Simply put, a mortgage is a loan you take out to buy a home. You enter into an agreement with a lender for a certain dollar amount to pay for the house. Over a period of time (typically 15 to 30 years), you pay back the loan plus interest in monthly installments. Until the loan is completely paid off, the lending institution holds the title to your home and can use it as collateral if you default.
When you apply for a home loan, you’ll hear lots of terms tossed around that are specific to the mortgage industry. It’s a good idea to understand what they all mean ahead of time so you’ll be familiar when you encounter them in the homebuying process, especially for first-time buyers.
- Amortization means splitting a large lump sum into smaller payments. When a home loan is amortized, the lender will take the total loan amount then divide it by the number of months you have to pay it off. For example, let’s say you have a 30-year loan for $250,000. There are 360 months in 30 years, so divide $250,000 by 360, which equals $694 per month to pay off the loan in full. Please note this is a simplified example since it doesn’t include interest, insurance or taxes, which are all factored into your monthly mortgage payments. When you get a reverse mortgage, negative amortization occurs.
- APR stands for Annual Percentage Rate, which indicates the total annual cost of your loan. Note that APR is different from interest rate — your interest rate is the rate at which you pay your mortgage back, but your APR factors in all other costs you incur while obtaining the mortgage, so it’s usually higher than your interest rate. For example, your APR could also include broker fees, loan origination fees and any points you bought down.
- Down payment
- A down payment is a lump sum of money you pay toward the purchase price of your home at the outset of the sale. This amount varies. For a conventional loan, expect to pay between 5% and 20% of the price of the home as an out-of-pocket expense.
If you can’t come up with a down payment, look for federally backed mortgage programs, such as FHA and USDA loans, with flexible requirements and lower percentage rates. There are also several Down Payment Assistance programs (DPAs) that can help borrowers who are having trouble coming up with this money. These are usually regionally funded. A local lender or broker can give you more information about the programs available in your area.
- Earnest money
- Earnest money is like a down payment, except the money goes straight to the seller instead of to your lender. Earnest money is not mandatory but can be used as leverage if you’ve already made an offer on the house and you’re in a competitive market. It shows the seller you’re serious about your offer (that you’re earnest about it), and this extra money is like insurance to them that you’re not going to get cold feet and pull out of the offer.
Earnest money is usually less than 5% of the purchase price and will ultimately go toward your final purchase, though you are in danger of losing it if you do get cold feet and decide to withdraw your offer. It’s worth noting there are a number of legitimate reasons to withdraw your offer after a disappointing inspection of the property. In these cases, you would get the earnest money back.
- Your escrow account is a reserve of funds held by your lender to pay for services that fall outside the base loan amount in a mortgage. This escrow fund is usually reserved for property taxes, homeowners insurance or PMI (private mortgage insurance). Your lender will hold back a certain amount of your monthly payments to go into this account and then use it to pay for these expenses. Since these values can fluctuate, your escrow account is reconciled at the end of each year.
Escrow can also refer to the period of time after your offer is accepted and the buying and selling agent work to finalize the sale. During this time, any earnest money you’ve offered will be held in trust until the sale is finalized.
- Interest rate
- Your interest rate is the percentage you pay on top of your loan as a fee to your lender. The Federal Reserve sets interest rates for home mortgages. Whatever interest rate you lock in at the time of signing on will be your interest rate for the life of your loan unless you refinance.
- Mortgage points
- A mortgage point refers to one percent of your loan amount, so one “point” on a $200,000 loan would be $2,000. Although you’ll sometimes encounter points in a first mortgage, this term is most commonly related to refinancing. Either way, you can get a lower interest rate by “buying down points.” This means you pay an upfront percentage of the home’s value in exchange for a better rate.
Note that the number of “points” you pay doesn’t correspond directly with the number of percentage points on your interest rate. For example, you may have to pay one “point” to achieve an interest rate that’s only .25% lower.
