What Is a Mortgage? Here’s What You Should Know

Many Americans dream of owning a house, but few have the cash to purchase one outright. Luckily, you don’t need hundreds of thousands of dollars up front to buy a home. That’s what a mortgage is for. 

If you’re thinking about buying a home, you should take the time to learn the basics of mortgages, how they work, and what the application process looks like. 

What is a mortgage?

A mortgage is a loan provided by a lender to purchase a house or to borrow against equity in a home you already own. 

When you take out a mortgage, you make an agreement with the lender to repay the principal, interest, and applicable fees. If you can’t pay according to the terms outlined in your loan documents, the lender can take action to foreclose on the property. 

How does a mortgage work?

When you apply for a mortgage, you undergo a thorough process to show the lender you can afford to repay the loan. 

The lender looks at your income, credit score, debt-to-income ratio, and other financial factors when reviewing your loan application and setting the terms. Terms include your mortgage interest rate, the amount you can borrow, and the required down payment. 

After you receive a mortgage, you’ll repay the principal, plus interest, in regular installments each month over your mortgage term. A 30-year mortgage term is most common, but other terms are also available, including 10-year and 15-year terms. 

Types of mortgages

There are many types of mortgages you can consider when shopping for a home loan. Here are three common types:

Conventional

A conventional mortgage is a home loan that isn’t insured by a government agency. These are the most common types of mortgages. 

Conventional loans can cost less for well-qualified homebuyers over the long term compared to government-backed loans, but they can be harder to qualify for. 

Government-backed

Government-backed loans are insured or guaranteed by the government. 

These loans can make homeownership more accessible to borrowers who have trouble meeting conventional loan requirements. For example, FHA loans are designed for buyers with lower credit scores. 

There are also government-backed loans for veterans (VA loans) and those living in designated rural areas (USDA loans). 

Special program

Depending on your situation and where you’re shopping for a house, there may also be state and local loan programs or special-purpose programs you can qualify for. 

These loans may be available to first-time homebuyers, low- or moderate-income borrowers, or even public service employees.

How to choose the right mortgage 

You should do some research when comparing mortgage loans to find the right one for you.

Start by reviewing your financial situation, especially your income, credit score, and down payment savings. This can help you get a sense of which loan types you may qualify for and how much house you can afford. 

You should also ask yourself some questions that can help you clarify which loan types to consider. For example:

• Would you prefer the lower upfront cost of an adjustable-rate mortgage or the predictability of a fixed-rate mortgage? 
• How do you prioritize monthly payment vs. long-term costs?
• How long do you plan to stay in the home?
• Do you qualify for any government-backed loans or special loan programs?
• How much are you willing and able to pay up front?

Once you’re ready to start looking for a home, you can compare lenders and get preapproved. At that point, you may want to call in the professionals, says Destinee Stice, VP of Loan Origination at NewDay USA. That typically means consulting with an independent mortgage broker or a mortgage loan officer who works for a specific lender.

“When choosing a mortgage, it’s important to collaborate with a trusted partner. There are so many programs available depending on your situation,” says Stice. “You should enlist someone and develop a relationship so you share all of your questions, concerns, and plans, and allow the professionals to recommend and compare programs.”

What costs come with a mortgage?

When you take out a mortgage, you’ll likely face a variety of upfront costs. These vary by lender and loan type but often include:

• A down payment: This is the portion of your home’s purchase price you pay out of pocket when you buy a home.
• Origination and lender fees: These include the administrative costs of originating your loan and cover things like application fees, underwriting fees, processing fees, and more.
• Points: Points are an optional charge that allow you to buy down your interest rate. They’re calculated as a percentage of your loan amount.
• Closing costs: These are the costs you’ll pay to close on your loan and take possession of your house. They may include appraisal fees, inspection fees, title insurance, and more. 

After the upfront costs, you’ll begin paying your mortgage each month. Your monthly payment will include:

• Principal: This is the money you borrow to cover your home purchase.
• Interest: Interest is the primary cost of borrowing money, expressed as a percentage. Annual percentage rate (APR) accounts for both the interest rate and certain upfront lender fees. It’s a useful way of comparing the total costs of different loans.
• Mortgage insurance: This additional cost protects lenders from borrower default. It may be required for certain government-backed mortgages, as well as conventional mortgages with down payments of less than 20%.
• Taxes and insurance: These costs are often bundled in your monthly payment but aren’t technically part of your mortgage.

When comparing mortgages, it’s easy to get hung up on the interest rate and ignore other factors that affect cost. But be careful: “A lower rate doesn’t automatically mean a lower monthly payment,” says Ashley Harris, Production Manager and Director of Homebuyer Education at Neighbors Bank. “Loan type, mortgage insurance, and down payment all play a role. The best option depends on credit, income, and eligibility.”

