How does a home loan work?
Home loans are typically provided by banks, credit unions, or private lenders. As the borrower, you agree to pay back the loan, or principal, plus a bit more, called the interest. The amount of interest you pay is based on the interest rate your lender charges.
The time frame for paying off your home loan is called a term. During the term, you agree to make regular payments until you’ve paid both the principal and the interest. Most home loan terms are 15 or 30 years, but you can have a different term. Payments are often monthly, but can also be biweekly to accelerate the payoff process.
Home loan vs. mortgage
The home loan is the actual money you borrow, and the mortgage is the document that describes all the conditions of the loan, including the:
- Loan amount.
- Interest rate.
- Term.
In reality, people use “home loan” and “mortgage” interchangeably. You might hear someone say that they’re “paying their mortgage” when in fact they’re paying the home loan described in the mortgage note. Don’t worry, your bank isn’t going to mince words as long as you're paying everything on time.
When do homeowners need a home loan?
In February 2024, the median price of a house reached $382,600, according to the National Association of Realtors. That’s more than most of us have in savings, so home loans are common for just about anyone buying a house. Where you get the loan from can vary. While most people go to a bank or credit union for a loan, they can also have a seller-backed financing agreement that is privately executed. This is where the seller extends credit to the buyer.
Home loans must be secured prior to the close of escrow. Most people get pre-approved for a loan so that their purchase offer is taken seriously and escrow has fewer hiccups, but this isn’t always the case. Ultimately, you need your home loan to be funded prior to the close of escrow so that the title can transfer according to the purchase agreement.
Qualifying for a home loan
Loan requirements vary from lender to lender and from loan type to loan type, but all require both income verification and creditworthiness. Here are some of the basic requirements for common home loan types:
- US Federal Housing Administration (FHA): To get an FHA loan, you need a minimum credit score of 500 and a 10 percent down payment, but a 580 and 3.5 percent down is. You also need a debt-to-income ratio (DTI) capped at 31 percent for the front end (just the home loan payment) and 43 percent for the back end (all debt payments including the home loan)
- US Department of Veteran Affairs (VA): While the VA doesn’t set a minimum credit score for getting a home loan, the private lenders that offer the loans often require a minimum score of 620. There are no down payment requirements, and your back-end DTI cannot exceed 41 percent unless you meet the residual income test.
- US Department of Agriculture: A USDA loan is designated for approved rural areas and has no down payment requirement. The minimum credit score is set by lenders and is often 640 or higher. The front-end DTI needs to be 29 percent or lower while the back-end DTI can’t exceed 41 percent.
- Conventional home loans: These loans typically require a minimum of 3 percent down with a credit score of at least 620. Generally speaking, the DTI must be 45 percent or lower but can be bumped up for people with higher credit scores or financial reserves.
No-money-down home loans can seem like a great deal because you don’t have to save up for a hefty down payment. However, you need to look at your current situation and long-term goals to know if they’re the right option for you.
What is a home loan pre-approval?
Pre-approval for a home loan means the lender has agreed that you qualify for a loan of a certain amount under certain terms. You have met the credit and income requirements and your DTI is in the approved ranges. The only thing missing is the actual property you are buying.
A pre-approval letter indicates that a lender is willing to a specific amount so you can make an offer on a house. This gives the seller confidence that you are qualified to buy the property, and the transaction can move forward.
The lender will still need an appraisal performed on the property to ensure that the value of the home is appropriate for the amount you’re borrowing. If the appraisal is below the amount the lender has approved, you may need to renegotiate the price of the home, pay more upfront, or walk away from the property because the loan won’t be funded.
