What Is a Mortgage and How Does It Work?

What Is a Mortgage?

A mortgage is a type of loan used to finance the purchase of a primary residence, 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.

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 (DTI): 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%.
• Down payment: The cash amount you contribute to the purchase. Lenders often require a down payment of at least 3% to 5% of the sale price, but many buyers aim for a 20% down payment so they can avoid paying mortgage insurance (more below). Some home loan programs don't require a down payment.
• Closing costs and fees: 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 what type of property is involved, but typically are 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. Tax rates can vary depending on where you live.
• Foreclosure: A proceeding 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 (PMI): 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, such as the Federal Housing Authority (FHA) loan program, 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, its LTV is 90%. Lenders use LTV to gauge risk when evaluating a loan application, and the lower the LTV, the lower the risk to the lender.

How Mortgages 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 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.

Your monthly mortgage payment will consist of three components:

• Principal: The amount of money that you still owe on your loan, not including interest.
• Interest: The finance charge based on the loan's annual percentage rate (APR).
• Escrow account: An account the lender uses to pay your homeowner's insurance and property taxes. You'll pay into the account with your monthly mortgage payment, and the lender will use the money to pay your bills when they come due. Escrow accounts may or may not be required depending on the type of loan or down payment amount.

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

Different 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.

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.

In some cases, conventional loans are issued by one mortgage lender and then sold to another mortgage lender who services the bulk of the loan. Your first few payments are to the mortgage lender that you closed with, and then you will receive a letter letting you know that your mortgage loan will be serviced by another lender.

Government-Insured Loan

As the name suggests, these loans are insured by a government agency, such as the Federal Housing Administration (FHA), Veterans Administration (VA) or the U.S. Department of Agriculture (USDA).

In most cases, the government does not originate these loans. Instead, you'll get the loan through a private lender, and it will be insured by a federal agency.

The only exception is the USDA Direct Housing Program, which provides loans to low-income families. Its Guaranteed Housing Loans program, however, acts similarly to other government-insured loans.

Here's a breakdown of some of the common government-insured loans that are available:

• FHA loans: Available to all types of homebuyers. The government 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 scores can go as low as 500. FHA loans require mortgage insurance.
• VA loans: A U.S. Department of Veterans Affairs loan for military members and their families. Borrowers can purchase a home with no money down and receive 100% financing.
• USDA loans: Mainly geared to rural borrowers who meet the income requirements from the program. U.S. Department of Agriculture 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.

Fixed-Rate Mortgage

Fixed-rate mortgage loans are very popular and typically come with repayment terms of 15, 20 or 30 years. They have 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.

Adjustable-Rate Mortgage

Adjustable-rate mortgage (ARM) loans have an interest rate that will change or adjust from the initial rate. For example, a 5/1 ARM loan will have a fixed interest rate for the first five years, then adjust every year based on the current market rates.

ARMs can be popular because they tend to come with a lower interest rate compared with a fixed-rate mortgage, at least initially; the risk with ARMs is that rates can rise dramatically over time.

Conforming Loan

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

The FHFA's 2022 limits for conforming loans are $647,200 or less in 48 states and $970,800 or less for Alaska and Hawaii.

Because conforming loans meet the guidelines set by Fannie Mae and Freddie Mac, they typically offer lower interest rates and better overall terms than non-conforming loans.

Non-Conforming Loan

A non-conforming loan is a mortgage loan that does not conform to Fannie Mae and Freddie Mac's loan limits or other requirements. Jumbo loans, government-backed loans, hard money loans, interest-only mortgages and purchase money mortgages are just some examples of non-conforming loans.

How to Qualify for a Mortgage

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

1. Check your credit score. The higher your credit score, the better your chances of getting approved. You can access your FICO^® Score^☉ for free for free through Experian. You generally need a score of 620 to qualify for a mortgage, but different programs can vary. If you want a good chance of securing a low interest rate, it's best to have a score in the mid-700s or higher.
2. Review your credit reports. Once you have an idea of your general credit health with your credit score, review your credit reports for any information that you can use to improve your credit before applying. You can get a free copy of each of your credit reports through AnnualCreditReport.com, and you can get ongoing access to your credit report for free through Experian.
3. Review your income and debt. As previously mentioned, your debt-to-income ratio 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.
4. Apply for preapproval. Once you're ready to apply, you can get started with a bank, credit union, online lender or mortgage broker. A mortgage preapproval is determined by a lender to indicate the amount you can borrow, the type of loan and the interest rate that you would likely qualify for. A mortgage preapproval is not actual approval, though. It's just a document that says the lender believes that it would likely approve a mortgage application based on the income and credit information submitted. The information needed for a home mortgage preapproval typically includes personal information such as your credit history, credit score, income, assets, debts, tax returns and employment history.
5. Compare offers. It's a good idea to shop around and compare loan terms from at least three to five mortgage lenders. This process gives you enough information to find the best available offer for you.
6. Submit your application. Once you've decided on a lender, 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.
7. 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.
8. Prepare for closing. Throughout the process, your loan officer or broker will guide you through the 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.

Monitor Your Credit Throughout the Process

A mortgage loan is an incredible 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.