about affordability—and putting you and your family in a position of strength. The last thing anyone wants to be is ‘house rich, and cash poor’ and that’s exactly what a pre-approval helps you discover. In other words, just because you qualify for $500,000, doesn’t mean you should buy that much.”

How does home loan pre-approval work?

Mortgage pre-approval is straightforward. It involves filling out a home loan application and information about your income and assets. 

We’ll review the application details—including your debt-to-income ratio and credit score. If everything looks good, we’ll make a conditional offer for a specific loan amount. You’ll then use that amount to focus your home search.

However, if your financial situation shifts suddenly—let’s say you applied for new credit cards (which means your credit score probably went down) or lost your job, the amount you’re approved for could also change.

Why is pre-approval important?

The last thing we want to do at Reali is waste your time. And pre-approval helps you narrow your search so you only look at homes that fit your budget.

Getting pre-approved also sends a message to sellers that you’re serious about buying. If you’re going up against another buyer for the same house, a seller may take your offer more seriously if you’re ready with a loan pre-approval. 2020 Note: For safety reasons, as COVID-19 restrictions continue, there are also a number of sellers who are only allowing pre-approved buyers to tour their home.

The good news is, you’re not “locked” into a particular loan if you’re pre-approved. You can still get a loan elsewhere.

Week 1: Applying for a Mortgage

Hooray! Your offer has been accepted. Now the home mortgage process really begins. Applying for a loan is a lot like the pre-approval process. Start by filling out a full loan application. This includes providing all the documents needed to send your loan through the underwriting process—which is when we take a deeper look at your financials to decide whether you’re approved for the loan, how much you can borrow, and what interest rate you qualify for. To save time, start gathering the following documents for your application:

  • Your pay stubs
  • Previous tax returns
  • Most recent bank statements
  • Recent profit and loss statement (if you’re self-employed)

How long is the loan application?

The Reali Loans loan application is as streamlined and simplified as possible. Once you submit it, we’ll review the details and get back to you within one business day. 

Which home loan is right for me?

Every home loan is different. You’ll know a mortgage is right for you if it fits your budget and offers the best interest rate. 

A fixed-rate loan: With a fixed-rate loan, your rate never changes. You’ll know upfront how much you will pay in interest and what your monthly payments will be.

A 15- or 30-year loan: If you’d like to get rid of your debt faster, consider a 15-year loan. If you need smaller payments, a 30-year loan may be a better fit for your budget. Make sure to compare rates on a 15-year mortgage against a 30-year fixed mortgage.

An adjustable-rate mortgage (ARM): These loans work a little differently. Typically, you pay at one rate for the first five to seven years, then the rate changes. The rate can go up or down over time, based on the index that it’s tied to. Reali doesn’t currently offer adjustable-rate mortgages, but we have plans to add them in the future.

Debunking the biggest home mortgage myths

Between what you hear from people in your life to things you see on TV, buying a home can feel intimidating. The following are four common myths we’d like to dispel about home buying.

Myth: “I must have a 20% down payment to buy.”
Reality: You can put down less than 20%.

Putting 20% down on a home can help you avoid private mortgage insurance (PMI), but there’s no rule that says you absolutely must have 20% in cash for the down payment. The Federal Housing Administration (FHA) offers loan programs to help. If you qualify, you can put as little as 3.5% down.

Myth: “Buying a home is as easy as it looks on TV.”
Reality: It’s not.

“House Hunters” is entertaining but it only scratches the surface of the home buying process. In 30 minutes, you’ll see home shoppers browsing through three choices of homes, and picking one at the end of the show. They almost always get their offer accepted, which is not always the case in a seller’s market. Then the show ends by fast-forwarding to a few months later when the homeowners are moved into their new home with new furniture, new upgrades to the kitchen—it’s all perfect! “House Hunters” reveals how much each home costs, it doesn’t give you details of all the work that goes on behind the scenes. We don’t find out how much buyers put down (in cash) to purchase the home, their credit scores, the type of mortgage they chose, the interest rate, or how long the entire process took to purchase the home.

Talk to our team at Reali Loans for a comprehensive overview of the home buying journey and get deeper insights into what you can expect from the process. 

