What is a mortgage and how does it work?

When you have your heart set on your dream home, looking at the price tag can be devastating. It’s no secret that many homes are hundreds of thousands of dollars, and most of us can’t afford that anytime soon. Mortgages help remove the upfront financial burden that comes with buying a home, allowing you to stretch payments out up to 30 years.

Today, we’ll walk you through the basics of a mortgage, how they work, and how to choose the right one for your financial picture.

What is a mortgage?

A mortgage is a type of loan that allows borrowers to buy real estate, such as a home or commercial property. With these loans, borrowers will need to pay their lender (typically a bank, credit union, or private lender) back in monthly installments, with interest. If you fail to repay the loan, your lender can take ownership of the property, since the property acts as collateral for the loan.

Mortgage terms you need to know

Before we dive into all that a mortgage is, it’s important to know all of the industry jargon. Here are a few terms you’ll hear along the way:

• Down payment: An initial payment that a buyer makes toward the purchase price of the property.
• Principal: The amount of money you borrow from a lender, not including your down payment.
• Interest: A percentage of your principal that you pay to your lender in exchange for borrowing money.
• Escrow: A process where a neutral third party holds money for you during the home-buying process, which makes sure all parties fulfill their financial obligations.
• Private mortgage insurance (PMI): A type of insurance that protects your lender should you default on your loan. Typically, you’ll need to pay this if you pay less than a 20% down payment.
• Closing costs: A collection of fees that are paid at the time of closing. These include title search fees, appraisal fees, attorney fees, and more.
• Amortization: The process of gradually paying off your mortgage through regular payments over a period of time.
• Adjustable-rate mortgage: A mortgage with interest rates that fluctuate over time based on the federal rate and real estate market.
• Fixed-rate mortgage: A mortgage with an interest rate that stays the same over the life of the loan.

How does a mortgage work?

When you buy a home, a mortgage pays off the seller and gives you years to repay the loan. From start to finish, the process takes about a month to a few months. Here’s how the full process works:

• Complete a loan application: Once you’ve gotten to the point where you’ve found a house and are ready to get started on the borrowing process, you’ll provide the lender with your financial information, including income, credit history, assets, and debts. The lender assesses your creditworthiness and determines your eligibility.
• Enter into a mortgage agreement: If you’re approved, the lender will send you a mortgage agreement that outlines the full terms and conditions of the loan. Among other things, this agreement typically includes the loan amount, interest rate, loan term, and how much you pay each month.
• Start making interest and principal payments: Each month, you make mortgage payments to your lender. Within this payment is the interest you’re paying for borrowing the money and the principal payment, which reflects your loan balance. In the early years of the mortgage, a larger portion of the monthly payment goes toward interest, while more of the payment goes toward the principal as the loan progresses.
• Your equity grows: While you’re making payments, your equity slowly goes up. Your equity is the difference between your home’s market value and what you still owe. As your equity grows, your balance goes down and you gain more ownership of the home.
• You reach your payoff date: Once you have made your final payment, you’ll fully own the property. After this, your only expense is your property taxes and insurance costs.

How much is a mortgage?

There is no singular mortgage amount. What you pay depends on the price of the home you’re buying, which is what makes up the bulk of your mortgage. Your interest rate makes up the rest of your mortgage. Borrowers with the highest credit scores qualify for low rates, significantly lessening their monthly payments.

Types of mortgages

Mortgages come in several different types, each with its own advantages and disadvantages. These mortgages are some of the most common:

• Conventional: A conventional mortgage is a basic mortgage offered by private lenders. Most of these lenders require or encourage at least 20% down to qualify for the best rates.
• Federal Housing Administration (FHA) loan: FHA loans give first-time homebuyers a chance to buy a home with as little as 3.5% down and lower credit scores than other types of mortgages.
• USDA loan: USDA loans help those in rural areas with low to moderate incomes buy, renovate, or construct safe housing. To qualify, the property location must be in a USDA-eligible area.
• Jumbo loan: Jumbo loans, or non-conforming loans, are mortgages designed to cover high-priced real estate. These loans don’t conform to Fannie Mae, Freddie Mac, and the Federal Housing Finance Agency (FHFA) maximum loan amounts.
• VA loan: VA loans are designed for veterans and their families, offering no down payment and low interest rates.

Pros and cons of mortgages

Mortgages are incredible financial products that have helped millions of people buy homes. But as with nearly every financial product, you’re going to pay big-time for the convenience. Here are some pros and cons to think through before deciding on a mortgage:

How to get a mortgage

Getting a mortgage is a long process, but it doesn’t need to be difficult. Having the documentation you need and the right team will help make your path to homeownership easier. Here’s what the process will look like:

1. Determine what you can afford: Before applying for a mortgage, make sure to assess your finances to determine what you can afford to pay. If your credit score is less than stellar, you’ll want to spend some extra time improving it to be eligible for a loan and land a competitive rate. To start, request a copy of your credit report and check to see if your credit score is in good standing.
2. Decide on a mortgage type: The right mortgage type can make buying a home a lot easier. If you’re overwhelmed by your choices, connect with a loan officer who can advise you on this decision.
3. Start saving your down payment: When you decide on a mortgage type, you’ll find out what the minimum down payment requirement is. If you haven’t already, start saving up so you’ll be prepared.
4. Shop around: Comparing rates from different lenders ensures that you’re getting the best deal. Shop through a loan marketplace that can give you an estimate of what your rates may be across multiple companies.
5. Seek pre-approval: Once you have narrowed down your choices, it’s time to get pre-approved. A pre-approval letter eases sellers’ minds and demonstrates you’ll qualify for the necessary funding to buy the home.
6. Complete the full application: Once you’ve put in an offer that’s accepted, you know how much you officially need for a mortgage. Submit your lender’s application and the requested documents (e.g. tax returns, pay stubs, asset documents).
7. Get approved and close on your home: Once approved for your mortgage, you can get through the rest of the closing process. From there, you start making monthly payments.

Mortgage FAQ

Why do I need a mortgage?

Mortgages help non-cash buyers secure housing. If you’re interested in buying a home and don’t have the savings to cover the entire cost in cash, you need to take out a mortgage to make the process more affordable.

What credit score do I need to qualify for a mortgage?

To qualify for a mortgage, you need to meet the credit score requirements set forth by your lender or loan program. Here are common credit requirements:

• FHA: 500+
• USDA: 640
• Conventional: 620 - 640
• VA: None

What is the minimum down payment required for a mortgage?

The minimum down payment required for a mortgage varies. For instance, FHA loans require a minimum of 3.5% down while USDA loans require no down payment at all. You’ll want to check with your loan officer to find out the exact amount you should put down.

Also know that if you put less than 20% down for certain loans, you’ll have to pay mortgage insurance or PMI and additional insurance that protects the lender if you stop making payments.

How can I get the lowest mortgage rate?

To get the lowest mortgage rate, start by comparison shopping with multiple lenders. Each will evaluate your credit and financial profile a little differently, and one may offer better rates than the others. In addition, focus on raising your credit score as much as possible, as this is a key factor in determining your interest rate.

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