- PITI stands for Principal, Interest, Taxes and Insurance. It gives an accurate picture of your monthly mortgage payment once all costs are factored in. Sometimes, lenders or brokers advertise low mortgage payments but list only the principal and interest, omitting the taxes and insurance. Be aware — this can be misleading, especially for first-time homebuyers.
- PMI (Private mortgage insurance)
- PMI is different from standard homeowners insurance and is required on some loans. While homeowners insurance covers the actual property, PMI insures your mortgage and is required on all conventional loans where you put down less than a 20% down payment. This is to give the lender extra insurance in case of default. After your loan has reached an LTV (loan-to-value) ratio of 80/20 (meaning you have paid off at least 20% of the value of the home), you can request to remove your PMI. The yearly cost of PMI ranges from 0.55% to 2.25% of the original loan amount.
- Refinancing means taking out a new mortgage on your home to replace the existing one. Most commonly, people refinance to achieve a lower interest rate, though it can also be done to remove or add someone’s name to the loan, such as in cases of divorce. When you refinance, you must start the loan application process from the beginning and meet all the standard eligibility requirements. For more information, read about how to find the best refinancing lender for you.
- Underwriting is the process that occurs between your loan application (or the acceptance of an offer) and closing. During underwriting, the lender reviews your loan package to verify your financial details have not changed and assesses the level of risk to ensure the lender is making a secure loan.
How does a mortgage work?
A mortgage is most easily understood as a loan you take out to pay for a home. Buying property is expensive. Since most people don't have hundreds of thousands of dollars lying around, they have to borrow it.
All mortgages are considered secured loans because they’re tied to a property (usually a house). Requirements vary by loan type and lender, but they all follow the same basic process:
1. You submit an application for the loan.
The borrower begins the application process by submitting various financial documents, including but not limited to tax returns and W-2s from your employer for the past two years, plus pay stubs, bank account statements and investment account statements from the past two months. If applicable, you will need documentation of alimony or child support and a gift letter if someone else is paying for a portion of the down payment.
2. The lender reviews your finances and creditworthiness.
Because a home loan is for such a large sum, a potential lender will vet your creditworthiness and financial standing thoroughly to ensure they’re not making a risky loan. So the lender will perform a credit check, and your credit score will help them determine two things:
- Whether or not you have a reliable record of making on-time payments and paying off loans in full
- What kind of interest rate you can qualify for — in general, the higher your credit score, the lower your interest rate
3. If qualified, you’re preapproved for a certain amount.
If you meet the lender’s qualifications, they will preapprove you for a loan up to a certain amount of money. You can then use this letter of preapproval to start shopping for homes. Without this prior authorization, you won’t be able to make any offers on homes.
4. You make an offer.
Underwriting generally takes 30 to 45 days.
If you make an offer and the seller accepts it, your lender will be notified and the underwriting process will begin. Underwriting generally takes 30 to 45 days as your loan package is reviewed and double-checked for accuracy while the lender ensures your financial situation has not changed since the initial review.
5. You sign a contract at closing.
At the end of the underwriting process, you will sign a contract with your lender, agreeing to pay back the loan amount plus interest over a set period of time (usually 15 to 30 years) at closing. With this, you also agree to maintain homeowners insurance and to pay the annual property taxes. All these costs are usually folded into your monthly payment.
6. You start making payments.
For the life of the loan, you will be obligated to make monthly payments to your lender. Your lending institution retains the title of the property until the loan is fully paid off or until you sell it. If you default, the lender can take the home as collateral to help pay back the loan. After you pay off your mortgage, your lender will turn the title over to you, and you will then be the official owner of your home.
- How do you get a mortgage?
- You need to meet certain qualifications with a lender to receive a mortgage. When a potential borrower wishes to buy a house (or refinance), they apply for a loan, usually through a bank or large lending institution. The basic process for obtaining a mortgage is generally the same from lender to lender, though specific requirements vary.
It’s advisable to contact two to three lenders to compare rates and find someone you feel comfortable working with. A good lender will take the time to answer all your questions, explain the process thoroughly and maintain open lines of communication. While they’ll be constrained by the Federal Reserve's interest rates, specific requirements like DTI, credit score and income levels may vary slightly. They may also have differing fee structures for their services. If you’re rejected by one lender or feel that the costs associated with one are too high, it’s always a good idea to contact another.
