A mortgage is a loan taken out to fund the purchase of a piece of property. Most homeowners will take out a mortgage if they can’t or don’t want to pay for the property in cash. Mortgage loans are one of the largest financial tools a person may use in their lifetime, which is why it’s important to thoroughly understand how mortgages work.
Let’s take a look at how mortgages work, the types of mortgages offered, and what you can expect when shopping and applying for a mortgage.
What is a mortgage and how does it work?
A mortgage is a key part of the homebuying process for many borrowers. A borrower applies for a mortgage loan to purchase a property from a seller; if the mortgage is approved, the seller receives the agreed-upon purchase amount from the lender while the borrower repays the lender for that amount, plus interest and other fees.
The borrower makes a down payment to secure the loan, typically around 20% or more of the property’s value. As the borrower pays off the rest of the mortgage loan amount, known as the principal, they will also pay the interest accrued on the loan.
Interest rates are a percentage of the mortgage amount and can significantly increase the overall amount paid for the property. That’s why it’s best to get the lowest interest rate possible when securing a mortgage loan.
The borrower also puts up the property as collateral, meaning that the lender can seize the property if the borrower fails to repay the mortgage according to the agreed-upon terms.
Typically, the timeline for the mortgage process looks like this:
- Apply for a specific type of mortgage loan, such as a VA or USDA loan, from a lender.
- Get a loan estimate that summarizes the loan amount, terms, interest, and other information.
- Get a conditional or pre-approval that states a lender agrees to provide a loan amount if the borrower meets certain conditions. This may include showing how you’re securing a down payment and other financial documents.
- Close on the loan, which is the formal acceptance of the loan, deposit the down payment, and pay closing costs.
- Start making monthly mortgage payments after the property is purchased.
Mortgage terms to know
Taking out a mortgage is one of the largest financial decisions you’ll make. Before you speak to a lender, make sure you know what these mortgage terms mean
- APR: Annual percentage rate is the interest rate plus other loan charges like points and broker fees.
- ARM: An adjustable-rate mortgage is a loan that has an interest rate that can rise or fall, increasing or decreasing your monthly payment.
- Amortization: When a loan amortizes, it means it is paid off with regular, decreasing payments over the term of the loan.
- Down payment: A percentage of the purchase price you put down to secure the mortgage loan; it is then applied to the purchase price of the home.
- Escrow: An account that retains a portion of your monthly mortgage payment to pay for taxes and homeowners insurance.
- Interest: The amount of money you pay in exchange for the loan, usually a percentage of the loan’s amount, which is either at a fixed or adjustable rate.
- Mortgage insurance: Insurance required from a lender when a borrower has a down payment of less than 20% of the property value.
- Origination fee: A fee paid to the lender for the administrative services required to create the loan.
- Payoff amount: The current balance of the loan plus the unpaid fees and interest accrued to completely pay off the mortgage.
- Principal: The amount of the mortgage loan a borrower needs to pay back, not including interest or other loan fees.
- Subprime mortgage: A mortgage program for borrowers who do not qualify for prime mortgages.
- Term: The maximum duration of time you have to repay your mortgage loan.
How much is a mortgage?
A monthly mortgage payment is much more than just paying back principal (the loan amount itself). Factors like the type of mortgage you have, your interest rate, how much your down payment is, and other costs impact how much your full monthly payment is.
For instance, let’s look at three scenarios involving a $300,000 loan on a 30-year term, using a mortgage calculator:
A $300,000 loan amount with no down payment and a 6% interest rate has a minimum monthly payment of $1,799. You’ll pay $347,515 in interest over the lifetime of the loan, totaling $647,514 paid by the end of the term.
Reducing the interest rate to 5% creates a $1,610 monthly payment with $279,767 in interest accrued and a total payment of $579,767.
Putting $60,000 as a down payment reduces the loan amount to $240,000. This has a $1,439 monthly payment, $278,012 in accrued interest with a 6% interest rate, and total payment of $518,011 by the end of the term.
Reducing the interest rate to 5% creates a $1,288 monthly payment with $223,814 in interest accrued and a total payment of $463,813.
