How does a mortgage work?

For most aspiring homeowners, obtaining a mortgage is an essential step in buying a house. Mortgages are typically large loans with long loan terms, so it’s essential to understand the basics of a mortgage and how it works before you make this significant commitment. You want to make sure you get the home loan that’s right for you.

Mortgage basics

A mortgage is a contract between a lender and a borrower for a loan used to purchase a property. The purchased property is used to secure the loan, which gives the lender the legal right to repossess the property and sell it if a borrower fails to make their mortgage payments. Most people have to take out a mortgage to buy a home or refinance.

Mortgages, like other loans, accrue interest throughout the loan term and have other fees and costs. A mortgage consists of a few basic elements:

Interest rate

The mortgage rate is the interest rate you pay to borrow the money, expressed as an annual percentage of your total loan amount. Essentially, the interest is the profit your lender earns for giving you money.

The annual percentage rate (APR) is an annual percentage of the loan amount that more broadly measures how much you’ll pay to take out a mortgage. APRs are higher than mortgage rates because they include interest plus other fees.

• Fixed rate: A fixed interest rate remains the same for the entire length of your mortgage. If your fixed rate is 4%, you’ll pay 4% in interest until you refinance or pay off the loan. With a fixed-rate loan, you know exactly how much you’ll pay each month of the loan term, making budgeting simpler.
• Adjustable rate: An adjustable rate is more unpredictable than a fixed rate, changing according to the terms of the contract and the market. Most adjustable-rate mortgages, or ARMs, start with a fixed-rate period that typically lasts up to 10 years. During this period, the interest rate on the mortgage doesn’t change. Once this period ends, however, the interest rate adjusts at a predetermined frequency. This means your monthly payments can change throughout the course of the loan.

Loan term

The loan term is the period of time you have to pay back the mortgage. If a borrower pays the loan off in full within this time frame, the loan balance moves to zero after the last month of the term.

Common loan terms are 15 years and 30 years, though there are also other options (like 10-year and 20-year terms.)

Loan amount

The loan amount is the amount you borrow to cover the purchase price of the property. The loan amount is the sales price of the home minus the down payment.

Repayment

The repayment of a mortgage includes the principal loan amount you borrowed and the interest accrued. A mortgage is paid off in a series of payments over the agreed-upon loan term.

Interest-only repayment is exactly what it sounds like: a payment you make that covers only the interest. Interest-only mortgages have interest-only payments for a set amount of time before you begin to pay the principal.

Closing costs

Closing costs are fees you pay to the lender during the home sale. These costs include discount points, the origination fee, loan processing fees, underwriting fees, loan funding fees and document preparation fees. This cost also includes title, appraisal, survey and recording fees.

Closing costs vary depending on the mortgage type and location. However, the typical range is between 2% and 6% of the loan amount. So, if your mortgage amount is $250,000, the closing costs might be anywhere between $5,000 and $15,000.

Mortgage insurance

Mortgage insurance protects the lender in case the borrower defaults on the loan. The specifics of your mortgage insurance depend on the type of home loan. If your down payment on a conventional mortgage is lower than 20%, the lender may require monthly private mortgage insurance (PMI) until you have enough equity in the property. If you get an FHA loan, you pay mortgage insurance premiums to the Federal Housing Administration, including an upfront and monthly payment.

Types of mortgage loans

There are several mortgage types to choose from. Mortgage rates are either fixed (stable rate over the course of the loan) or adjustable (relatively lower fixed rate for a temporary period before adjusting at predetermined intervals).

Long-term mortgages

A popular mortgage option is the 30-year home loan. With this longer term, you pay higher more interest, but your monthly payments are lower. Some lenders and banks also offer 40-year mortgage options, but these are rare.

Short-term mortgages

The 10-year mortgage is often the shortest-term home loan available to borrowers. A 10- or 15-year mortgage comes with a lower interest rate — and you’ll pay less interest overall — than a long-term loan, but you'll pay more each month because of the shorter term.

Conventional mortgages

A conventional loan is a privately backed loan (meaning it’s not backed by the government, which makes it riskier for lenders). Conventional loan programs typically require a credit score of at least 620 and a down payment of at least 3%. However, if you put down 20% or more, you can avoid paying PMI.

Conventional loans can be conforming or nonconforming. A conforming loan adheres to rules from Fannie Mae, Freddie Mac and the Federal Housing Finance Agency, while a nonconforming loan does not meet these requirements. Jumbo loans are generally nonconforming loans that have higher borrowing amounts and require good credit and a large down payment.

Government-backed mortgages

Government-backed loans are loans insured by the government in case the borrower defaults. This makes it easier for the private lender to approve applicants. Government-backed loan options include FHA, VA and USDA loans.

FHA loans

FHA loans are backed by the Federal Housing Administration. You can obtain an FHA loan with a credit score as low as 500 and a minimum 3.5% down payment for those with good credit. They do require FHA mortgage insurance, regardless of how much you put down. FHA loans are popular among first-time homebuyers and those with less-than-ideal credit.

VA loans

VA loans, which are guaranteed by the U.S. Department of Veterans Affairs, are meant for eligible retired and active-duty military personnel and surviving spouses. In most cases, they don’t require a down payment or mortgage insurance. Often, a borrower needs to pay the VA funding fee, though there are exemptions.

USDA loans

Loans backed by the U.S. Department of Agriculture (USDA) are designed for low- to moderate-earning borrowers. These loans finance home purchases in designated rural locations. USDA loans don’t require a down payment and aren’t limited to first-time homebuyers.

The mortgage process

The mortgage loan process can be challenging to navigate, especially if you’re a first–time home buyer. It’s helpful to learn about the process before getting into it so you know what to expect.

Mortgage requirements

With any type of loan, there are specific requirements for qualification. These will depend on the lender, the type of loan and your personal financial profile, including your credit score, debt-to-income ratio, monthly income and down payment amount.

Credit score

A credit score is critical in taking out a mortgage. It reflects how you’ve managed various credit accounts throughout your financial history. Having a higher credit score can help you qualify for a lower interest rate.

FICO Score minimums for most lenders:

• 620 for a conventional mortgage
• 500 to 640 for a government-backed loan
• 680 to 700 for a jumbo loan

Debt-to-income ratio

Your debt-to-income ratio (DTI) is the total of your monthly debt payments divided by your gross monthly income. DTI helps lenders evaluate your ability to make your loan payment each month.

Monthly income

It’s important to be able to show your mortgage lender you have a sufficient and stable income. Lenders review your pay stubs, income tax returns, W-2s and other documents showing your earnings. They might also consider how often you’ve switched jobs and how long you’ve worked in a particular field.

Down payment

A down payment is the amount of money you pay out of pocket upfront to purchase a home. Not all loan programs require borrowers to make a down payment. Making a bigger down payment means you borrow less money and make smaller monthly mortgage payments; you may qualify for a lower interest rate and avoid paying private mortgage insurance.

Pros and cons of a mortgage

Most people don’t have the option of buying a home without the help of a mortgage. If you’re trying to decide whether getting a mortgage is right for you, here are some benefits and drawbacks to consider.

Bottom line

A mortgage is the only path to homeownership for most of us. Applying for a mortgage is a good idea if you can afford the down payment, monthly payments, closing costs and the overall cost of homeownership.

However, keep in mind that a mortgage loan is a significant debt that uses your property as collateral. Before you take out a mortgage, examine your personal finances closely and educate yourself as much as possible about home loans. Once you’re ready to apply, compare offers from a variety of lenders to get the best deal possible.