What is a mortgage? (And how it works)

Mortgage definition

A mortgage promissory note is an agreement between a borrower and a lender — usually a bank or other financial institution. The mortgage terms outline the following items:

• The borrowing amount
• The length of the agreement
• The amount of each payment
• The interest to be paid

A mortgage is a collateral-backed loan, which means if the borrower fails to make timely payments, the lender will be able to recover the property and resell it to recoup their costs. A collateral-backed loan is also beneficial to the borrower since it allows fair interest rates and some flexibility with less-than-perfect credit scores.

How do mortgages work?

Buying a home is expensive. The mortgage process exists so that buyers can purchase real estate from a seller without having to pay the total purchase price upfront. While the seller is involved in the sales agreement, the actual mortgage is a financing agreement between the lender, also called the mortgagee, and the buyer, also called the mortgagor.

This agreement defines the terms, including the loan amount, interest rate and repayment period, typically 15 to 30 years. Because financing a long-term loan is risky for a lender, buyers have to prove they are a safe risk through their creditworthiness, debt-to-income ratio (DTI) and down payment, which is an upfront payment toward the property's total cost. The down payment is usually a percentage of the home's purchase price and serves as the borrower's initial equity in the property. The more equity a buyer has in the property, the less of a risk they are in the eyes of the lender.

As the borrower makes regular monthly mortgage payments over the loan's term, a process called amortization occurs. Amortization involves the gradual reduction of the outstanding loan balance while simultaneously paying the interest accrued on the remaining principal. At the beginning of the mortgage term, a larger portion of each payment goes toward interest, but over time, more of the payment is applied to reduce the principal balance. This steady reduction in debt, combined with consistent payments, allows borrowers to build equity in their homes over the years.

» MORE: What is a balloon mortgage?

The mortgage approval process

Your mortgage application will pass through several hands before it reaches final approval.

“There are many people involved in the mortgage process — while your conversation typically starts with the loan officer, you should think of them as the captain — you will have many touch points with different team members throughout the process,” said Sarah Alvarez, vice president of mortgage banking at William Raveis Mortgage.

She explains that many lenders have an upfront team that helps assemble the necessary documentation in order to submit the loan to the bank.

“These team members can have different titles but serve the same purpose in doing an initial sweep of the information and documentation provided to make sure that your file is as complete as possible and tells the same story outlined in the loan application,” she said.

Once your mortgage documents are submitted to the lender, an underwriter reviews the file and makes a credit decision. You won’t have direct contact with the underwriter, but there is a good chance your lender will request additional information from you on behalf of the underwriter, such as updated bank statements or clarifications on credit dings.

“After the loan is approved, the borrower will work with a processor who is the liaison between the borrower and the bank to satisfy any outstanding conditions and assist in getting you across the finish line to closing,” said Alvarez.

» MORE: How to apply for a mortgage

Mortgage types

The good news is that you don’t need perfect credit or a 20% down payment to enter the mortgage process. Some mortgage types offer flexible credit and down payment requirements.

Here’s a brief overview of the most common types of mortgages:

How are mortgage payments calculated?

Unlike other types of loans, mortgage payments contain a few more components.

• Principal: The principal is the initial loan amount borrowed from the lender to purchase the home. It forms the foundation of your mortgage payments. As you make monthly payments over the loan term, the principal balance gradually decreases, leading to an increase in your home equity.
• Interest: This is the cost of borrowing money from the lender and is expressed as an annual percentage rate (APR). Your rate will determine how much you pay for the loan in the long run; the lower your interest rate, the less you have to pay overall. At the beginning of your loan term, a significant portion of your monthly payments goes toward paying the interest.
• Taxes and insurance: In addition to the principal and interest, your mortgage payments may include funds for property taxes and homeowners insurance. The lender typically collects these amounts as part of your monthly payments and holds them in an escrow account. When the taxes and insurance payments are due, the lender pays them on your behalf.
• Mortgage insurance: If your down payment is less than 20%, you will have to pay private mortgage insurance (PMI) until you have at least 20% of equity built up in your new home. Some loan types, such as an FHA loan, come with mortgage insurance premiums (MIP) that remain on the life of the loan.

» MORE: How to save for a down payment

Bottom line

Getting a mortgage is an exciting financial step and probably one of the biggest financial decisions you’ll make in your lifetime. Before you start shopping for your new home, make sure you understand the types of mortgages that are out there and what your options are. Then, compare various mortgage lenders to ensure you get the right terms, rates and funding for your situation.