Myth: “I’m not allowed to pay more than the minimum payment on my monthly mortgage payment.”
Reality: You can prepay your mortgage—but watch out for penalties.

Want to become debt-free faster and save money on interest? Paying extra on your home loan can help, but some lenders actually charge a penalty when you pay off a mortgage early. If this is part of your debt payoff plan, you should check with your lender ahead of time.

Myth: “I need to have a realtor or agent to get started.”
Reality: You don’t need an agent to get a mortgage.

You don’t need an agent to apply for a mortgage, but when it comes to negotiating a deal on your home, they are good to have. Keep in mind real estate agents charge a percentage (typically 6-7% or more) of the home’s total sales price.

Home Mortgage Checklist: Mistakes That Cost You Time and Money

  • Not checking your credit. Understanding your credit report can help you gauge your chances of getting approved. You can also check to see if there are any reporting mistakes made on your credit profile (for example, it said you paid your credit card late when you didn’t) so you can quickly fix them. If your score is low, you should take steps to make improvements right away.
  • Skipping pre-approval. Being pre-approved helps you understand how much home you can afford and which loan is best. That said, this doesn’t always guarantee you’ll be approved for a mortgage.
  • Not comparing your loan options. You likely compare prices when making expensive purchases, so why wouldn’t you evaluate multiple loan types? Pick the loan that fits your income and budget; just make sure you know which options are out there first.

Week 2: Home Inspections & Rate Locks

Before you finalize your home purchase, you’ll need to get a home inspection.

What does a home inspection do?

A home inspection ensures the house is in good shape and there aren’t any major lurking problems. 

Some sellers will get their own inspection. If you trust the seller, you can use their inspection. If you’d rather get a second opinion, you can hire your own inspector to look at the house or talk to your agent for a recommendation. 

The inspector will look at the following parts of the house and make sure it’s in solid, working condition:

  • Roof
  • Foundation
  • Heating and air system
  • Wiring and the plumbing
  • Basement and the attic for mildew and draining problems
  • Fireplace
  • Chimney

A home inspection costs anywhere from $300-$700, so factor that into your budget. You should also set money aside for septic and pest inspections, since those aren’t included in the home inspection.

What if the inspection uncovers a problem?

If your inspector discovers an issue, there are a few ways to handle it. First, you can ask the seller to fix the problem. You could also ask them to give you a credit at closing and then make the repairs yourself.

If there’s something seriously wrong with the home, the third option is to cut your losses and cancel the sale.

Why is it important to understand mortgage rates?

When buying a home, the interest rate is incredibly important because it ultimately determines how much your loan will cost over the long term.

Mortgage expert Stephen Moye explains, “The most misunderstood part of the mortgage process is how mortgage rates are determined and what factors (out of the loan officers’ control in most cases) affect mortgage rates.”

If you’re not completely comfortable running the numbers, ask a Reali Loans home loan advisor to help you understand the details. We can’t stress this enough—your interest rate (even a few points difference) can mean thousands of dollars over the life of your loan.

How do mortgage interest rates work?

You’re probably wondering where Reali’s rates come from. Like all mortgage lenders, our rates are calculated based on the 10-Year Treasury market rate, plus a spread.

Rates aren’t fixed. In fact, they can change daily. That’s why it’s important to lock in your rate as soon as possible. We’ll explain how rate locks work a little later on.

Your interest rate is linked to your credit rating. The better your credit, the better your rate. If you don’t have great credit, you may be able to get a lower rate by purchasing discount points. Discounts points are fees paid directly to the lender at closing in exchange for a reduced interest rate. The question is, should you do it?

When you buy points, you’re really prepaying the interest on your loan. Each point you buy lowers your interest rate. One point is worth 1 percent of your mortgage. So for every $100,000 you borrow, a point would cost $1,000.

An easy way to decide if you should buy discount points is to plug the numbers into a mortgage calculator. Determine what your mortgage would cost with points and without them.

If you’d save a lot on interest over the life of the loan, then buying points upfront may make sense. If buying points wouldn’t lower your rate enough to have a big impact, you may want to just save the cash instead.

Are mortgage interest rates going up?

When the Federal Reserve raises the federal funds rate, interest rates on loans and credit lines move in tandem. While mortgage rates have hit historic lows several times this year, it’s important to lock in a rate as soon as you’re comfortable, in case they go up again. 

