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What Is a Mortgage and How Does It Work?

15 min

January 22nd, 2025

Owning a piece of property is everyone’s dream, whether you want to move in it or use it as investment property. The problem is that in today’s real estate market, about 90% of people younger than 45 can’t afford to buy any type of property. This is where real estate investment financing options come in, as they can give you the starter you need.

Mortgages are the most common way for people without a hefty trust fund to get a property in their name. That said, there are various nuances to mortgages, and it’s important to choose one that works for your benefit. This article will give you some guidance in that matter.

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What Is a Mortgage?

A mortgage is a loan where the lender offers the finances needed for you to buy property, with the principal plus interest given back in monthly payments. With this type of loan, the home itself serves as collateral: if you fall behind on the payment, the financial institution can take your house.

Mortgages started being a thing in the 1930s, during the Great Depression. At that point, the FHA (Federal Housing Administration) decided to introduce low-interest loans to balance the market. Since things were hectic after the housing market crashed, causing people to default on their loans, mortgages aimed to make things much easier for potential homeowners.

Different Types of Mortgage Loans

Mortgages come in different types, depending on your possibilities. Here’s a breakdown of your main options:

Conventional Loan

These are the most standard loan types, not insured by any government, and often offer the best convenience. They are a suitable solution for those with a good credit history who can afford a generous down payment (usually around 20% of the house price). The rates for these loans are competitive, but you’ll have to prove financial stability to get access to them.

FHA Loan

Backed up by the FHA (Federal Housing Administration), FHA Loans are a great option for first-time home buyers who cannot afford a huge down payment or don’t have a stellar credit score. The down payments can go as low as 3.5%, making them an attractive alternative to those who are financially struggling.

VA Loan

Backed up by the U.S. Department of Veterans Affairs (VA), these loans are available to veterans, military members, and their families. These options are particularly convenient for those mentioned, as they need no probate mortgage insurance, nor do they require you to provide a down payment. Considering that around 80% of veterans are struggling financially, these can be advantageous.

USDA Loan

USDA loans are suitable for those looking to move into rural areas but cannot get their hands on conventional loans. These often come with minimal to no down payments, the loan amount covering the entire payment. Rates are also competitive, which usually happens because rural homes are less expensive than those in urban areas.

Jumbo Loan

Jumbo loans are the preferred choice for high-value homes and home loans that don’t meet the limits set by the FHA. Considering their price, they are also quite strict when it comes to credit requirements while coming with a higher interest rate.

Interest-Only Loan

The average mortgage payment involves paying a principal and an interest rate part, but interest-only loans have you paying the interest rate for about 5-10 years. This can be quite beneficial for short-term investors, as you can pay the rest of the mortgage back the moment it appreciates enough to sell. However, this type of loan can lead to a larger remaining balance, making it unsuitable if you don’t expect an increased income.

Home Equity Loan or HELOC

Home equity loans and home equity lines of credit (HELOC) allow you to tap into your home equity, keeping the loan expenses minimal. This is usually a common option if you’ve already been paying your mortgage for some time, offering fixed or flexible interest rates and terms. The money can be used for more considerable expenses along with debt consolidation.

Understanding Mortgage Interest Rates

When getting a loan to buy property, you’re not just paying for the money you get from the financial institution. You are also paying the interest rate that every loan comes with. This is particularly important for you if you are an investor. If you want to make a profit, you’ll have to learn more about mortgage rates for investment properties.

Factors That Influence Mortgage Rates for Investment Properties

The mortgage rate can vary from one buyer to another, depending on personal and economic factors. Below are some key influencing factors:

Federal Reserve Policy

The monetary policy of the Federal Reserve is perhaps one of the most important factors that influence the interest rate. As they lower or increase their key interest rates based on the banks’ decisions, so will your mortgage interest rate change.

Inflation Rate

The global inflation rate is at an average of 3%-5% (except for the hiccup in 2022 when the rate went up to 8.73%). When that number goes up, so does your interest rate. Lenders often raise the interest rate based on inflation to keep being in a profit. Similarly, if the inflation rate drops, so can the mortgage rate.

Credit Score

The credit score is perhaps the most influencing factor of the interest rate because it informs the lender of your reliability as a borrower. If you have a high credit score, the lender will not see you as a risk, offering you a more attractive interest rate. On the other hand, if your credit score is poor, the lender might charge more to account for potential risk.

Down Payment Amount

Above everything else, lenders want security – and this is where the down payment comes in. Since you already provided some of the money, the lender will at least know there is some coverage in the short term, putting them less at risk. Consequently, this can also affect the interest rate.

Mortgage Term

Investment property mortgage rates are also significantly affected by the mortgage term. For instance, a shorter 15-20-year mortgage is less risky, as the repayment is done faster. This helps secure a better interest rate. Conversely, a longer mortgage, such as the usual 30-year one, comes at a higher risk, which means the interest rate can also be higher.

Debt-To-Income Ratio

Finally, the debt-to-income ratio can influence your overall interest rate because it gives an image of your financial stability. The higher the debt compared to your income, the more stress it can cause in your lenders that you won’t be able to make the payment. On the other hand, if you have a low DTI, lenders may not be as stressed about overlapping or missed payments, thus offering you a better rate.

Types of Investment Property Mortgage Rates

Mortgage rates come in different types depending on your possibilities. Below are the most common ones:

Adjustable-Rate Mortgage (ARM)

Also referred to as a flexible rate mortgage, the ARM offers a low interest for a specific time. This can be quite attractive if you expect good market conditions or want to sell fast. However, if something happens that causes interest rates to go higher, the same thing will happen to your mortgage rate.

