What is a mortgage? (And how it works)

Understanding home loan basics

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Not everyone has cash on hand to buy a house. While 36.1% of home sales are cash buyers — a nine-year high according to ATTOM, a provider of real estate data — the majority of homebuyers rely on a mortgage to finance their purchase.

The good news is you can still become a homeowner even if you haven’t put a lot into savings. Knowing the process and lingo that goes into securing a mortgage can help you feel confident when it’s time to start house shopping.

Key insights

  • A mortgage is an agreement between a borrower and a lender to finance the purchase of a home.
  • Mortgage loans are risky for lenders, which is why there are strict credit score, down payment and debt-to-income requirements.
  • Your monthly mortgage payment will include the loan’s principal and interest, as well as possible taxes and insurance.

Mortgage definition

A mortgage promissory note is an agreement between a borrower and a lender — usually a bank or other financial institution. The mortgage terms outline the following items:

  • The borrowing amount
  • The length of the agreement
  • The amount of each payment
  • The interest to be paid

A mortgage is a collateral-backed loan, which means if the borrower fails to make timely payments, the lender will be able to recover the property and resell it to recoup their costs. A collateral-backed loan is also beneficial to the borrower since it allows fair interest rates and some flexibility with less-than-perfect credit scores.

How do mortgages work?

Buying a home is expensive. The mortgage process exists so that buyers can purchase real estate from a seller without having to pay the total purchase price upfront. While the seller is involved in the sales agreement, the actual mortgage is a financing agreement between the lender, also called the mortgagee, and the buyer, also called the mortgagor.

This agreement defines the terms, including the loan amount, interest rate and repayment period, typically 15 to 30 years. Because financing a long-term loan is risky for a lender, buyers have to prove they are a safe risk through their creditworthiness, debt-to-income ratio (DTI) and down payment, which is an upfront payment toward the property's total cost. The down payment is usually a percentage of the home's purchase price and serves as the borrower's initial equity in the property. The more equity a buyer has in the property, the less of a risk they are in the eyes of the lender.

As the borrower makes regular monthly mortgage payments over the loan's term, a process called amortization occurs. Amortization involves the gradual reduction of the outstanding loan balance while simultaneously paying the interest accrued on the remaining principal. At the beginning of the mortgage term, a larger portion of each payment goes toward interest, but over time, more of the payment is applied to reduce the principal balance. This steady reduction in debt, combined with consistent payments, allows borrowers to build equity in their homes over the years.

» MORE: What is a balloon mortgage?

The mortgage approval process

Your mortgage application will pass through several hands before it reaches final approval.

“There are many people involved in the mortgage process — while your conversation typically starts with the loan officer, you should think of them as the captain — you will have many touch points with different team members throughout the process,” said Sarah Alvarez, vice president of mortgage banking at William Raveis Mortgage.

She explains that many lenders have an upfront team that helps assemble the necessary documentation in order to submit the loan to the bank.

“These team members can have different titles but serve the same purpose in doing an initial sweep of the information and documentation provided to make sure that your file is as complete as possible and tells the same story outlined in the loan application,” she said.

Once your mortgage documents are submitted to the lender, an underwriter reviews the file and makes a credit decision. You won’t have direct contact with the underwriter, but there is a good chance your lender will request additional information from you on behalf of the underwriter, such as updated bank statements or clarifications on credit dings.

“After the loan is approved, the borrower will work with a processor who is the liaison between the borrower and the bank to satisfy any outstanding conditions and assist in getting you across the finish line to closing,” said Alvarez.

» MORE: How to apply for a mortgage

Mortgage types

The good news is that you don’t need perfect credit or a 20% down payment to enter the mortgage process. Some mortgage types offer flexible credit and down payment requirements.

Here’s a brief overview of the most common types of mortgages:

Conforming mortgages, or conventional loans, are loans that adhere to guidelines set by government-sponsored enterprises like Fannie Mae and Freddie Mac. They typically have a maximum loan amount and must meet specific criteria, such as credit score requirements and DTI ratios.

A conventional non-conforming loan would be a jumbo loan, which is used for property purchases that exceed the loan limits. A jumbo loan typically requires a higher credit score and down payment and has higher interest rates.

