A mortgage loan, or home loan, is a type of consumer financial product used to finance the purchase of a residence, usually a house. Like all closed-end credit, mortgages have a predefined end date by which the borrower must completely pay off the loan.
Mortgages are not the same as hard money loans, which are used to purchase a home or other property with the intention of quickly improving and reselling it and therefore have higher interest rates than mortgages.
Summary
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Mortgages finance houses and real-estate investments.
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They're the most critical asset in the economy and the most integrated in the U.S. tax code.
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There are four types.
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They represent about 60% of U.S. consumer debt.
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500 is the bare minimum credit score, but few lenders accept under 560.
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Rates generally range from 2.5% — 8%.
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Recourse is the lender's right to pursue non-house assets in the case of default.
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Renegotiation is the possibility for settling on a lower rate post-closing.
Purpose
The purpose of a mortgage is to finance the purchase of a primary or secondary house or other real estate property.
Integral Part of Economy
Mortgages are more pervasive than other loan variations such as auto, education, and personal loans. Their ubiquity and size make them critical to modern economies.
The U.S. Federal Reserve views mortgage debt as a premiere macroeconomic indicator and therefore tracks it independently of other loans.
Evidence of their importance appears in the U.S. Federal Government's relationship to Freddie Mac and Fannie Mae, two government sponsored enterprises (GSEs) that purchase single-home mortgages from regional banks to provide liquidity banks can use for funding on other loans.
The integration of Freddie Mac and Fannie Mae into the mortgage molds the risks and opportunities available to borrowers. Notably, borrowers can make mortgage-related decisions using 5 loan categories, shown below.
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Conforming
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Jumbo
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FHA
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USDA
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Veterans Affairs
Conforming Mortgage
A conforming loan is defined as the maximum home value Freddie Mac and Fannie Mae are authorized to purchase by the Federal Housing Finance Agency.
At its core, the conforming loan limit is a reference for home values that should be considered "normal." Normal loans are those available to a large part of the American population, so Freddie Mac and Fannie Mae will buy these loans to provide opportunities to the "average" American.
In 2023, the Conforming Loan Limit (CLL) baseline amount is $762,200.
In contrast, the average home price as of mid-2023 is $495,100. This means the conforming loan limit is 54% higher than the average.
Borrowers can use the CLL as a gauge for amounts lenders feel comfortable with, given that they can resell the mortgage to the Fannie Mae and Freddie Mac.
Jumbo Mortgage
By contrast, a jumbo loan is a mortgage that exceeds the CLL, which is $762,200 in 2023. This does not mean that borrowers cannot purchase a home over the CLL because they can use a down payments (usually ~10%) to bring the value under the threshold.
Using a down payment can create more competition among lenders and procure better rates. On the flip side, a down payment is a lump sum of money the borrow cannot use for other purposes.
In 2023, the maximum house price with a 10% down payment that can quality for a conforming loan is $846,889.
It's important to note that the conforming loan limit applies to the full amount of the loan. A single lender cannot fragment the home value into two loans to qualify each one.
The jury is still out, however, on whether borrowers can use two lenders to split the cost of a home into two loans.
FHA Mortgage
A Federal Housing Administration (FHA loan) loan is a mortgage provided by a private lender but insured by the FHA so borrowers have access to favorable terms, such as down payment as low as 3.5% and lower interest rates.
The eligibility criteria for FHA loans include debt-to-income, primary residence, and more outlined below.
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Mortgage Insurance Premium. Borrowers must pay a mortgage insurance premium.
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Proof of employment. Borrowers must be employed and show a W-2.
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Steady income. Borrowers must show 2 years of income. There is some flexibility, but 2 years is the disclosed target.
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Debt-to-Income Ratio of <43%. The monthly loan payment must not exceed 43% of the borrower's monthly income.
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500 FICO Minimum. Though unofficial, most lenders will not consider borrowers with a FICO 8 score lower than 500.
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Primary residence. The home must serve as the borrower's primary residence and not a secondary home.
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Bankruptcy or not. Bankruptcy does not exclude borrowers from FHA loans.
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Foreclosure or not. Past foreclosures do not exclude borrowers from FHA loans.
Borrowers who meet these criteria enjoy a number of benefits, shown below.
