What Is A Mortgage And How Does It Work?
Before you begin the process of buying a house, it’s important to understand the basics of a mortgage, starting with a simple mortgage definition. That’s because most aspiring home buyers will need a mortgage to purchase a home.
Let’s take a look at what a mortgage is, how a mortgage works and how you can get one.
What Is A Mortgage Loan?
A mortgage is a loan from a bank, credit union, lender or other financial institution used to buy or refinance a home. Mortgages are an agreement between a borrower and a lender whereby the home buyer agrees to repay the borrowed money, plus interest, over a clearly defined period of time. If the borrower fails to do this, the lender can take possession of the property. A mortgage loan is likely the largest and longest-term loan you’ll ever take out.
There’s no reason for you to feel intimidated, though. Mortgages are considered “good debt,” meaning it’s debt that can help create wealth – much like a student or business loan can. Over time, a mortgage may lead to home equity, value appreciation and a host of other benefits for the homeowner.
How Does A Mortgage Work?
A mortgage is just one type of loan. Different types of loans are designed to finance a variety of needs, but a mortgage is used solely for the purpose of buying or refinancing a home. Mortgages are also secured loans, meaning the real estate property is used as collateral on the loan.
When you take out a mortgage, the lender pays for your home upfront. In exchange, you repay the lender the money you’ve borrowed, plus interest, over an agreed-upon time frame known as a loan term. In the meantime, the lender maintains a lien on the title to the home as collateral until the mortgage is fully paid off. This means you won’t fully own the property free and clear until you’ve made your final payment.
The Mortgage Process
No matter what type of home loan or lender you use, the approval process will most likely follow the same basic steps, which we’ll outline next.
Start The Preapproval Process
When you decide to buy a home, one of the first to-do items in the mortgage process is applying for a preapproval after finding and selecting a mortgage lender. At this time, your lender will consider your application and decide how much they’re willing to let you borrow.
During the underwriting process, the lender will require you to provide information on your income, current debts and credit history. Once you’re preapproved, the lender will write a preapproval letter so you’ll know your price range as you search for the right home.
Get A Home Appraisal
Next, you’ll need to show your lender that the house you want to buy is worth the purchase price. The appraisal considers the location and current market conditions in addition to the physical state of the home.
Your lender doesn’t want the security for the loan – your prospective home – to be worth less than the loan amount. While you’re paying back the loan, the lender has a mortgage lien on your home. Your home needs to be approved just as thoroughly as you do as a prospective borrower.
Order A Home Inspection
Around the same time you’re getting your house appraised, you also have the option of getting a home inspection. The home inspection is a significantly deeper dive into the physical state of the home. You’ll be able to walk through the home with an inspector and learn of any existing problems and what to look out for.
Wait For Final Approval
If you have an inspection contingency and encounter major red flags like a roof needing to be replaced or an HVAC system on the fritz, you can use this to negotiate a lower price, have the seller fix the issues before you move in, or walk away from the transaction.
Once you have the home inspection report and are satisfied with any repairs made, the last step is for your lender to let you know the home is clear to close. Once this happens, you’ll be ready to close on your new home.
Types Of Mortgage Loans
As a borrower, you’ll need to determine what type of loan to get. You’ll choose from two main types of mortgage loans: conventional mortgage loans and government-backed mortgage loans. Included within the first category are jumbo mortgage loans, which are used far less than the more standard conventional conforming loan.
Conventional loans are the most common type of mortgage. Backed by a private lender rather than an agency of the federal government, conventional loans offer more flexible term options than some government-insured loan programs. However, they typically come with a higher interest rate (unless you have excellent credit) and most often require a higher down payment and credit score.
A government-insured loan is backed by a government agency. These loan options have more flexible credit score requirements and may allow you to buy a home with little to no money down. Here are some examples of common government-backed mortgages:
- Federal Housing Administration (FHA) loan
- Department of Veterans Affairs (VA) loan
- United States Department of Agriculture (USDA) loan
Rocket Mortgage® doesn’t offer USDA loans at this time.
