What Is a Mortgage?

What Is a Mortgage?

A mortgage is a type of loan used to finance the purchase of a primary residence, a second home, an investment property or land on which the borrower wants to build a home. Mortgages are installment loans, which means that the borrower pays off the debt in monthly installments over a fixed period of time, usually 15 or 30 years.

Learn more: The Ultimate Guide for First-Time Homebuyers

How Does a Mortgage Work?

When you purchase a home, a mortgage loan allows you to finance the price of the sale minus any cash you bring to the table in the form of a down payment. In turn, you agree to repay the money you borrowed to the mortgage lender over 10, 15, 20, 25 or 30 years. While you're making payments, the lender holds the deed to the home.

This means that if you stop making payments, the lender has the right to take possession of the house, otherwise known as foreclosure. But if you make all your payments on the loan, you'll receive the deed for the home when you pay the loan in full.

Keep in mind that there are many different types of mortgage loan programs available, and each may work a bit differently—more on that below.

What Is in a Mortgage Payment?

Mortgage payments are usually made up of four components: principal, interest, taxes and insurance (PITI). However, some homeowners may choose to pay their property taxes and homeowners insurance on their own, separately from their mortgage payment. Here's a quick look at each one:

• Principal: This portion of your payment goes toward paying down the balance of the loan.
• Interest: The monthly finance charge based on the loan's interest rate.
• Taxes: Property tax rates vary based on where you live, and they can change each year. You'll typically pay a set amount each month into an escrow account, and the lender will pay your annual tax bill on your behalf.
• Insurance: Your lender will require you to obtain homeowners insurance to protect its investment. Also, depending on the type of loan you have and how much you put down, you may have mortgage insurance. Both expenses are typically paid into an escrow account.

Tip: You'll make one payment comprising the four components of a mortgage payment, known together as PITI, if you use an escrow account. Otherwise, you'll make just the principal and interest payment to your lender each month and pay homeowners insurance and property taxes separately when they're due.

Types of Mortgages

There are many different types of mortgages, and each can vary based on the length and amount of the loan, eligibility requirements, how the interest rate works and whether the loan is backed by a government agency. Here's what you need to know about some of the most common options.

Conventional Loan

A conventional mortgage loan is any mortgage loan that's not backed by a government program or insured by a government agency. Conventional loans include mortgages originated by banks, credit unions and mortgage lenders.

Conventional loans typically require a down payment of at least 5%, though first-time homebuyer programs may go as low as 3%. If you put down less than 20% on your home purchase, your lender may require you to pay private mortgage insurance (PMI).

FHA Loan

FHA loans are available to all types of homebuyers, but they're primarily designed for borrowers with lower incomes and credit scores. The Federal Housing Administration (FHA) insures the lender against the borrower defaulting on the loan.

FHA loans allow buyers to make a down payment of as low as 3.5% on the purchase price of a home. Credit score requirements can go as low as 500. FHA loans require mortgage insurance.

Learn more: How to Qualify for an FHA Loan

VA Loans

VA loans are backed by the U.S. Department of Veterans Affairs (VA) and are available only to eligible members of the military community.

Borrowers can purchase a home with no money down and receive 100% financing. Rather than charging ongoing mortgage insurance, VA loans require an upfront funding fee, the amount of which depends on your down payment amount and whether it's your first VA loan.

Learn more: Pros and Cons of a VA Loan

USDA Loans

USDA loans are mainly geared toward rural borrowers who meet the income requirements of the program. U.S. Department of Agriculture (USDA) loans don't require a down payment, and if you get a direct loan, the USDA may be willing to work with a low credit score.

USDA loans require an upfront and ongoing guarantee fee, which functions similarly to mortgage insurance.

Conforming Loan

A conforming loan is a home loan that conforms to limits set by the Federal Housing Finance Agency (FHFA). It also meets the funding criteria of Fannie Mae and Freddie Mac, government-sponsored enterprises that purchase mortgages from lenders, providing stability to the housing market.

Learn more: Conforming Loan Limits

Non-Conforming Loan

A non-conforming conventional loan is a mortgage loan that does not conform to the FHFA's loan limits or other standards set by Fannie Mae and Freddie Mac. Examples of non-conforming loans include:

• Jumbo loans
• Government-backed loans
• Hard money loans
• Interest-only mortgages
• Seller financing

Learn more: What Type of Mortgage Loan Is Best?

Fixed-Rate vs. Adjustable-Rate Mortgages

Depending on the type of mortgage loan you choose, you may have the option to pick a fixed interest rate or an adjustable rate.

Fixed-rate mortgage loans offer the same interest rate for the entire loan term, which means the principal and interest portion of the monthly payment will stay the same throughout the life of the loan.

In contrast, an adjustable-rate mortgage loan (ARM) offers a fixed interest rate for a set period, such as five, seven or 10 years. After that, the rate becomes variable and may change every six or 12 months based on market conditions and the terms of your loan.

Learn more: What's the Difference Between Fixed-Rate and Adjustable-Rate Mortgages?

