What Is a Mortgage?

Mortgage

Understanding the mortgage process is the first step to homeownership.

couple signing a mortgage

The median purchase price of a home in the United States is $428,700. Many Americans can’t afford to pay for their homes outright, so they rely on a home loan to finance the purchase. These home loans, or mortgages, are funds that the bank lends you in exchange for using your property as collateral.

What is a mortgage?

A mortgage is a loan that is used to purchase a property, such as a house. The borrower receives the money from the lender and agrees to pay it back over time, usually in monthly installments.

The property serves as collateral for the loan. So, if the borrower fails to make the required mortgage payments, the lender is entitled to foreclose on the property and sell it to recover the money owed.

How does a mortgage loan work?

To obtain a mortgage, a borrower applies for a loan from a lender and provides information about their income, credit history, and the property they wish to purchase. If the loan is approved, the lender provides the borrower with a mortgage loan offer that includes the terms of the loan, such as the interest rate and length.

The borrower reviews the offer and, if they accept it, signs a mortgage agreement and provides required documents. The lender then provides the borrower with the funds to purchase the property. The borrower becomes the owner of the property and is responsible for making monthly mortgage payments to the lender until the loan is paid off.

What is a mortgage used for?

There are two main reasons to take out a mortgage on your property. The first reason is to borrow money to purchase a new home. The second reason is to refinance the terms of an existing mortgage on a home you already own.

What is a mortgage refinance?

There are two main types of refinance transactions: a cash-out refinance or a rate and term refinance. A cash-out refinance simply means that you’re taking cash out of the equity in your home. It doesn’t always mean that the bank cuts you a check directly, though.

Since a mortgage is backed by collateral, the interest rates are lower than that of personal loans and credit cards. Making them a better option for borrowers looking to pay down, or pay off, other debts. Borrowers may also find themselves using this money to make home improvements or other large purchases.

A rate and term refinance are generally used by homeowners who have had their existing mortgage in place for at least a year. That is long enough for them to have built up some equity and maybe changed their financial situation.

Or perhaps the current interest rates are more favorable than when they originally took out their mortgage. But don’t expect to get a lower rate and take out a large chunk of equity. The cash back amount is limited to the lesser of 2 percent of the loan amount or $2,000.

What is the difference between a fixed and adjustable-rate mortgage?

There are two main types of interest rates, fixed and adjustable-rate mortgages (ARMs). With a fixed-rate mortgage, you and the lender agree upon a rate upfront. That rate does not change for the life of the mortgage loan. With an adjustable-rate mortgage, the interest rate will fluctuate over time.

For example, you may have an adjustable-rate mortgage that begins as a fixed mortgage. After the initial fixed period (usually 2 years), the rate will adjust each year for the life of the mortgage. This rate will come with a margin that lets you know the threshold of the interest rate. It will never drop below or rise above that amount.

What is included in a mortgage payment?

Your monthly mortgage payment is made up of two main parts, the principal and the interest. The principal is the portion of the payment that goes towards paying down your loan amount. The interest is the cost of borrowing the money.

Many people are surprised by how much the interest is added to their payment and isn’t applied towards their principal. You may decide to roll your property taxes and homeowners insurance into your monthly mortgage payment as well. This is called escrowing, and the lender distributes these payments on your behalf as they become due.

What is private mortgage insurance?

Private mortgage insurance (PMI) is insurance that protects a lender against loss if a borrower defaults on their mortgage loan. Mortgage insurance is typically required for home buyers who make a down payment of less than 20% of the purchase price of the property.

Conventional Mortgage vs. FHA Mortgage

There are different types of mortgages. A conventional mortgage and an FHA mortgage are two common programs that many borrowers find themselves using.

Conventional Loans

Conventional mortgages generally have stricter qualifying guidelines, such as a higher credit score and lower loan to value (LTV). An FHA mortgage is insured by the government and is typically more flexible with its credit score requirements.

FHA Loans

FHA loans, backed by the Federal Housing Administration, also allow you to borrow more money to purchase your home. Typically, conventional loan programs will only allow you to borrow up to 80 percent of your home’s purchase price. This means for a purchase, you’ll need to come up with a 20 percent down payment on your own.

With an FHA loan, you can borrow up to 97 percent of the value of the home. While it may allow you to save on your down payment, it will cost you more each month. Loans with an LTV above 80 percent are required to carry private mortgage insurance (PMI). PMI is the monthly premium that you will pay as part of your monthly payment to ensure your loan against default.