Jumbo loans are mortgages that exceed the conventional loan limit, which is $726,200 for a single-unit property in most areas of the country but higher in high-cost areas. For example, the “limit” – or amount you can’t exceed without getting a jumbo loan – is $1,089,300 for all of Alaska and Hawaii. That may sound like an amount of money that buys an extravagant home, but in the most expensive real estate markets, it can be difficult to find homes that fall within conforming limits.
As with atypically pricey areas, conforming loan amounts are likewise higher for properties that are 2 – 4 units. However, regardless of how many units the property holds, a jumbo loan could be your only viable option. You can get a Jumbo Smart loan of up to $2.5 million at Rocket Mortgage.
Mortgage Rate Options
Another choice you’ll make as a borrower is the choice between a fixed-rate mortgage and an adjustable-rate mortgage. The “rate” refers to the percentage of your loan’s principal balance that you’ll pay your lender in interest over time. Mortgage rates change regularly, but you can find the most up-to-date mortgage loan interest rates online or through a lender.
A fixed-rate mortgage has an interest rate that remains the same throughout the life of your loan. This is a great option for those who prefer consistency and ease while budgeting, because the monthly payment will never change. These types of loans are often built in 15-year fixed-rate loans or 30-year fixed-rate loans.
The 30-year fixed-rate mortgage is typically the most popular choice among home buyers.
Adjustable-rate mortgages, or ARMs, have interest rates that can change over time. This means your monthly mortgage payments won’t be the same throughout the life of your loan, though the initial interest rate you receive with an ARM is typically lower than with a fixed-rate mortgage.
ARMs are generally 30-year loans with fixed rates for a set time (typically, the first 5, 7 or 10 years of the loan). After the fixed-rate period ends, your interest rate can adjust up or down based on market conditions. Don’t worry – caps have been put in place so your payment won’t spiral completely out of control.
What Goes Into A Mortgage Payment?
- Principal: This is the amount of money left on the balance of the loan. Your principal is factored into the monthly payments and becomes a little lower with each payment. You can make extra payments toward your principal in order to pay your mortgage off early and save in interest over time.
- Interest: The amount of interest that you’ll pay each month is determined by your interest rate and the remaining principal amount.
- Taxes: No matter where you live, you’ll need to pay property taxes on your home. The amount you’ll pay is determined by several factors, including your property’s assessed value and local tax rates.
- Insurance: You may need to pay two types of insurance. Homeowners insurance protects your home from loss and damage, while mortgage insurance can help protect the lender’s financial investment in your home.
Depending on whether you have a conventional loan or an FHA loan, your mortgage insurance will either be private mortgage insurance (PMI) or a mortgage insurance premium (MIP). Conventional loans may or may not require PMI depending on your down payment, but FHA loans always require MIP. With a USDA loan, you’ll have a guarantee fee that functions like mortgage insurance. Both your property taxes and insurance will be paid from your escrow account, which is set up by your lender at the time of closing.
If your residence is tied to a homeowners association or condo association, the dues you’re required to pay to the association are separate from your mortgage payment.
How To Qualify For A Mortgage
To qualify for a mortgage, you first need to get started with a preapproval, sometimes known as an initial mortgage approval. Getting preapproved will help you understand how much home you can afford and put you in the best position to make a strong offer.
When you apply for preapproval on a mortgage, the lender will review your assets, your income and your credit. The lender needs to review this information because you must meet a few eligibility requirements to qualify for a mortgage.
While they differ by lender, here are a few basic requirements:
- A FICO® Score of 580 for an FHA loan or a VA loan and 620 for a conventional loan
- Income and assets that show good financial standing
- A debt-to-income ratio, or DTI, of 50% or less for conventional loans, or a bit higher for FHA and VA loans
- A down payment of at least 3% (conventional loan) or 3.5% (FHA loan)
Preapproval also requires a hard inquiry on your credit report and may lower your credit score by a few points. During the underwriting process, the lender will dig even deeper into your financial history and current situation before issuing final mortgage approval.
Now let’s take a closer look at some of the factors that mortgage lenders consider.
Your credit score and credit history help the lender determine the type of borrower you will be. A good credit score shows that you’re a responsible borrower, likely helping you qualify for a better interest rate.