What interest rate will I get approved for?

The rate you’re approved for depends largely on the following:

  • Type of loan you applied for
  • Loan amount
  • Loan term
  • Where the home is located
  • Your down payment
  • Whether you choose a fixed or adjustable-rate loan

Again, this is where a mortgage calculator comes in handy because you can use it to compare rates using different loan scenarios.

What does a “rate lock” mean?

After you fill out the online application, you’ll see a Loan Estimate, which includes the details of your loan terms. Then, your Reali Loans home loan advisor will ask for confirmation to lock in your loan’s interest rate. This means we’re guaranteeing you a certain rate for a set period of time.

Your rate is usually locked for 45 days. Your home loan advisor will let you know how long it is locked for when your loan is locked.

Why should I lock in my rate?

Locking in your rate can keep you from paying more in interest if rates go up between the time you apply for a loan and the time you close. You can extend a rate lock for longer if you need to, but there may be a fee. 

Why wouldn’t my loan be approved?

There are many reasons why this may happen, and although it’s a setback (and a disappointment) if you didn’t get approved, use this as a learning opportunity. There are a few possible reasons:

If your credit score is too low

One of the first things that happen when you apply for a loan is a complimentary credit check. 

Unfortunately, a poor credit score can be a roadblock to a mortgage. Every lender has a minimum credit score to approve borrowers, so if your score falls short, it’s likely you won’t get approved. If that happens, you’ll need to work on raising your score.

Start with these three steps, in this order.

  1. Pay all your bills on time. Your payment history has the most impact on your score.
  2. Pay down your debt. A large percentage of your score is based on how much of your available credit you’re using in relation to your total available credit. This is known as your credit utilization ratio.

For example, if you have two credit cards with a maximum limit of $5,000 each, you have $10,000 available credit. Let’s say you use up $5,000. This means your utilization is 50%—not great in the eyes of lenders. Basically, the lower your utilization ratio, the better. Try to get it under 10%.

  1. Hold off on applying for new credit. Credit inquiries can negatively impact your score. Also, don’t rush to close any credit accounts you’re not using. Closing old accounts may work against your score.

If your debt-to-income (DTI) ratio is too high

To determine your DTI, simply add up your monthly debt payments and divide that by your gross monthly income.

For example, if you make $4,500 a month and $1,500 goes to debt, your DTI ratio would be 33%.

Reali likes to see a debt to income ratio of 45% or less. If you’re above that percentage, you’ll need to increase your income or pay off some of your debt.

Week 3: Handling the Appraisal & Insurance

By this time, you should be ready to schedule an appraisal. This is one of the most important steps in the homebuying process.

What is an appraisal and how does it work?

An appraisal is a professional estimate of how much the home you want to buy is worth. You’ll pay for an appraisal about halfway through the loan process with Reali Loans. The fee is non-refundable, but we generally don’t ask you to order the appraisal until we’re confident that your loan will be approved. Reali Loans uses a preferred Appraisal Management Company (AMC) to ensure it gets completed on time and correctly.

We use the appraisal to make sure we’re lending you the right amount of money. An appraisal that’s higher than the sales price is good—it means the home is worth more than you’re paying for it.

An appraisal that comes in too low can be a problem. When the sales price and the appraisal value don’t match up, one of two things has to happen. Either the seller has to adjust their price to fit the appraisal, or you have to pay the difference out of pocket.

If you think your appraisal was wrong, you can get a second opinion. Just factor in that you’ll need to pay for the cost of any other appraisals you order, and there’s no guarantee that the end result will be different.

What should I expect from the appraiser?

Unlike an inspector, the appraiser is only interested in finding out the home’s value—not uncovering any flaws.

The appraisal process can take anywhere from a few minutes to a few hours. The appraiser will look at the outside and inside of the home to check the condition of doors, windows, floors, plumbing and light fixtures.

They’ll take into account the age of the home, the square footage, the lot size, its location and what kind of view it offers. Finally, they’ll look at “comps” (comparables) in the area to see the value of similar homes. The appraiser uses everything they learn about the home to create an appraisal report and you will get a copy of it.

What should I know about homeowners insurance?

