How does a mortgage work?

What is a mortgage?

A mortgage is a loan used to purchase a property. Because mortgages are typically very large, they are risky for lenders. To mitigate this risk, the purchased property is used to secure the loan, giving the lender the legal right to repossess the property if you fail to make your payments.

Most people have to take out a mortgage to buy a home or refinance an existing home.

Mortgage fees and costs

Mortgages, like other loans, charge interest and have other fees and costs. A mortgage consists of a few basic elements:

• Annual percentage rate: The APR is the interest rate you’ll pay plus other fees. It measures how much you’ll pay to take out the mortgage.
• Principal: This is the loan amount you borrow to cover the purchase price of the property.
• Down payment: Most lenders require some form of down payment. This is the amount of money you pay out of pocket upfront to purchase a home. A bigger down payment means you borrow less money and make smaller monthly mortgage payments.
• Loan term: This is the period of time you have to pay back the mortgage. Common loan terms are 15 years and 30 years, though there are also other options (like 10-year and 20-year terms.)
• Closing costs: These are fees you pay to the lender during the home sale. Closing costs include discount points, the origination fee, loan processing fees, underwriting fees, loan funding fees and document preparation fees. This cost also includes title, appraisal, survey and recording fees. The typical range is between 2% and 6% of the loan amount.
• Mortgage insurance: If your down payment is lower than 20%, the lender may require monthly private mortgage insurance (PMI) until you have enough equity in the property.

» MORE: How are mortgage rates determined?

Types of mortgage loans

There are several mortgage types to choose from, enabling you to pick the interest payment and term length that work best for you.

Fixed vs. adjustable-rate mortgages

Mortgage rates can be fixed, meaning the rate remains the same for the length of your mortgage, or adjustable, which changes according to the market. With a fixed-rate loan, you know exactly how much you’ll pay each month of the loan term, making budgeting simpler. An adjustable-rate mortgage (ARM) is less predictable.

Most ARMs start with a fixed-rate period that typically lasts up to 10 years. During this period, the interest rate on the mortgage doesn’t change. Once this period ends, however, the interest rate adjusts at a predetermined frequency. This means your monthly payments can change throughout the course of the loan.

There are also interest-only mortgages that have interest-only payments for a set amount of time before you begin to pay the principal.

Long-term vs. short-term mortgages

The most popular mortgage option is the 30-year home loan. With this longer term, you pay more in interest, but your monthly payments are lower. Some lenders and banks also offer 40-year mortgage options, but these are rare.

For those who want to pay off their home sooner, the 10-year mortgage is often the shortest term available. A 10- or 15-year mortgage means you’ll pay less interest overall, but you'll pay more each month because of the shorter term.

Conforming vs. nonconforming mortgages

Mortgages can be conforming or nonconforming. A conforming loan adheres to rules set by Fannie Mae, Freddie Mac and the Federal Housing Finance Agency, while a nonconforming loan does not meet these requirements.

The 2024 conforming loan limit for a single-family home in most U.S. states is $766,550. Any mortgage amount above that is nonconforming and considered a jumbo loan. Jumbo loans typically require very good credit and a large down payment.

Conventional vs. government-backed mortgages

A conventional loan is a privately backed loan (meaning it’s not backed by the government). Conventional loan programs typically require a credit score of at least 620 and a down payment of at least 3%. However, if you put down 20% or more, you can avoid paying PMI.

Government-backed loans are insured by the government in case the borrower defaults. This makes it easier for the private lender to approve applicants.

• FHA loans are backed by the Federal Housing Administration. You can obtain an FHA loan with a credit score as low as 500 and a minimum 3.5% down payment for those with good credit. FHA loans are popular among first-time homebuyers.
• VA loans are guaranteed by the U.S. Department of Veterans Affairs and are for eligible retired and active-duty military personnel and surviving spouses. In most cases, they don’t require a down payment or mortgage insurance; however, there is a VA funding fee.
• USDA loans are backed by the U.S. Department of Agriculture and designed for low- to moderate-earning borrowers. These loans finance home purchases in designated rural locations. USDA loans don’t require a down payment and aren’t limited to first-time homebuyers.

The mortgage process

Determining your budget is the first step when buying a home. Calculating how much property you can afford helps to set realistic expectations and can ensure you choose the right mortgage for your situation.

Instead of determining the maximum purchase price possible, it’s better to estimate what monthly payments you can manage reasonably. Once you know this figure, check out the current mortgage rates to determine your homebuying power.

From there, the typical mortgage process looks like this:

1. Get preapproved. Preapproval from a lender tells you how much you’re approved to borrow based on your income, credit score and savings. A preapproval letter shows you’re qualified and ready for a home loan.
2. Find a home. It’s smart to hire an experienced real estate agent who can help you find a home that meets your needs. Once you’ve found it, you can make an offer, pledging earnest money to show the buyer you’re serious.
3. Choose a lender. You’ll want to compare a few different lenders to find the right type of loan at the lowest rate with the best customer service. Potential lenders will give you a loan estimate that outlines the terms of your potential loan. Remember: You don’t have to go with the lender that gave you preapproval.
4. Apply. Most of this process is completed in the preapproval stage, but you’ll need additional documents to get your loan underwritten. The lender will provide you with a list of everything needed.
5. Get a home appraisal. The mortgage lender arranges for an appraiser to conduct an independent value estimate of the home you’re buying. This step helps the lender determine whether it’s lending a fair amount for the property.
6. Go through underwriting. After you submit a full loan application, underwriting begins. During this time, the bank verifies your application details and reviews your banking and credit history for any red flags.
7. Close. The lender sends the closing documents with instructions for the title company and closing attorney. At this point, you’ll sign a big stack of documents, including the closing disclosure (which looks similar to the loan estimate you got when completing the loan application).

» MORE: How to apply for a mortgage

Mortgage requirements

With any type of loan, there are specific requirements for qualification. These will depend on the lender, the type of loan and your personal financial profile.

• Credit score: Your credit score reflects how well you’ve managed borrowed money in the past. A higher score can help you qualify for a lower interest rate. Most lenders require 620 for a conventional mortgage, 500-640 for a government-backed loan and 680-700 for a jumbo loan.
• Debt-to-income ratio: Your debt-to-income ratio (DTI) is the total of your monthly debt payments divided by your gross monthly income. DTI helps lenders evaluate your ability to make your loan payment each month.
• Monthly income: Lenders review your pay stubs, income tax returns, W-2s and other documents showing your earnings. They might also consider how often you’ve switched jobs and how long you’ve worked in a particular field.

Pros and cons of a mortgage

Most people don’t have the option of buying a home without the help of a mortgage. If you’re trying to decide whether getting a mortgage is right for you, here are some benefits and drawbacks to consider.

Bottom line

Applying for a mortgage is a good idea if you can afford the down payment, monthly payments, closing costs and the overall cost of homeownership.

However, keep in mind that a mortgage is a significant debt that uses your property as collateral. Before you take out a mortgage, examine your personal finances closely and educate yourself as much as possible about home loans. Once you’re ready to apply, compare offers from a variety of lenders to get the best deal possible.