Fixed-Rate Mortgage

The fixed-rate mortgage is effective if you don’t plan on selling the house anytime soon and want to live in it or rent it out. This payment won’t change based on market behavior, and you’ll pay the same rate in 20 years as you do now. This option has slightly higher interest rates at first, but you have the peace of mind that everything remains the same.

Pro Tip: To ensure you get a good interest rate, you might want to work on improving your credit rating while reducing your debt. Changes can occur at any type of interest rate, so you can use the REI Lense calculator to keep your mortgage strategy up to date. This can help you keep track of interest rates over time.

Tips for getting a good interest rate:

  • Keep track of changes and compare offers from various lenders.
  • Improve your credit rating.
  • Reduce your debt.

Main Components of a Mortgage

Each mortgage has a series of elements that determine its amount. This includes the following:

Property Price

This is the total amount that the seller agrees to get for the property. While there’s no exact formula for it, the seller will usually go for similar values on the market for the same kind of property.

Loan Amount

The loan amount is the sum that you get from the lender. The exact amount is usually determined by the mortgage specifics (e.g., whether you need to make a down payment). If a down payment is required, then the formula is as follows:

Loan Amount = Price of the Property - Down Payment

Interest

The interest on the mortgage is the cost you have to cover to borrow a percentage of the loan. Lenders usually charge a specific rate based on risks and other factors, so you can’t predict that. However, you can calculate how much you’ll have to pay once you get the interest rate and the principal amount. For the most part, this is the formula used:

Total Interest = Principal amount x Annual Interest Rate x Loan Term (Years)

Loan Term

This is the duration over which the loan has to be repaid. This is often chosen based on what the borrower and lender agree on, but for the most part, it’s between 15 and 30 years.

Down Payment

The down payment is the money you’ll have to give upfront when taking out the mortgage. It’s a percentage of the property, usually around 20% for conventional loans. The formula is as follows:

Down Payment Amount = Down Payment Percentage x Property Price

For example, if the house costs $300,000 and the down payment is 20% (0.20), then you’ll have to give out $60,000 upfront.

Amortization

The amortization of the loan is the process of paying off the interest and mortgage amount over time. The formula is as follows, with “M” being the monthly payment, “P” being the principal, “i” being the interest rate, and “n” being the total payment number.

A = P(i(1+i)n/((1+i)n-1))

Property Taxes

Last but not least, property taxes are the amount you must pay based on the local tax rate. It doesn’t depend on the house itself but on the amounts set by your local authorities. The formula is as follows:

Property Tax=(Annual Property Tax)/12

Whether you are calculating the interest, down payment, amortization, or property taxes, the calculations can be complex. Rather than calculating manually, a good idea is to use the REI Lense mortgage calculator. This way, you’ll be sure that no mistakes slip through.

The Process of Obtaining a Mortgage

Obtaining a mortgage is simpler than you might think. Here are the standard steps to go through:

Submitting an Application

Applying is the first and most important step, so you should ensure your finances and paperwork are in order. You’ll need your tax return for at least the past two years, bank statements, income statements, and information about your current debt. Calculate your credit rating and DTI to get a good rate, and be prepared for every piece of paperwork you may be asked for. You can use a mortgage calculator for rental property to see what you’ll need.

Pre-Approval

The next step is to get in touch with the lender and see how much you can get based on the paperwork. The last thing you want is to set your eyes on your dream home only to realize you are too many grands short. Once you get pre-approved, you get the peace of mind that you can get that loan.

The fun part starts now, as this is when you search for your new home. A good tip is to work with a broker or a realtor, as they can help you find a property within your possibilities. Once you find a house that meets your needs, it’s time to make an offer.

Applying for a Loan

If the seller accepts your offer, it is time to take your pre-approval letter and apply for the mortgage. Keep in mind that the lender might still take a look at your financial situation, as they need to make sure the property matches the loan. This confirms that you can indeed pay the loan.

Loan Processing

At this point, the lender will review your documents and check important ones, such as your credit report and bank statement. They will also look at the property’s appraisal to make sure it meets the home’s price.

Underwriting

This is where the lender takes a deep look at your ability to pay. Additional documents may also be requested if extra clarification is needed.

Closing the Deal

The closing is the part where you can take a big breath. Here, you take the money and sign the documents covering the costs of the loan. Once this transaction is over, you officially become the owner of the property.

Start Paying

Starting with the next month, you’ll begin making payments for the property. The schedule will depend on your discussions with the lender, but in most cases, you’ll have to pay by a specific monthly deadline.

Which Mortgage Loan Option Should Real Estate Investors Choose?

Choosing how to finance an investment property is an essential step for every investor, and below are the general options:

  • Property Type: You can choose from residential or commercial properties and resale projects. Determine if your goal is to lease or flip.
  • Holding Period: It can be either short-term or long-term. The former is excellent for house flipping, whereas the latter is great for rental properties.
  • Financial Strategy: Consider your credit rating and expected income. The goal is to get an interest rate that keeps you in profit.

Each type of mortgage may appeal to different types of investors. For instance, while conventional loans might work in the long term for those with good credit, interest-only loans are helpful for short-term investments.

It’s always better to consult a professional when determining which type of mortgage works best for you. Tools such as the REI Lense mortgage calculator can help.

The Bottom Line

A mortgage can be a good solution for those who don’t have the immediate funds to buy property. You just need to choose the type of mortgage that fits your needs the most. With the help of a good calculator such as REI Lense, you should be able to find a suitable property in no time.

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