How to Get a Mortgage

Depending on your situation, the mortgage process can vary. But here are the general steps to take to get a mortgage loan:

1. Check Your Credit

Get free access to your Experian credit report and FICO^® Score^☉, so you can evaluate your credit health and look for opportunities to improve your credit score if needed. Keep in mind that while you generally need a score of 620 to qualify for a mortgage, it's best to have a score in the mid-700s or higher.

2. Review Your Income and Debt

Your debt-to-income ratio (DTI) is a crucial factor that lenders consider. Your proposed housing payment should generally be no more than 28% of your monthly gross income, and your total debts should remain below 43% in most cases.

3. Define Your Budget

Take a look at your budget to get an idea of how much you can afford to put toward a mortgage payment, including taxes, insurance, maintenance and repairs. Getting prequalified can also give you an estimate of how much you can borrow. You can calculate how much house you can afford by using a mortgage calculator, like the one from Experian below.

Mortgage calculator

4. Save Up for a Down Payment

If you haven't already, determine how much you want to save up for a home purchase and start setting aside money toward your goal. Don't forget that you may also need to pay closing costs.

Learn more: How Your Down Payment Affects Your Mortgage

5. Research Loan Options

Review the different types of mortgage loans to determine which one is the right fit for you. If you're having trouble deciding, consider speaking with a mortgage broker or loan officer.

Learn more: Compare Current Mortgage Rates

6. Apply for Preapproval

Getting preapproved can provide you with more concrete details about what you might qualify for with a mortgage loan. It's recommended to get preapproved with at least three lenders, so you can compare mortgage offer rates, fees, terms and other features. It's important to note, though, that a mortgage preapproval is conditional based on a full review of your credit and financial profile.

7. Find a House and Make an Offer

Consider hiring a real estate agent who knows the local market well and can help you find the right home for your budget. Once you find the home you want, make an offer to the seller.

8. Submit Your Application

Once you've decided on a lender and a seller has accepted your offer, submit an official application. You'll typically need to provide various documents to confirm your income, employment and other details. The faster you respond with your documents, the quicker the process will go.

Learn more: Checklist of Documents You'll Need for a Mortgage

9. Avoid Applying for New Credit

For several months before you apply for a mortgage and throughout the loan process, it's crucial that you avoid applying for new credit. Not only can it impact your credit score, but taking on a new debt will also increase your DTI, both of which can affect your eligibility.

10. Prepare for Closing

Your loan officer or broker will guide you throughout the mortgage process. Shortly before closing, the lender will typically run a final credit check and provide you with disclosures and other documents. Make sure you read through everything carefully and return signed copies promptly to avoid delays. At closing, you'll complete the process with more documents and get your keys.

Key Mortgage Terms to Know

Prospective homebuyers will come across multiple terms that might not be self-explanatory. Here's some of the most common terminology you'll come across and what it means:

• Debt-to-income ratio: Your DTI is an important factor that mortgage lenders consider when underwriting your loan application. It refers to the percentage of your gross monthly income that goes toward debt payments. Lenders typically prefer a DTI below 43%, but some loan programs go as high as 50% or more.
• Down payment: The cash amount you contribute to the purchase. Down payment requirements can vary depending on the loan program and whether or not you're a first-time homebuyer.
• Closing costs: Closing costs are the upfront charges you pay when you finalize the sale and purchase of the home. They can vary based on location, type of loan and property type, but they're typically 2% to 5% of the purchase price. You can either pay closing costs in cash, roll them into the loan or ask the lender to pay them in exchange for a slightly higher interest rate.
• Loan term: The repayment period for your loan—typically 15 or 30 years, but some lenders may offer other variations.
• Property taxes: An amount you must pay to your local, county or state government each year based on the value of the home and property. Property tax rates can vary depending on where you live.
• Foreclosure: The legal process that occurs when you fail to make mortgage payments on time and as agreed. During foreclosure, the mortgage lender has the right to take ownership of the home unless you make the necessary payments.
• Private mortgage insurance: This insurance protects the lender in case you default on your loan obligation. It's generally required by lenders if your down payment is less than 20% of the total original loan amount. Government loan programs may require other forms of insurance.
• Loan-to-value ratio (LTV): Compares the loan amount to the value of the home. If a home is worth $300,000 and has a $270,000 loan, for example, the mortgage has an LTV of 90%. Lenders use LTV to gauge risk when evaluating a loan application—the lower the LTV, the lower the risk to the lender.

Frequently Asked Questions

Monitor Your Credit Throughout the Process

A mortgage loan is a significant commitment, so it's important to take your time during the process. It can be easy to get caught up in the emotions of homeownership and getting your dream home. But understanding how the mortgage process works and what's best for your situation can potentially save you thousands of dollars over the years.

It's also important to safeguard your credit during the mortgage process. With Experian's free credit monitoring service, you can access your Experian credit report and FICO^® Score at any time and also get real-time alerts when changes are made to your credit report.