As you can see, the down payment and interest rate have a substantial impact on how much you’d pay on your mortgage loan by the time the term ends.
Types of mortgages
There are many types of mortgages available, some of which you may qualify for and others that are only applicable to certain borrowers. Shop around to see which mortgage type is best for your unique borrowing situation:
- Conventional mortgage: A conventional mortgage loan is offered by a private lender and not insured by the government.
- Fixed-rate mortgage: A loan that has the same monthly principal and interest rate payments for the lifetime of the loan.
- Adjustable-rate mortgage: A loan that has principal and interest payments that could increase or decrease over the lifetime of the loan.
- Jumbo loans: A loan that exceeds the limit set by the Federal Housing Finance Agency.
- VA loan: A loan for qualifying veterans, military service members, and surviving spouses that is provided by a private lender but partially guaranteed by the U.S. Department of Veteran Affairs.
- USDA loan: A loan designed to assist low-income borrowers in eligible rural areas, guaranteed by the U.S. Department of Agriculture.
- FHA loan: A loan provided by a private lender with more flexible borrower credit score limits that is insured by the Federal Housing Administration.
Pros and cons of mortgages
Although there are many different mortgage options, you should be aware of their pros, cons, and eligibility requirements before applying for one.
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How to get a mortgage
Applying for your first mortgage can be feel overwhelming, but the process is much more straightforward than it may seem:
- First, evaluate your credit. Check your credit report and remove any errors, then see what your credit score is with at least one of the three credit bureaus. If you can improve your score to the next level, such as from fair to good, try to so you can qualify for the best rate.
- Then, identify which type of mortgage is right for you. A conventional home loan with a fixed interest rate is quite common, but some borrowers might benefit from other loans. For example, veterans may benefit more from VA loans than from conventional loans.
- Next, shop around for mortgage loans from different lenders. Remember that there are many places to get mortgage loans, including traditional lenders like banks and credit unions, as well as online-only companies that offer mortgage loans.
- Finally, when you find a mortgage that you believe will meet your needs, start the pre-approval process to determine whether you’re likely to get approved.
How do mortgages work FAQ
Whether you’re purchasing a home for the first time or getting a mortgage for the first time in decades, here are answers to frequently asked questions about how mortgages work.
What credit score do I need for a mortgage?
Each lender may prefer a range or require a specific credit score before approving a mortgage. Typically, prospective homeowners with high credit scores will have a better chance of approval compared to those with low credit scores. It can be difficult to find a lender who will approve you for a mortgage if your credit score is in the mid-600s or below. Borrowers with low credit scores may be able to secure a loan, but it will likely be with the highest rates and less-than-ideal features.
How do I get the lowest mortgage rate?
One way to get the lowest mortgage rate available is to secure as high of a credit score as possible, as lenders tend to reward high credit score borrowers with the lowest rates. Because there are many different loan providers in the market, shopping around allows you to compare rates and negotiate to secure the lowest rate available.
What’s the 3-7-3 rule for mortgages?
The 3-7-3 rule refers to timing requirements lenders must meet when making cost disclosures before closing. The lender must provide a good faith estimate and truth-in-lending statement to the borrower within three days of receiving the loan application. To give the borrower time to review the documents, the rule calls for at least seven business days from their receipt before closing can take place. The lender must also provide an accurate annual percentage rate (APR) three business days before closing. If the APR changes more than 0.125% in that time, the lender has to make a new disclosure and wait three more days.
How does a mortgage get paid?
A mortgage is paid through monthly payments over the course of the mortgage loan term. Even though you only make a single monthly payment, that amount pays for four elements of the loan: the loan principal, the interest accrued on the loan, taxes assessed, and insurance. Although the loan principal is the amount of the loan you received, homeowners typically pay more than that over the lifetime of the loan because of the interest, taxes, and insurance fees.
What hurts your chances of getting a mortgage?
A low credit score, specifically one at or below the mid-600s, can hurt your chances of getting a mortgage. Other factors that might make you appear risky to lenders include having a lot of debt, insufficient income, and a poor credit history.