Not every buyer will meet the criteria set for a conventional conforming loan. For these homebuyers, government-backed loans are available.
  • FHA loans: Insured by the Federal Housing Administration, FHA loans offer more lenient credit requirements and lower down payment options, often as low as 3.5% of the purchase price.
  • VA loan: Guaranteed by the Department of Veterans Affairs, VA loans are exclusively available to eligible veterans, active-duty service members and surviving spouses. These loans come with extra benefits, such as no down payment requirement and reduced closing costs.
  • USDA loans: Backed by the U.S. Department of Agriculture, USDA loans help homebuyers receive flexible financing and competitive interest rates for purchases in rural and suburban areas. No down payment is required.
No matter what type of home loan you choose, your loan will either be a fixed-rate or adjustable-rate mortgage (ARM).
  • Fixed-rate mortgages have a consistent interest rate throughout the loan term, providing predictable monthly payments. Fixed-rate mortgages are best for buyers who plan to own their home for over five years.
  • ARMs typically offer lower rates for an initial fixed-rate period, which can range from a few months to several years. After the set term is over, your rate is determined by the current market rate. This means your rate can go up or down. You can refinance your ARM to a better term or a fixed-rate loan at any time.

How are mortgage payments calculated?

Unlike other types of loans, mortgage payments contain a few more components.

  • Principal: The principal is the initial loan amount borrowed from the lender to purchase the home. It forms the foundation of your mortgage payments. As you make monthly payments over the loan term, the principal balance gradually decreases, leading to an increase in your home equity.
  • Interest: This is the cost of borrowing money from the lender and is expressed as an annual percentage rate (APR). Your rate will determine how much you pay for the loan in the long run; the lower your interest rate, the less you have to pay overall. At the beginning of your loan term, a significant portion of your monthly payments goes toward paying the interest.
  • Taxes and insurance: In addition to the principal and interest, your mortgage payments may include funds for property taxes and homeowners insurance. The lender typically collects these amounts as part of your monthly payments and holds them in an escrow account. When the taxes and insurance payments are due, the lender pays them on your behalf.
  • Mortgage insurance: If your down payment is less than 20%, you will have to pay private mortgage insurance (PMI) until you have at least 20% of equity built up in your new home. Some loan types, such as an FHA loan, come with mortgage insurance premiums (MIP) that remain on the life of the loan.

» MORE: How to save for a down payment

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    Who owns the house with a mortgage?

    Your lender or financial institution that financed your mortgage technically owns the home and is referred to as the note holder. As the mortgagor, you live in the home and do with it as you please — you aren’t in a landlord/tenant situation. However, your lender acts as the owner of the mortgage with the ability to sell the loan to another lender at any time or to foreclose on the house if you fail to repay your loan.

    How much house can I afford?

    Determining how much house you can afford depends on various factors, including your income, debts, credit score and monthly expenses. Many financial experts recommend that your total monthly housing costs (mortgage payment, property taxes, insurance and any homeowners association fees) should not exceed 28% of your monthly income.

    What credit score is needed for a mortgage?

    Lenders set credit score requirements, which can vary based on the loan type. Typically, conventional loans require a credit score of 620 or higher, while a government-backed loan requires a minimum score between 500 and 580.

    How much down payment do I need for a mortgage?

    Your down payment requirement will depend on your loan type. Some government-backed loans, such as VA and USDA loans, require 0% down. Conventional loans start at 3% down, but a larger down payment can increase your loan approval chances.

    Bottom line

    Getting a mortgage is an exciting financial step and probably one of the biggest financial decisions you’ll make in your lifetime. Before you start shopping for your new home, make sure you understand the types of mortgages that are out there and what your options are. Then, compare various mortgage lenders to ensure you get the right terms, rates and funding for your situation.

    ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
    1. Chase, “What percentage of your income should go towards your mortgage.” Accessed June 25, 2023.
    2. Consumer Financial Protection Bureau, “What is a mortgage?" Accessed June 25, 2023.
    3. USA.gov, “Government-backed home loans and mortgage assistance." Accessed June 25, 2023.
    4. ATTOM, “U.S. Home Seller Profits Top 50 Percent In 2022 Despite Market Slowdown.” Accessed June 25, 2023.
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