How Home Purchase Loans Work
Almost every time someone buys a home, they finance it with a loan called a mortgage. These specialized home loans come in several main types, each of which has unique features. Given the sheer number of mortgage lenders on the market, homebuyers have more choice than ever. So, it’s important that you understand the essential features of home loans so you can make quick, accurate comparisons.
This guide introduces and explains mortgage essentials for borrowers. It covers important definitions, major home loan types, typical application processes, and frequently asked questions.
What Is a Home Purchase Loan?
A home purchase loan is issued by a lender for a residential property. They’re also known as mortgages, and the terms “home loan” and “mortgage” are interchangeable. Mortgages are secured loans, so the property itself acts as the loan collateral.
Lenders issue home loans to cover the balance between the buyer’s down payment and the sale price. If you buy a house for $250,000 and offer a $25,000 down payment, you’ll need to finance the remaining $225,000. The mortgage loan provides this financing so the seller receives the full value of their property when the sale closes.
Like all other loan types, mortgages charge interest and have set repayment schedules. Different types of mortgages calculate interest in different ways. The following section explains these differences in detail.
What Are Common Types of Mortgages?
Fixed-rate and adjustable-rate (also called variable-rate) home loans are the most popular types of mortgages. Qualified homebuyers can also take advantage of federally backed programs including VA, FHA, and USDA loans.
Get a basic overview of common mortgage types with the following table:
|Fixed-rate loans||The interest rate stays the same over the lifetime of the loan|
|Adjustable-rate loans||After a set amount of time, the interest rate rises or falls based on economic conditions|
|VA loans||Government-backed loans for active-duty and retired service members|
|FHA loans||Government-backed loans with low down payments for eligible buyers|
|USDA loans||Government-backed loans for eligible rural properties|
|Jumbo loans||For properties with values higher than Federal Housing Finance Agency limits|
Pros and Cons of Fixed-Rate Mortgages
Fixed-rate mortgages are popular since they offer predictability that adjustable-rate home loans can’t match. Many homeowners are okay with paying a little more in exchange for the security fixed-rate home loans provide. With a fixed-rate loan, monthly payments stay the same no matter what happens with interest rates.
However, like all specialized loans, fixed-rate mortgages have advantages and drawbacks:
5 Steps To Get the Right Home Purchase Loan
Fortunately, you have a lot of mortgage options. But you may not know where to start. Follow these five simple steps to make the overall process easier to navigate:
1. Get your paperwork together.
Requirements vary among mortgage lenders and home refinance companies. But no matter which lender you choose, you’ll need to provide several essential documents. These include:
- Two or more pieces of government-issued identification
- Two to three years of tax returns
- Proof of income, such as pay stubs, earnings statements, or W-2 forms
- Bank statements (usually covering the past three to six months or longer)
You also might be asked for a copy of your current rental agreement and/or a detailed history of your renting arrangements. Some lenders also request lists of your non-cash assets and financial holdings.
2. Save money for a down payment.
For conventional loans not backed by the government, down payments often range from 5% to 15%. FHA loans ask the borrower to pledge at least 3.5% of the property’s purchase price upfront.
Keep in mind, the higher your down payment, the less you’ll need to borrow. So, it’s a good idea to save up at least 5% to 10% of your home-buying budget in advance.
3. Check your credit score (and improve it).
Every mortgage lender will research your credit score. People with good scores typically qualify for higher loan amounts and lower interest rates. This gives borrowers a strong incentive to improve their creditworthiness before applying for a home loan.
So, your initial step should be to check your current score with at least one of the three main credit bureaus. Under federal law, everyone is entitled to one free credit report per year from each of these three major agencies.
If your score isn’t where you want it to be, spend some time improving it before applying for a mortgage. Here are some quick pointers to help boost a low credit score:
- Pay down your revolving debt, such as credit cards
- Resolve any late or past-due payments
- Dispute errors and have them removed from your report
- Don’t close existing credit accounts or apply for new ones
4. Decide on a type of mortgage loan.
Before you can apply for a mortgage, you need to figure out which type is right for you. A good first step is to find out if you qualify for any special government loan programs, like VA and FHA loans. If you opt for a conventional loan, the next step is to decide if you want a fixed-rate or adjustable-rate mortgage.
