What Is A Mortgage And How Do I Get One?
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Before you begin the process of buying a house, it’s important to understand mortgages since, for many, a mortgage is needed to purchase a home.
In this article, we’ll explain what a mortgage is, how it works and how you can get one.
A mortgage is a loan from a bank, mortgage lender or other financial institution used to buy or refinance a home. Mortgages work as an agreement between the borrower and lender, that if the buyer fails to repay the borrowed money and interest, the lender can take possession of the property. It’s likely the largest and longest-term loan you’ll ever take out.
But don’t be intimidated! Mortgages are considered “good debt,” meaning that the debt could help create wealth, much like student or business loans. Over time, a mortgage may lead to equity, value appreciation and a host of other good things.
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How Does A Mortgage Work?
A mortgage is just one type of loan. There are many types of loans that can be used 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, which means that the real estate property is used as collateral on the loan.
When you take out a mortgage, the mortgage lender pays for your home upfront. In exchange, you repay the money you’ve borrowed based on the agreed-upon loan terms and conditions, plus interest. In the meantime, the lender holds the deed to the home as collateral until the mortgage is fully paid off. This means that you won’t fully own the property free and clear until your last payment is made.
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The Mortgage Process
When you decide to buy a home, one of the first things you’ll need to do in the mortgage process is apply for a mortgage 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 lend you. During the underwriting process, the lender will require you to provide them with information regarding your income, debt and credit history. Once you have been preapproved, the lender will then write a preapproval letter to help you when searching for the right home.
Next, you will 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.
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 much more thorough deep dive on the physical state of the home. You’ll be able to walk through the home with an inspector and find out about any existing problems and what to look out for.
If you have an inspection contingency and there are major red flags like a roof needing to be replaced or an HVAC system on the fritz, you can use this to negotiate the price down, have it fixed before you move in or walk away from the transaction.
Once your mortgage is approved, 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. There are three main types of mortgage loans to choose from: conventional mortgage loans, government-backed mortgage loans and jumbo mortgage loans.
Conventional Mortgage Loans
Conventional loans are the most common type of loan. Conventional loans are backed by a private lender and typically offer better interest rates and more flexible term options than government-insured loan programs. However, they sometimes require a higher down payment and a higher credit score.
Government-Backed Mortgage Loans
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. They also tend to come with additional restrictions and fees, like MIPs. 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 Mortgage Loans
Jumbo loans are mortgages that exceed the conventional loan limit. That limit is $726,200 in most areas of the country, but is higher in high-cost areas, Alaska and Hawaii. You can get a jumbo mortgage up to $2.5 million at Rocket Mortgage.
In high-cost markets, the loan limit to avoid getting a jumbo loan may be higher and the limit is $1,089,300 for all of Alaska and Hawaii. Conforming loan amounts are also higher if you have a 2 – 4-unit property. 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.
Find out which loan option is right for you.
Mortgage Rate Options
Another choice you’ll make as a borrower is whether you want a fixed-rate mortgage or an adjustable-rate mortgage. The “rate” refers to how much you’ll pay in interest back to your lender. Mortgage rates change regularly, but you can find the most up-to-date mortgage loan interest rates here.
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, as 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.
With today’s low interest rates, the 30-year fixed-rate mortgage is probably the most popular choice for home buyers right now.
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 in comparison to 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 expires, your interest rate can adjust up or down based on market conditions. Don’t worry – there are caps in place so your payment won’t spiral out of control.
What Goes Into A Mortgage Payment?
Your mortgage payment is the amount of money that you pay towards your mortgage each month. Mortgage payments are made up of four main costs referred to as PITI. Those costs are:
- Principal: This is the amount of money that is left on the balance of the loan. Your principal is factored into the monthly payments and is lowered over the course of the loan. You can make extra payments towards your principal which will help you to pay your mortgage off early and save you interest over time.
- Interest: The amount of interest that you will pay each month is determined by your interest rate and the 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: There are two types of insurance that you will likely need to pay. The first is homeowners insurance which covers loss and damage to your property, as well as your assets inside the home. Mortgage insurance, on the other hand, is required for borrowers who make smaller down payments and is used to protect the lender. Depending on the loan you have, your mortgage insurance will either be Private Mortgage Insurance (PMI) or Mortgage Insurance Premium (MIP). If you have a USDA loan, these have guarantee fees that function like mortgage insurance.
Both your taxes and insurance will be paid from your escrow account which is set up by your lender at the time of closing.
If you live in a homeowners or condo association, your dues are separate from your mortgage payment. However, when you qualify for your loan, they’re included because they’re a known part of your housing expenses.
How To Qualify For A Mortgage
Here’s what you need to know in order to qualify for a mortgage.
To qualify for a mortgage, you first need to apply for preapproval. This process will help you understand how much you can afford, and will put you in the best position to make a strong offer. To make sure you qualify for a mortgage, the lender will review your assets, your income and your credit. The lender needs to review this information because there are a few eligibility requirements you must meet 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 (see below)
- Income and assets that show good financial standing
- A debt-to-income ratio, or DTI, of 50% or less
- A down payment of at least 3%, depending on the loan
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To get preapproved, you’ll answer some questions about your income and assets and give the lender permission to pull your credit report. This will be considered a hard inquiry on your report and may cause your credit score to lower by a few points. It is during the underwriting process that the lender will really dig into your financial history and current situation to qualify you.
It should be noted that preapproval is a concept that only applies to buying a home. When you’re refinancing, you don’t have to find a home and start moving immediately through the underwriting process.
Your credit score and history help the lender determine the type of borrower you will be. A good credit score shows that you are a responsible borrower, which can help you qualify for a better interest rate.
If your credit is less than perfect, get started now on a program of cleaning up old debt and building 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.
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 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 below 50%.
Keep in mind that the lender does not consider your other financial obligations, like utility costs, transportation expenses or groceries. If these other expenses mean you’re barely scraping by, you may want to borrow less money or wait until you have more income or less debt before purchasing a home.
Depending on the type of loan you get, you’ll need to make a down payment of at least 3 – 3.5% of the purchase price. If you're a first-time home buyer, or a low or moderate-income earner, there are a variety of down payment assistance programs available to help you put together your down payment.
You’ll often read about how it’s best to put 20% down when you buy your home, because at that point, you can avoid paying PMI or MIP. While that is true, waiting until you have that amount has a cost, too.
You might continue to pay rent while you’re trying to save money. You could be putting your rent toward saving money by building up your equity. When you reach the level of 20% equity, you can apply to have that payment removed or, in the case of an FHA loan, apply for a conventional refinance.
How To Get The Right Mortgage For You
Mortgages have three main elements. These elements are combined in different ways, depending on the borrower and lender – loan type, interest rate and loan terms. Selecting the right combination of rate type, loan type and loan term depends on your financial situation and your goals.
You can use our home affordability calculator to help you understand what you can afford in a house currently 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 begin the process of applying for a mortgage.
If this is the first time you’re buying a home, it may be helpful to learn more about first-time home buyer loans and programs. Knowing what each program is, what you get with each and what you should consider will help you make an educated decision about what is right for you.
The Bottom Line
Now that you have basic knowledge of what a mortgage is, you can begin to dive deeper into understanding the ins and outs of the loan and how they work. Knowing this information can help you make the right decision when it comes to choosing a mortgage that is right for you.
If you’re ready to get started, apply for a mortgage preapproval today through Rocket Mortgage.
Apply for a mortgage today!