If your credit is less than perfect, get started now on a program designed to clean up old debt and build up your credit score. The better your credit score, the lower your mortgage cost, because the interest rate you’ll be offered depends in part on how big of a credit risk you are to the lender.
Income And Assets
A lender reviews your income and assets to ensure you can make your monthly mortgage payments with the money you earn monthly or have set aside. To verify your income and assets, you’ll need to provide certain documents to your lender.
Such documents may include:
- Bank statements for your checking and savings accounts or any other accounts you want to use to qualify
- Wages and tax statements, like a W-2 or 1099
- Recent pay stubs
- A copy of your most recent federal tax return (in certain instances, you may need 2 years of tax returns or more)
Income is just one piece of the puzzle. Your DTI will also help the lender determine if you can afford your monthly payment since some of your income will go to paying off other debts, like credit cards, student loans and auto loans. To ensure you don’t default on the loan because of other debts, the lender will set a maximum DTI – typically at or below 50% for conventional loans, 57% for FHA loans, and possibly higher for VA loans.
Keep in mind that the lender doesn’t consider your other financial obligations, like utility costs, transportation expenses and groceries. If factoring in these other expenses means you’re going to be barely scraping by, you may want to borrow less money or hold off on purchasing a home until you have more income or less debt.
Unless you’re approved for a VA or USDA loan (neither of which requires a down payment), you’ll need to make a down payment of at least 3% of the purchase price. If you’re a first-time home buyer, or a low or moderate-income earner, a variety of down payment assistance programs are available to help you put together your down payment.
You’ll often read about the 20% rule when buying a home, but that doesn’t mean you need to forgo a purchase until you’ve saved up enough to make a down payment that large. That said, a 20% down payment can be beneficial because it allows you to avoid paying PMI on a conventional loan.
It’s also important to keep in mind that you’ll need to save up for more than your down payment. That’s because you’ll need to pay closing costs when you finalize the mortgage. Closing costs can include your property taxes, escrow fees, insurance premiums and more.
How To Get The Right Mortgage For You
Mortgages have three main elements – loan type, interest rate and loan term – that are combined in different ways, depending on the borrower and lender. The right combination of rate type, loan type and loan term for you will depend on your financial situation and your goals.
You can use our home affordability calculator to gain a better understanding of how much home you can afford, and our payment calculator can give you an idea of what your monthly mortgage payment will be. This information can be helpful to have on hand when you apply for a mortgage.
If this is the first time you’re buying a home, it may also be helpful to learn more about first-time home buyer loans and programs. Knowing the ins and outs of each program, including what you get with each and what you should consider, will help you choose your best option.
Use the answers to these frequently asked questions to learn more about mortgages and how they work.
What is a mortgage amortization schedule?
A mortgage amortization schedule is a table showing how each monthly payment is applied to your loan’s principal and interest. As you make more mortgage payments, a larger amount of each installment will go toward your principal while less goes toward interest.
What does “conforming” mean for a home loan?
A conforming loan is a mortgage that meets the conforming loan limits set by the Federal Housing Finance Agency (FHFA). Conforming loans can be purchased by government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, while non-conforming loans, like government loans, are sold to private investors.
What is a second mortgage?
A second mortgage is a loan you must pay back in addition to the original mortgage you took out to purchase the home. A second mortgage functions like your first and uses your property as collateral. Therefore, if you fail to make your monthly payments on your second mortgage, your home could go into foreclosure. The most common examples of a second mortgage are a home equity loan and a home equity line of credit (HELOC).
What is a reverse mortgage?
A reverse mortgage is a loan that converts the home’s equity into a lump-sum payment or monthly payments that go to the homeowner. Reverse mortgages are only available to homeowners who are age 62 and older.
The Bottom Line
Now that you have some general knowledge you may have previously lacked about what a mortgage is, you can learn even more about mortgage loans and how they work. All this information can help you make the right decision on a home purchase, ensuring you choose the mortgage and the house that are best suited for you.
If you’re ready, start the mortgage process online today and talk with a Home Loan Expert to learn more about your options.