Run estimates for both fixed-rate and adjustable-rate loans. As you compare, remember to factor in the cost certainty advantages of fixed-rate loans. And remember to plan for a worst-case scenario when projecting adjustable-rate payments. You need to be prepared for anything when it comes to an investment as important as your home.
5. Shop around for custom rates.
No matter what kind of financial profile you have, chances are you’ll qualify for multiple mortgage offers. It’s important to spend time comparing these offers. As you do, look beyond surface features like interest rates and loan terms. Consider details like origination fees and mortgage points, if they apply.
Failing to do your research could be costly. According to the Consumer Financial Protection Bureau, nearly half of U.S. home loan borrowers only consider one lender when shopping for a mortgage. By comparing top mortgage lenders, you’re more likely to get the best bang for your buck.
Historically Low Rates Have Recently Started Rising
It’s normal for interest rates to rise and fall over time. Right now, they are near the bottom of historically low levels. This is largely the result of market forces that have kept inflation and other critical factors in check for an extended period. However, in early 2021, inflation made a sudden and dramatic comeback, mainly because of economic pressures created by COVID-19.
Average 30-year fixed rate over time
Given inflation’s return, many economists believe interest rates are soon due for an inevitable rise. Guidance from the U.S. Federal Reserve indicates this could happen imminently. So, from a borrowing perspective, now is an excellent time to get a home loan.
Glossary of Important Mortgage Terms to Know
|Annual percentage rate||The total annual cost of a mortgage (interest rate plus fees and expenses)|
|Appraisal||A professional assessment of a property's market value|
|Balloon mortgage||A relatively short loan in which most of the principal is repaid in a lump sum at the end|
|Cash-out refinance||Replaces your existing mortgage with a larger one, giving you access to the cash difference|
|Closing costs||Fees and expenses paid for things like appraisals, attorneys, and taxes|
|Debt-to-income ratio||The percent of your monthly income that goes toward debt payments|
|Down payment||Money paid upfront, reducing the amount you need to borrow|
|Home equity loan||Allows homeowners to tap into the equity built up through previous mortgage payments|
|Home equity line of credit||A revolving credit account that uses the borrower's home equity as collateral|
|Mortgage refinance||Replaces your existing mortgage with a new one offering better terms|
|Origination fee||A one-time service fee charged by lenders to process a loan|
|Principal||The money you borrow to cover the cost of the property (doesn’t include interest)|
Frequently Asked Questions
Does applying for mortgage loans affect my credit score?
Yes. Applying for a mortgage requires what is known as a “hard pull” of your credit report. Anytime a lender performs a hard pull of your credit file, your score temporarily dips.
How long does the mortgage application process take?
The application process usually takes about 4-6 weeks from start to finish. However, some mortgage lenders can process applications in as little as 1-2 weeks.
What are common fees associated with buying a house?
The most frequent fees and closing costs include loan application and origination fees, appraisals, title searches, attorney fees, and title insurance. These and other common fees usually add up to about 2% to 5% to the home’s purchase price.
How are interest rates and APRs different?
Interest rates focus only on the amount of interest you pay on your home purchase loan. They are expressed as an annual percentage. APRs include interest as well as insurance, closing costs, discount points, and other fees. Therefore, they reflect total borrowing costs more accurately.
Are mortgage refinance rates higher than home purchase rates?
In most cases, even the best refinance companies have higher rates for refinancing plans than they do for initial mortgages. Refinancing plans come with extra fees, resulting in higher rates.
Too Long, Didn’t Read?
Interest rates continue to hover near all-time lows, making now an excellent time to get a mortgage. Homebuyers typically have the choice of a fixed-rate or adjustable-rate mortgage. Since both options have pros and cons, it’s important to consider your finances when choosing a mortgage loan. The market offers many options, so comparing top mortgage lenders is worth it to find the right one for you.