What Is a Mortgage & How Does It Work? Everything You Need To Know

A mortgage is a loan you use to borrow funds to buy a home when you can’t (or don’t want to) pay for it all in cash. For most people, it’s a crucial part of the home-buying process.

What is a mortgage?

On the surface, buying a home seems simple: You find one for sale, and pay the seller an agreed-upon price. But with the median price of a new home topping $430,000, coming up with that kind of cash isn’t easy. That’s where a mortgage comes in. 

When you use a mortgage to buy a home, you agree to use the house as collateral. That means if you stop making payments, the mortgage lender can reclaim your house. Make the payments as agreed, and the home will be yours, free and clear.

How does a mortgage work?

A mortgage is a key part of the home-buying 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 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.

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.

Usually, you’ll start with a pre-approval, during which the lender tells you how much you can likely borrow and the interest rate you can expect to pay based on the information you provide. You can use this pre-approval to begin home shopping. 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.

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 you need to know

Before shopping for a mortgage, it helps to understand some of the terms you’ll commonly find:

• Amortization: The gradual repayment of a debt in regular installments over time.
• APR: Annual percentage rate, or the actual yearly costs for the loan, including interest and 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.
• Closing: The final settlement of all necessary details of a home loan.
• Down payment: The portion of the home purchase you pay upfront, out of pocket.
• Equity: Your ownership stake in the home.
• Escrow: A special account that holds funds before they are transferred from one party to another.
• Interest rate: The percentage of the loan amount you pay in interest to the lender.
• PMI: Private mortgage insurance, which is often required for loans with less than a 20% down payment.
• Principal: The amount borrowed, not including interest or 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.

Types of mortgages

There are many different types of mortgages, each with different features and terms. The most common types include:

• Conventional mortgage: Any mortgage that is not part of a government program.
• Fixed-rate mortgage: A home loan with an interest rate that does not change over time.
• Adjustable-rate mortgage: A mortgage with an interest rate that changes based on market conditions.
• Jumbo loans: Mortgages that are larger than conventional loan limits approved 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

How to get a mortgage

These are the basic steps to get a mortgage:

• Determine your budget: Start by evaluating your expenses to see how much you can afford to put toward a mortgage each month.
• Review your credit report: Look for any errors that could be affecting your credit score.
• Get pre-approved: When you apply for pre-approval, the lender will review your credit history, income, debts, and other factors to determine how much you could borrow.
• Compare lenders: Rather than going with the first lender you find, compare different loan options before you choose a mortgage. The lower your interest rate, the less you’ll pay in the long run.
• Make the deal: A real estate agent can help you find a home, make an offer, and negotiate with the seller on the terms of the sale.
• Get approved: Once you’ve chosen a house and a lender, complete the mortgage application and wait for approval.
• Close on the sale: The last step is to close on the property. Closing is where you’ll complete the final paperwork and transfer the title into your name.

Getting a mortgage is not a one-size-fits-all process. “There are so many nuances to how a bank will review a loan file,” said Sarah Alvarez, vice president at William Raveis Mortgage. “You want to make sure that you are putting your best foot forward when making an application,” Alvarez recommends speaking to a professional who can help you during this process.

Calculate the cost of a mortgage

Different factors will change the cost of your mortgage, including the type of mortgage, your interest rate, and how much you put down as a down payment.

For example, suppose you apply for a $250,000 mortgage. With 5% interest and a 30-year fixed term, your payments would be $1,342 monthly and you’d wind up paying $483,139 by the end of the loan.

If your interest rate was 8% instead, your monthly payment would be $1,834 and you’d pay $660,388 in total by the end of the loan.

You can use our mortgage calculator to see how different factors affect your mortgage costs over time.

What is a mortgage FAQ

Why do I need a mortgage?

With the median price of a home hovering near $400,000 in 2023, not many people can afford to buy one outright with cash. Getting a mortgage lets buyers pay a small percentage of the price upfront and finance the rest over time.

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

With credit scores, higher is better when it comes to qualifying for a mortgage.

“The very best rates are reserved for 780+ (although some banks use 740+),” Alvarez said.

That’s why checking your credit history and credit score ahead of time is important; it can help you target the right loan options for your situation, and can also motivate you to boost your credit score if necessary.

What is the minimum down payment required for a mortgage?

If you can save up at least 20% for a down payment, you’ll avoid having to pay private mortgage insurance (PMI).

But many conventional and government-backed loans are available that will allow you to put down much less. For example, you could qualify for a loan from the Federal Housing Authority (FHA) with just 3.5% down, and some lenders will approve conventional loans with as low as 3% down.

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.

How can I lower my mortgage interest rate?

You may be able to lower your rate by making a larger down payment, improving your credit score, or buying down your rate with points. Adjustable-rate mortgages are another option for lowering your rate in the short term.

“In an elevated rate market, it doesn’t necessarily make sense to lock in for the long term, and banks incentivize you to take an adjustable rate by offering lower rates for lower fixed periods,” said Alvarez.

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 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.