You may find it helpful to contact both a lender and a broker. A lender works for only one financial institution, usually a bank. On the other hand, a broker can look at rates and packages from several financial institutions and match you with the best one. Some mortgage brokers charge an extra fee for their services that you won’t find with traditional lenders. Both are qualified to lend, and you may find that you prefer working with one over the other. Sometimes you can obtain more lenient terms going through a traditional lender, especially if you have a long relationship with a bank. For more information, read about how to get a mortgage next.
- What is a balloon mortgage?
- A balloon mortgage starts with a set interest rate (typically with terms over five to seven years), then you must pay it off in full. The last payment is referred to as the "balloon" payment because it’s higher than all previous installments.
- What is a second mortgage, and what can you use it for?
- A second mortgage is a loan you take out using the equity of your home as collateral. In general, you need to have paid off at least 20% of the value of your home to qualify for a second mortgage.
There are two main types of second mortgages: a home equity line of credit (HELOC) and a home equity loan. A HELOC allows you to keep a revolving line of credit, much like a credit card. A home equity loan is a single lump-sum loan, paid back in monthly installments like your first mortgage. If approved, you can use a second mortgage in whatever way you like. Still, in general, people use the funds for renovations to their existing home, to finance education or a business venture or to pay off debts. For more, read about home equity loans and lines of credit next.
- How can you determine how much mortgage you can afford?
- There are many guidelines out there to answer this question, but a good one is that you can afford a house that’s roughly four to 4.5 times your gross yearly income. For example, if you gross $75,000 a year, you could afford a house that costs roughly $300,000. If you are borrowing with a partner, you would add your incomes together to determine this number.
You can also use different online calculators to determine how much of a mortgage you can afford. If you use one of these, make sure to find one that includes reasonable estimates of annual property taxes and insurance in addition to the principal loan amount and interest. The amount you’ll pay each month is also dependent on your interest rate, which fluctuates based on federal directives and your credit score.
- What does my credit score need to be to buy a house?
- The credit score needed to buy a house will vary depending on your lender and mortgage type. Most conventional loan lenders look for a minimum credit score of 620 to 640. That said, you will get more favorable terms the higher your score is. Typically a "good" credit score is over 720 or, in some cases, 740. If your score falls significantly below this, there are several federally backed programs available, such as FHA, USDA or VA loans, which accept applicants with scores as low as 580.
Lenders will also look at your income compared to spending. Specifically, lenders will calculate your DTI (debt-to-income ratio). A “good” DTI is generally one under 36% (though this number can go as high as 45% for some conventional loans). This means lenders are looking to see if 36% or less of your gross monthly income goes toward your current debt. This includes housing expenses, consumer debt like credit cards and any outstanding loan payments like car, business or student loans. Monthly expenses like utilities, groceries and entertainment are not included in this calculation.
Bottom line: What to know about mortgages
Buying a home is usually the most significant purchase a person makes in their life. As such, it’s essential to know as much about it as possible going in to ensure you’re making sound and informed decisions every step of the way. By familiarizing yourself with the process of obtaining a home loan and educating yourself on standard mortgage terms, you’ll be better prepared for your journey to homeownership.
- Article sources
- ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. To learn more about the content on our site, visit our FAQ page.
- Consumer Financial Protection Bureau. “What is a mortgage?." Accessed March 8, 2021.
- Consumer Financial Protection Bureau. “What is the difference between a mortgage interest rate and an APR?." Accessed March 8, 2021.
- USA.gov. “Mortgages: Learn some of the basics about mortgages." Accessed March 8, 2021.
- Federal Trade Commission. “Shopping for a mortgage." Accessed March 8, 2021.
- U.S. Department of Housing and Urban Development. “Resources for Individuals." Accessed March 8, 2021.
- The Federal Reserve. “Credit, Loans, and Mortgages." Accessed March 8, 2021.
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