Is taking out a mortgage ever a bad idea?

If the subprime housing crisis of the mid-aughts taught us anything, it’s that you never want to overextend yourself. That is especially important when considering how much you can afford to pay each month towards your mortgage payment. The requirements for loan approval vary among mortgage lenders.

However, the rule of thumb is that you don’t want to spend more than 28 percent of your monthly income on your housing expenses. Even if your mortgage lender approves you for an amount that is higher than that, consider borrowing less. You can always apply any leftover money at the end of the month towards lowering your principal balance.

Understanding Mortgage Terminology

Part of demystifying the mortgage process is understanding the terminology. It can be overwhelming when your loan agent throws around terms like DTI and APR when you are unfamiliar with them. We’ve broken down some commonly used mortgage terms that you’ll need to know to navigate your first mortgage application.

Prequalification or Preapproval

This is your first step when considering purchasing a home. You’ll speak with a loan agent or mortgage broker and review all of your debts and income. They will use this information to estimate how much you can expect to be approved for.

Just keep in mind that this isn’t a guarantee, but only an estimate of what you can afford. But it’s enough to get you and your realtor started on finding properties in your price range.

Annual Percentage Rate (APR)

It’s a little different from the interest rate, which determines how much your monthly payment will be. This number includes what your rate would be if all costs were rolled into the loan. It allows you to compare the cost of your mortgage across different lenders who may charge different fees and points.

It helps you make an apples-to-apples comparison with the points and fees other lenders charge for the same product. This way you can see who has the best deal without having to go line by line through the fees.

Credit Score

Your credit scores represent your creditworthiness as a borrower. They are based on your credit reports issued by the three main credit reporting agencies, Equifax, Experian, and TransUnion.

Credit scores range from 350 to 850. The five factors that determine your credit score are:

  1. Payment history: This is the most important factor in determining your credit score. Lenders want to see that you have a history of making timely monthly payments on your debts.
  2. Credit utilization: This is the amount of credit you are using compared to the amount of credit that is available to you. High credit utilization, or using a large percentage of your available credit, can lower your score.
  3. Credit history length: A longer credit history indicates that you have a track record of managing credit responsibly over time.
  4. Credit mix: Having a variety of credit accounts, such as credit cards, mortgages, and car loans, can improve your credit score.
  5. New credit: Applying for new credit accounts can temporarily lower your credit score, as it may indicate that you are taking on more debt.

Debt to Income Ratio (DTI)

This is the percentage of your income that goes towards paying your monthly obligations. The thing to remember with this number is that the income is based on your gross earnings. The debts they use are those that report to the credit agencies. So, things like your cell phone bill or car insurance aren’t included. This is why that 28% rule of thumb is so important to remember.

Loan-to-Value (LTV)

This is what your mortgage lender means when they talk about much you can borrow verse what your down payment is. If your loan-to-value is 80 percent that means you have borrowed 80 percent of the home’s value. You’ll need to come up with the remaining 20 percent out of pocket. For a refinance, the loan-to-value refers to the equity you have built up in your property.

If your home is worth $100,000 and you only owe $40,000 on your mortgage, you have $60,000 in equity. That means with a conventional loan, you could borrow up to 80 percent of the value of your home. In this example, you could get $40,000 cashback (excluding fees and costs associated with the refinance).

Down Payment

The down payment on a house is a payment made by the buyer at the time of purchase, usually in the form of cash. It’s typically a percentage of the purchase price of the property and can vary in size, ranging from 3% to 20% or more.

The size of the required down payment on a property is typically influenced by the type of mortgage being used and the borrower’s financial situation. Down payments may also be affected by the type of property being purchased, such as whether it is a primary residence or an investment property.

Closing

This is where you sign the mortgage documents. Whether you’re refinancing or purchasing your home, you will need to sign legal documents securing your property against the loan. These documents will include a promissory note and a deed stating how the property title is held.

Closing Costs

Closing costs are the expenses that buyers and sellers are subject to pay at closing to complete a real estate transaction. These costs may include loan origination fees, discount points, appraisal fees, title insurance, title searches, credit report fees, surveys, property taxes, and deed recording fees.

If you’re ready to talk to someone about buying a home, check out our recommended list of lenders.

Lauren Wellbank
Meet the author

Lauren Wellbank is a writer and former mortgage professional from the suburbs of Philadelphia. You can find more of her work at her website below.