Money Research Collective’s editorial team solely created this content. Opinions are their own, but compensation and in-depth research determine where and how companies may appear. Many featured companies advertise with us. How we make money.
What is a Mortgage?
By Aly J. Yale MONEY RESEARCH COLLECTIVE
A mortgage is a financial tool used for buying real estate. They’re issued by banks, credit unions and other financial institutions and have monthly payments, allowing borrowers to spread the costs of their homes over many years or decades.
Are you considering homeownership? Here’s what you need to know about mortgages before diving into your home search.
Table of contents
- What is a mortgage, and how does it work?
- How does a mortgage work?
- How to qualify for a mortgage
- How to get a mortgage
- Summary of what is a mortgage
What is a Mortgage, and How Does it Work
A mortgage is a type of loan used to purchase real estate. The borrower makes a down payment — typically between 3% and 20% of the home’s purchase price — and the lender covers the rest. The borrower then repays the lender, plus interest, over the course of 10 to 30 years.
How does a mortgage work?
When you take out a mortgage, you agree to repay your balance, plus interest, over a certain timeframe. With the most common mortgage — the 30-year fixed-rate mortgage — your balance and interest costs are calculated from the start and spread out in set monthly payments across the entire 30-year repayment term. This is called amortization.
With many mortgages, you’ll also pay into an escrow account each month as part of your payment. Those funds are then used by your lender to pay your annual homeowners insurance premium and property taxes when they come due.
It’s important to note that mortgages are secured loans, so they use your property as collateral. If you fail to make payments as agreed upon, your lender can turn to foreclosure (meaning they’ll seize the home and use it to recoup their losses).
Types of home loans
There are several types of mortgages, each with its own pros, cons and qualifying requirements.
Here’s a look at the four most common types of home loans:
- Federal Housing Administration (FHA) loans: FHA loans are guaranteed by the U.S. Department of Housing and Urban Development and are popular with first-time home buyers due to their low credit score and down payment requirements. With these loans, borrowers can have credit scores as low as 500 (with a 10% down payment) or 580 (with a 3.5% one). FHA loans require mortgage insurance premiums both upfront and annually.
- Conventional loans: Conventional mortgages are issued by private mortgage lenders. There are many subsets of these loans, including conforming loans, which follow the lending guidelines set out by Fannie Mae and Freddie Mac. There are also jumbo loans, which exceed the loan limits on conforming loans ($647,200 in most areas) and can be used to purchase higher-cost homes. Many conventional loans require private mortgage insurance (PMI) if you make a down payment lower than 20%.
- VA loans: These loans are backed by the Department of Veterans Affairs and are for veterans, military members and their spouses only. They have very low interest rates and require no down payments.
- USDA loans: USDA loans are mortgages guaranteed (and sometimes issued) by the U.S. Department of Agriculture. They’re often referred to as rural home loans since they’re for use in less-populated parts of the country. Like VA loans, they don’t require a down payment.
Mortgage loans also vary by interest rate and term. Loans can either carry fixed interest rates, which means the interest rate and payment remain consistent for the life of the loan, or adjustable interest rates. With an adjustable-rate mortgage, your rate is set for an initial period of time (typically three to 10 years), and then your rate will increase or decrease annually based on the index rate it’s tied to.
Other mortgage loan types
Home equity loans are another type of mortgage, though these are considered second-lien mortgages — a second loan that uses your home as collateral. A home equity loan allows you to borrow against your home equity, or the difference between what you owe on your home and its current value, for a lump sum payment. You can then use those funds to pay for home improvements or any other expenses.
HELOCs, or home equity lines of credit, are similar second-lien mortgages, but they work more like credit cards. You can withdraw funds as needed over time. Additionally, HELOCs generally feature variable rates, while home equity loans tend to have fixed rates. Nevertheless, both home equity loans and HELOCs result in an extra monthly payment (in addition to your existing monthly mortgage).
Refinancing
Refinancing is probably another mortgage term you’ve heard of. A refinance is when you replace your current mortgage loan with a new one — often one with a lower interest rate or different loan term. Many homeowners use refinancing to reduce their monthly mortgage payments or long-term interest costs.
There is also cash-out refinancing. With this option, you replace your existing mortgage with a larger one, taking the difference back in cash. You can then use the loan to pay for home repairs or any other expense you might need to cover.
How is mortgage interest calculated?
