What Is A Mortgage And How Does It Work?
If you’re new to the idea of buying a house, it’s essential to understand the basics. Since most buyers can’t pay cash for a home, you’ll need to know what a mortgage is and how it works.
Key Takeaways:
- A mortgage is a loan for buying a home. It typically is repaid over 15 to 30 years and uses the home as collateral.
- The most common loan type is a conforming conventional loan, but jumbo or government-backed loans may better fit some borrowers.
- You’ll need to meet financial requirements to get a mortgage, including making a down payment and paying closing costs.
What Is A Mortgage?
A mortgage is a loan from a bank, credit union, mortgage lender or other financial institution used to buy or refinance a home. Both parties agree the borrower will repay the mortgage principal plus interest over a specific time, usually 15 or 30 years. If the borrower defaults on the mortgage, the lender can take possession of the property and sell it to recover its losses.
Mortgages are considered good debt because you’re borrowing money to buy something that can create wealth. Most homes appreciate in value over time, which justifies taking on so much debt. Once you pay off your mortgage, you own an asset you can expect to be worth more than you paid for it.
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How Does A Mortgage Work?
A mortgage is a loan designed for buying a home. When you take out a mortgage, the lender provides upfront the cash you need to complete the sale. In exchange, you repay the principal with interest over an agreed-upon time frame known as a loan term.
Repayment of your loan is amortized, which means your monthly payments are calculated to repay the principal and interest by the end of the loan term.
As you pay down your mortgage balance, you build home equity, which is the difference between the value of your home and what you owe on it. Equity also can grow as your home appreciates. Equity is valuable because you can borrow against it if you need cash for a significant expense. If you sell your home before paying off your mortgage, your equity becomes your profit.
A mortgage is a secured loan, which means the lender maintains a lien on your home until you pay the mortgage in full. If you default on the loan, the lien allows the lender to seize ownership of the property. It then would evict you and sell the home to recoup its losses. You don’t fully own your home until you make the final payment.
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Types Of Mortgage Loans
There are two basic types of mortgages: conventional loans and government-backed loans.
Conventional Loans
Conventional loans come in two types: conforming and nonconforming.
Conforming Conventional Loans
Conforming conventional loans are the most common type of mortgage. Backed by a private lender rather than an agency of the federal government, conforming loans meet a set of requirements set by the Federal Housing Finance Agency. These requirements include a maximum loan amount, as well as a minimum down payment amount, minimum borrower credit score and a maximum borrower debt-to-income ratio. Lenders can sell loans that meet these requirements to Fannie Mae or Freddie Mac, which are government-sponsored enterprises. Selling these loans frees up cash for the lender to make additional loans.
Nonconforming Conventional Loans
These are loans that don’t meet the requirements for conforming loans. Most often, these mortgages exceed the maximum conforming loan amount, which is why they are also called jumbo loans.
Jumbo loans are mortgages that exceed the conforming loan limit, which in 2024 is $766,550 for a single-unit property in most areas of the country. In high-cost areas such as Alaska and Hawaii, the limit is $1,149,825 for a single-unit property. That may sound like enough to buy an extravagant home, but in the most expensive real estate markets, it can be hard to find homes that fall within conforming limits.
Since lenders can’t sell these loans, they can set any requirements they like. Nonconforming loans usually require a larger down payment, and borrowers may have to meet stricter financial requirements.
Government-Backed Loans
A government-backed loan usually is issued by a private lender and insured by a federal agency. These loans generally have more flexible credit score requirements than conventional loans and are aimed at specific buyers or types of homes.
There are three main types of government-backed mortgages.
FHA Loans
Loans insured by the Federal Housing Administration are designed for borrowers with a lower credit score and less saved up for a down payment. You can make a minimum down payment of 3.5% of the purchase price if your credit score is 580 or higher. If your credit score is between 500 and 579, you can get a loan with a 10% down payment.
VA Loans
Veterans Affairs loans are available only to active-duty military, veterans, and eligible surviving spouses. VA loans require no down payment.
USDA Loans
U.S. Department of Agriculture loans are available only to low- and moderate-income borrowers looking to buy homes in specific rural areas. There’s no down payment requirement.
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Mortgage Rate Options
Another choice borrowers must make is between a fixed-rate and an adjustable-rate mortgage.
Fixed-Rate Mortgage
A fixed-rate mortgage has an interest rate that remains the same throughout the life of your loan. This is a great option for those who prefer consistency and predictability because the monthly payment will never change. These types of loans are often offered as 15-year or 30-year fixed-rate loans.
Adjustable-Rate Mortgage
ARMs are loans where you pay a fixed introductory rate that’s usually lower than for a fixed-rate loan for the first five, seven or 10 years of your loan. Then, the rate adjusts based on market conditions, usually once a year. This means your monthly mortgage payment may increase. Most ARMs cap how much your rate can increase in any one adjustment and set an overall maximum interest rate.
What Goes Into A Mortgage Payment?
A mortgage payment usually consists of four main costs, called PITI.
- Principal: This is the amount of your payment used to reduce the overall balance of the loan.
- Interest: This is the amount you pay the lender to borrow the principal. It’s determined each month by how much you still owe on your loan.
- Taxes: Most lenders require borrowers to make a payment toward their property taxes with each monthly payment. The amount you pay each month is a prorated estimate of your annual tax bill. Your lender will hold these payments in an escrow account and pay the property tax bill on your behalf when it’s due.