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Down payment of 3.5%. A 580 FICO 8 score creates a minimum deposit as low as 3.5%.
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Down payment of 10%. A 500 - 579 FICO 8 score creates a minimum deposit as low as 10%.
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Interest rates. FHA loans typically have interest rates 0.1% - 0.5% lower than the average for all mortgages¹.
Borrowers can use FHA loans to fund up to 4 houses before facing more constraints.
Altogether, FHA loans are a great way to acquire a primary residence for borrowers with subpar credit and limited cash for down payments.
USDA Mortgage
The United States Department of Agriculture (USDA) provides guarantees and payment assistance for mortgages in rural areas. The two eligibility criteria are property location and income.
That said, the criteria are not as strict as borrowers might assume. Even $138,000 income can be eligible, and upwards of 97% of land is eligible.
In other words, USDA loans are an excellent way for borrowers who don't want to live in the heart of major metropolises to obtain lower rates on mortgages.
The map below demonstrates ineligible lands in red.
Borrowers outside major metropolises should always consider applying, even if they have moderately-high income.
Veterans Affairs Mortgage
The U.S. Department of Veteran's Affairs (VA) provides home loan guarantees, home equity loans, and refinancing loans. It's important to note that VA-loans are not provided by the government, just guaranteed. The guarantee allows private lenders to provide favorable terms.
Officially, the 8 types are below, but in most cases borrowers start with a purchase loan and use the other options as add-ons.
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Purchase loans. The U.S. Department of VA guarantees your loan with a private lender, which establishes its own eligibility criteria and rates. The VA's guarantee procures more favorable rates. They can be used to buy, build, or manufacture a new home.
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Cash-out refinance. A cash-out refinance loan provides a loan at the full market value of the house, regardless of whether the borrower has paid off a portion of the loan (the equity portion). The difference between the two is "cash-out" the borrower can use for other purposes.
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Interest Rate Reduction Refinance Loan (IRRRL). Used to refinance an existing VA-guaranteed loan. It is different from cash-out refinancing because the IRRRL covers only the remaining balance on a mortgage, rather than the full value of the home.
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Alteration & repair loan. This is an add-on to the purchase loan that borrowers can use to repair a home. It can be used on a new home purchased with a purchase loan OR with a cash-out refinance loan.
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$6,000 Energy-Efficient Mortgage (EEM) loan. Similar to alteration & repair loans, the EEM is not a separate loan and must be used in conjunction with a purchase loan. Unlike alteration and repair loans, it cannot be used on a cash-out refinance. In other words, it's only possible on new home purchases. Possible uses include:
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Solar heating and cooling systems
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Caulking and weather stripping
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Furnace efficiency modifications
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Clock thermostats
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New or additional insulation
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Storm windows/doors
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Heat pumps
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Other energy related improvements may also be considered
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Construction loan. These are separate from purchase loans and a used to finance a new residence for the borrower. They cannot be used as investment tools. They can be used for new purchases or on property you already own.
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Farm Residence loan. This loan is a purchase loan used to buy, construct, repaid, alter, or improve a farm residence. It can be used for new purchases or on property you already own.
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Native American Direct Loan (NADL) Program. These are purchase loans used to buy, build, improve, or refinance a home on Federal Trust Land (reservations).
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Adapted Housing Grants. These are not loans. They are grants, which come without repayment obligations. They are therefore not relevant to this article but are included for the sake of completeness.
The core benefits associated with VA loans are:
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No down payment required. No down payment is required, but there are fees that borrowers can eliminate by provided 5% - 10% down payment. Purchase loan fees are generally 2.30% - 3.60%, and this is money borrowers never get back. With 5% down, the fee drops to 1.65% and for 10% down it drops to 1.40%
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Competitively low interest rates. Lenders provide lower interest rates because the loans are guaranteed by the U.S. Department of VA.
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Limited closing costs. These are the fees outlined above. The full range of fees across all 8 loan types is 0% - 3.60%.
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No need for Private Mortgage Insurance (PMI). Unlike FHA mortgages, there is no requirement for PMI. This is one less expense the borrower pays until earning 20% of equity in the home.
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The VA home loan is a lifetime benefit. Borrowers can use the benefit multiple times over their life.