Read More: Exploring the Total Costs of Buying a House

How do you qualify for a mortgage?

Mortgage qualification requirements vary by lender and loan type. But in general, here’s what lenders look for: 

• Income: “Something that borrowers consistently ignore, yet it matters greatly, is the stability and documentability of income,” says Cody Shuiteboer, President and CEO of Best Interest Financial. “Lenders want to know about not only borrowers' incomes, but also how the borrowers earn that money, for how long, and if it will continue.”
• Credit score: Lenders want to see a positive history of repaying your debts, reflected in your credit score. The higher your score, the easier it generally is to get a loan. While many lenders require a score of 620, certain loan programs have more lenient credit score requirements. For example, you can generally get an FHA loan with a score of 580 or 500 with a 10% down payment.
• DTI: Lenders want to make sure your income won’t be swallowed up by other debt payments before you can cover your mortgage costs. They measure this risk by looking at your DTI, or debt-to-income ratio. This measures your monthly debt payments compared to your gross monthly income. You generally need a DTI below 36% to get a conventional loan, although some lenders may accept a DTI of up to 45% or higher. The lower your DTI, the better. 
• Assets: Your assets can help you pay your mortgage if you lose your income for a period of time. Lenders will want to see how much money you have in checking, savings, retirement, and brokerage accounts.

Learn More: How To Qualify for a Mortgage

How to apply for a mortgage

When you’re serious about buying a home, it's time to think about applying for a mortgage. Here’s an overview of different steps in the application process. 

Prequalification

Before you start preparing for applications, prequalify with multiple mortgage lenders to get an idea of how much you might be able to borrow and the rates and terms you might qualify for. A prequalified quote is an estimate rather than a formal loan offer, but it is useful for comparison-shopping among different lenders without a hard credit check. 

Also, keep in mind that prequalification and mortgage pre-approval aren't the same thing.

Pre-approval

After comparing quotes, you may choose to get a mortgage pre-approval from your lender of choice. Sometimes called a pre-approval letter, this document outlines how much a lender may be willing to lend you based on your financial information. It typically involves a hard credit inquiry, which can temporarily lower your credit score, and requires documentation such as pay stubs, bank statements, and tax returns. 

A mortgage pre-approval isn't a loan offer, but it can show sellers that you’re a serious buyer. A pre-approval letter may be valid for anywhere from 30 to 90 days, depending on the lender.

Application and loan estimate

Once you’ve chosen a property and signed a purchase agreement, you’ll submit a formal mortgage application. Lenders typically collect detailed information about your income, assets, debts, employment, and bank accounts.

After receiving your application, the lender is generally required to provide a Loan Estimate within three business days. The Loan Estimate outlines important details such as the estimated interest rate, monthly payment, closing costs, taxes, and other loan terms. The lender typically continues reviewing your financial information during underwriting.

Accept the loan terms and close on the house

If your application is approved and you accept the offer, closing on your home is the final step in the process. This involves all parties meeting to sign the necessary paperwork and transfer the keys from seller to buyer. Closing costs typically range from 2% to 5% of the home's purchase price. After closing, you’re officially responsible for the mortgage loan.

Learn More: How To Get a Mortgage: Step-by-Step Process

Mortgage terms you should know

Learning about homebuying involves a lot of new vocabulary. Here are some common mortgage terms you should know when you’re starting to shop for a loan:

• Adjustable-rate mortgage (ARM): A mortgage with an interest rate that can change throughout the loan term
• Amortization: The process of paying off your loan with regular installments
• Annual percentage rate (APR): The cost of borrowing money, including the interest rate and certain upfront fees
• Conventional loan: A mortgage that isn’t insured by a government agency
• Credit score: A measure of how responsible you have been with credit, used as an indicator of how likely you are to pay your loan back on time
• Debt-to-income ratio (DTI): Your monthly debt commitments compared to your gross monthly income
• Down payment: The amount you pay toward your home purchase upfront
• Fixed-rate mortgage: A mortgage with an interest rate that doesn’t change throughout the loan term
• Interest rate: The primary cost of borrowing, expressed as a percentage
• Mortgage insurance: A policy that protects the lender in case the borrower defaults on their loan
• Mortgage term: The time it will take you to pay off your mortgage loan if you stick to scheduled payments
• PITI: The makeup of your monthly mortgage payment, including principal, interest, taxes, and insurance
• Principal: The amount of money you borrow to buy a home, not including interest or fees

For a more comprehensive list of mortgage terms, check out this article on 30 mortgage terms homebuyers should know.