Mortgage interest is calculated based on your assigned interest rate and current mortgage balance. Lenders set your interest rate by looking at several factors, including your down payment size, loan amount and credit score. Generally speaking, the better your credit score is, the lower your rate will be. The overall economy and the lender’s individual risk appetite and overhead costs will also play a role.
Typically, adjustable-rate loans carry lower interest rates than fixed-rate ones. Shorter-term loans will also have lower interest rates than longer-term ones because they present less risk to the lender. Case in point: In 2021, the average rate on 15-year mortgages was 2.27%, according to Freddie Mac. The average rate on 30-year loans, on the other hand, was 2.96%.
You can reduce your interest rate by buying mortgage points — or discount points — at closing. These allow you to pay a certain amount of money upfront in exchange for a lower rate. The exact discount varies, but you’ll typically pay 1% of your loan amount to reduce your rate by around 0.25 (from 6% to 5.75%, for example).
Note: If you want to get a feel for what interest rate you can expect, apply for pre-approval with a bank or mortgage lender. They’ll look at your credit score and financial details and provide you with an estimated loan amount and rate.
How to qualify for a mortgage
The exact requirements you’ll need to meet will depend on your lender and loan program, but you can expect your credit score and debt-to-income ratio to play a big role.
With FHA loans, you’ll need a minimum credit score of 500 to 580. Conventional loans typically require at least a 620, while VA and USDA loans don’t have set credit score minimums (at least from the VA or USDA). Individual lenders usually ask that you have at least 620, though.
Your debt-to-income ratio — or DTI — is how much of your monthly income your debt payments take up (car loan payment, credit card minimums, new mortgage payment, etc.) On FHA loans, you will need a 43% DTI or lower. Conventional loans go up to 45% if you have enough in cash reserves.
If you’re worried you might have trouble qualifying for a mortgage, you can improve your chances by:
- Making a larger down payment
- Increasing your credit score
- Paying down your debt balances
Increasing your income can also help, as this reduces your DTI. You can do this by asking for a raise, taking on more hours or picking up a side gig, like driving for Uber, for example.
How to get a mortgage
You’ll need to work with a bank, credit union or independent mortgage lender to get a mortgage loan. Because rates, products and terms vary widely from one financial institution to the next, it’s smart to consider at least a few lenders when applying for a mortgage. You can use our best mortgage lenders list to start and check the NMLS database for lenders that operate in your area.
Once you’ve settled on a few lenders, you’ll fill out their pre-approval applications. This usually requires pulling your credit report, some financial details and several financial documents, including:
- Your two most recent tax returns and W-2s
- Recent pay stubs
- Statements for your bank and retirement accounts
- A copy of your driver’s license or state ID
After you’ve been pre-approved, the lenders will give you a loan estimate form, which you can use to compare each company’s fees, annual percentage rate, closing costs and more. From there, you’ll simply need to shop for a home and move forward with the lender of your choice once a seller accepts your offer.
The loan will then enter underwriting, the last major part of the mortgage process. It’s when the lender verifies your financial information and makes sure you can afford the loan. If all goes well, you’ll attend a closing appointment, pay your down payment and closing costs, and close on your mortgage loan.
Summary of What is a Mortgage
- A mortgage is a type of loan that allows you to borrow enough funds to cover the cost of a new home, and you pay that back to the lender (plus interest) over a period of time.
- There are several different types of mortgage loans available, including conventional loans, FHA loans, USDA loans and VA loans.
- Conventional loans are issued by private lenders and may be conforming — which follow the lending guidelines set by Freddie Mac and Fannie Mae — or jumbo, which exceed the lending limits of conforming loans.
- FHA loans, those backed by the Department of Housing and Urban Development, are an option for first-time buyers that have a low credit score or don’t have enough money for a large down payment.
- USA loans are backed and sometimes issued by the U.S. Department of Agriculture and can be used to purchase property in rural and less-populated areas.
- Lastly, VA loans are backed by the Department of Veterans Affairs and are only available to veterans and military members. They feature low interest rates and don’t require a down payment.
- What you pay for your home loan will depend on your interest rate and mortgage balance. In turn, your interest rate will be based on factors such as your down payment amount, credit score and loan amount.
- To improve your odds of qualifying for a mortgage you can: improve your credit, pay down debt, put more money down on your home and seek to increase or supplement your income.
- Borrowing money is a big move. Be mindful of your finances going into the loan, and shop around for a mortgage lender to get the best possible terms and rate.