- Homeowners insurance: Lenders require borrowers to have homeowners insurance to protect the property against damage and loss. As with property taxes, you pay a monthly amount into an escrow account, and your lender pays the bill on time.
Additional fees you may have to pay as part of your monthly mortgage payment include:
- Mortgage insurance. If you have a conventional loan and have made a down payment of less than 20% of the purchase price, you’ll pay private mortgage insurance until you reach 20% equity. With an FHA loan, on the other hand, you’ll pay a monthly mortgage insurance premium for at least 11 years. With a USDA loan, you’ll have a guarantee fee that functions like mortgage insurance, while a VA loan charges a similar funding fee.
If your home is part of a homeowners association, you must pay dues that it will use to pay the group’s common expenses. These dues usually are paid separately from your mortgage payment.
What To Look For When Choosing A Mortgage
Mortgages have three main elements – loan type, interest rate and loan term – that are combined in different ways, depending on the borrower and lender. The right combination for you depends on your financial situation and goals.
You can use our home affordability calculator to better understand how much home you can afford, and our mortgage payment calculator can give you an idea of what your monthly mortgage payment will be. This information can be helpful when you apply for a mortgage.
If this is your first time buying a home, it may also be helpful to learn more about first-time home buyer loans and programs. Knowing the ins and outs of each program, including what you get with each and what you should consider, will help you choose your best option.
The Mortgage Process Explained In 7 Steps
No matter which type of loan or the lender you choose, the mortgage approval process usually follows the same basic steps.
1. Review Your Finances
Review your finances to be sure you can afford both the upfront and ongoing costs of a mortgage.
Upfront costs include the down payment and closing costs. You need a down payment of at least 3% of the home’s purchase price to get a conforming conventional loan. If you put down less than 20%, you’ll need to pay PMI. If you’re a first-time home buyer or a low or moderate-income earner, various down payment assistance programs are available to help you put together your down payment.
Closing costs also need to be paid upfront. These fees pay for the cost of underwriting and funding your loan, as well as transferring legal ownership of the home to your name. Expect closing costs to total 2% to 5% of the purchase price.
You’ll also want to review your credit history, which your lender will use to determine how responsible you are with paying your bills. Most loans also have a minimum credit score, and higher credit scores can score you a lower interest rate. If your credit isn’t where it needs to be, you might want to work on improving it before buying a home.
Lastly, you’ll want to calculate your debt-to-income ratio. This figure shows how much of your gross monthly income goes to paying your debts. This includes your estimated monthly mortgage payment, which will be based on how much you borrow and your interest rate and can be determined using a mortgage calculator. Most loans have a maximum DTI ratio, with lenders preferring a DTI ratio of less than 36%.
2. Get Mortgage Preapproval
When your finances are in order, you’re ready to apply with a few lenders for mortgage preapproval. Each lender will review your application and provide a letter estimating how much you can expect to borrow.
Preapproval is based mainly on the information you provide your lender about your income, assets and debts. The lender will order a hard inquiry on your credit report, temporarily lowering your credit score.
You can compare preapproval offers from multiple lenders to decide which is best for you.
Once you have preapproval, you’ll know how much you can afford to spend and begin to look for a home you want to buy.
3. Find A Home And Make An Offer
A real estate agent can help you look for homes in your price range and put together a competitive offer when you find the right place. Make sure your offer includes appropriate contingencies that will let you cancel the deal if unexpected problems occur. You also may want to offer the seller an earnest money deposit. When you and the seller agree on terms, you’ll both sign a purchase and sale agreement that makes the deal official.
4. Apply For A Mortgage
Now, you can finally apply for a mortgage. You’ll include the transaction details from the purchase and sale agreement, fill out an application, and document your finances for underwriting. Your lender will verify your finances and provide a loan estimate within three days of receiving your application. The loan estimate will include the expected terms and costs of your loan.
5. Get A Home Appraisal
Your lender will hire a professional third-party appraiser to examine and evaluate the home. The appraisal considers the location and current market conditions in addition to the physical state of the home. Lenders won’t approve a loan for more than the home is worth. If your home appraises for less than expected and you have an appraisal contingency, you can cancel the sale or pay the difference yourself.
6. Order A Home Inspection
This also is when you can order a home inspection, which is a thorough evaluation of the home’s condition. The inspection will alert you to any potential problems with the home, such as any safety issues or systems that need repairs. If the house is found to be unsafe or in need of major repairs and you have an inspection contingency, you can ask the seller to renegotiate the sale or cancel it.
7. Close The Sale
Your lender will provide a closing disclosure at least three days before closing. This document details all the final costs of funding your loan and completing the sale. On closing day, you’ll need to pay your down payment and closing costs, sign the loan papers, record the property transfer and receive the keys to your new home.
FAQ
Use the answers to these frequently asked questions to learn more about how a mortgage works.
The Bottom Line
Understanding what a mortgage is, how it works, and how to get one is essential to buying a home. Aspiring homeowners must evaluate their finances and decide what kind of mortgage best fits their lives. While conforming conventional loans are the most common, jumbo loans, FHA loans, VA loans and USDA loans all have their pros and cons. The process may seem daunting at first, but learning how it works at each step can start you on the path to successfully buying and owning a home.