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Assumable by others, even non-veterans. Perhaps the most powerful attribute, assumability allows veterans to sell their home to investors or other vets without consequence or losing the VA guarantee.
Integration in Tax Codes
The importance of mortgages to the economy is so critical that FHA and VA loans were created, and several tax benefits exist. Unlike personal and auto loan interest, mortgage interest is tax deductible.
This means borrowers can reduce their taxable income and essentially "pay less" than the actual interest rate by "not paying" taxes on it.
In fact, tax deductibility and the ability to borrow against home equity are key components in wealth planning strategies. Consult with a tax expert to learn more (Thick Credit is not a tax advisor).
Popularity
Mortgages represent approximately 41% of American consumers' monthly debt. This it is the single most popular financial obligation.
It also means mortgages represent less than the combination of auto, personal, credit card and other debts, which represent 59% of Americans' debt².
Structure
Mortgages are structured as installment loans. The borrower receives the loan proceeds, known as principal, at the start of the loan.
Each month, s/he pays a fixed installment. The installment consists of the periodic interest rate on the outstanding balance, and the remaining portion consists of principal.
The duration of the loan, or the total number of monthly installments, is predefined (as with all closed-end credit).
For example, imagine a $500,000 mortgage with 0.004% monthly interest (5% annually) and a 30-year term. The first month's interest payment is $2,083 (0.004% * $500,000).
The remaining payment is principal, but how much?
Given the 30-year duration, a complex formula computes that the monthly payment is $2,684. This means the principal amount is $600 ($2,684 total - $2,083 interest).
Mortgages are Secured Loans
Mortgages are secured loans because they always use the home purchased as collateral for the loan. As collateral, the house can be repossessed by the lender in the case the borrower stops making payments.
Collateral is good for both the lender and borrower. The lender minimizes its risk, and the borrower gets better rates than unsecured structures such as personal loans.
Rates
Mortgage rates typically range from 2.5% to 8.0%, and the historical average is 4.28% across categories. The chart below shows rates from 2017 to 2023 for conforming, jumbo, and FHA loans.
Credit Requirements
Mortgage lenders typically demand a bare minimum FICO score of 500 and rarely accept under 560. Moreover, better credit and larger down payments procure better rates.
The graph below shows average mortgage rates per FICO 8 score range and with at least 20% down (at loan start or refinanced). The FICO ranges are less than 680, 680—699, 700—719, 720—739, and greater than 740.
Parties Involved
A mortgage must have at least one lender and at least one borrower It is rare to have more than 1 lender on a single home loan but not uncommon to have 2 borrowers.
Lender
The lender is the party that provides the loan. In rare cases, 2 or more lenders can provide funds for a single home. This occurs mostly in cases of major real-estate construction for high-net-worth individuals, or in commercial real estate.
Borrower
The borrower is the party that receives loan principal and carries the obligation to reimburse it. It's not uncommon for couples or married individuals to co-borrow a mortgage loan.
Recourse
Recourse is the lender's right to pursue assets other than the house in the case of borrower default. For example, if a borrower stops paying his mortgage and has a boat, the lender has recourse to confiscate the boat. The difference is that collecting the boat requires more legal steps than the house.
Renegotiation
Renegotiation is a key component of mortgages. It allows the borrower to refinance his home to obtain better interest rates. It also allows him to take out a line of credit or small loan against the equity s/he has paid into the home.
Finally, renegotiation allows the borrower to refinance the value of the home regardless of her equity ownership, and collect the difference between the remaining balance of the current mortgage and the new one.
Markets
Mortgages are available in every economy on Earth. Unlike other closed-end credit loans such as personal loans, mortgages are not more common in Anglo-Saxon countries such as the United States, Canada and the UK.
Countries across Europe, Africa, Asia, and South America have large mortgage industries.
Citations
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“Optimal Blue’s Mortgage Market Indices.” n.d. Thickcredit.com. Accessed April, 2024. https://thickcredit.com/datasets/public-optimal-blue-mortgage-market-indices.
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“Federal Reserve’s Household Debt Service & Financial Obligations Ratios Dataset.” n.d. Thickcredit.com. Accessed April, 2024. https://thickcredit.com/datasets/public-federal-reserve-household-debt-service-and-financial-obligations-ratios-dataset.