Once the appraisal is finished, it’s time to tackle homeowners’ insurance. Most states don’t require you to have homeowners’ coverage by law. However, it is a lender requirement if you’re using a mortgage to buy your home.

You’ll need enough coverage to pay the cost of completely rebuilding and furnishing your home, in the event something terrible should happen. At a minimum, your policy should cover against:

  • Fire
  • Accidents
  • Theft
  • Wind damage and other natural disasters

If you live in a flood or earthquake zone, you’ll need separate flood and earthquake coverage.

You have time to get coverage, so don’t rush the process. Take your time, do your research, talk to experts and compare quotes from different insurers. Make sure you clearly understand what is and isn’t covered.

Once you choose a policy, you’ll need to get proof of coverage from your insurer. You may need to pay your first year’s premiums in advance if you’re escrowing your insurance into the loan.

Reali Tip: You may be able to bundle your homeowners’ policy with your car insurance and get a discount.

What paperwork do I need?

By now, you have collected some paperwork and receipts. Keep them all organized so you can reference your documents quickly as needed.

Be sure to organize the following documents:

  • Your application (should be completed by now)
  • Receipts showing payments for home inspections, appraisal and homeowners insurance
  • If you put up an earnest deposit (which is a deposit made to the seller to show that you’re serious about buying the house), you should have documentation showing what you paid
  • Copies of any disclosures we’ve provided during the loan process.

Week 4: Countdown to Closing Day

Once we have everything we need to approve your loan and finalize the terms, you’re ready to close. Ideally, this happens within 15 days of locking your rate, although the timing can vary for different borrowers, depending on your situation.

What should I expect during closing?

This is an exciting time! The closing process itself usually takes an hour or two and you’ll meet with a notary or closing attorney to sign all the final loan paperwork and pay your closing costs. Closing costs are paid with a cashier’s check, so come prepared with one ready.

At Reali Loans, our goal is to get you to the signing table within four to five days of being cleared to close. Once you sign off on the Closing Document Package, you’re almost done.

Next is disbursement, which is when we send the loan funds to your escrow company. The funds are divvied up among the involved parties:

  • The bank that previously held the mortgage on the home gets their share
  • The sellers get their cut if they made a profit on the sale
  • The agents on both sides collect their fee and any necessary amounts are paid into escrow

All of this happens as soon as possible after closing—then you can relax and start enjoying your new home.

What if I’m traveling or out of state during closing?

We get it, life is busy and you may not necessarily be at home when it’s time to close your loan. Reali Loans customers often ask if it’s okay to be located in a different state than where the home is being purchased. The answer is yes. We will simply send a mobile notary to wherever you are to handle the closing.

How much are closing costs and other hidden expenses?

Closing costs cover a range of transaction fees and they typically run between 2- to 5% of the purchase price. These fees cover all the costs associated with completing the loan process. This infographic highlights the various fees included in your closing costs and overall mortgage process.

 

What if I have an impound account?

An impound or escrow account is used to collect your homeowners insurance or property tax payments. You make payments for your insurance and taxes monthly, along with your regular mortgage payment. These payments are held in the impound account. When your homeowners insurance or property taxes are due, the lender takes money out of the account to pay them.

Even if you’re not using an impound account, your property tax and insurance costs will show up on your loan disclosure. These fees are required to be paid when items are due within a certain timeframe from your closing to mitigate the risk of insurance or taxes going unpaid.

What should I have ready for closing?

Your closing agent will have all of the necessary paperwork on hand. The main thing you need to bring is a cashier’s check to cover closing costs. You’ll also need a photo ID to verify your identity. If necessary, your Reali agent may ask you to bring copies or original documents of paperwork that we need to complete your file.

 

We know the mortgage process can seem complicated, but with this guide and the trusted team at Reali Loans, you’re more than capable of buying your first home with confidence. Make sure to do your homework and have a clear understanding of what you need to apply and qualify for a mortgage successfully. Ask your agent lots of questions, Google what you don’t understand and call to speak with our home loan experts at Reali Loans, 1-855-846-7334. All of the effort will be well worth it when you’re finally walking through the door of your new home for the first time!

Important Note: Reali Loans is expanding quickly, but does not currently operate in all 50 states. Contact us at loans@reali.com to find out if Reali Loans operates in your state.

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