What Is a Mortgage? And How Do They Work?

Updated: 28th Dec 2021 Written by Kim Pinnelli
Share this article
Make Offer on a House
How to Make an Offer on a House
Title Insurance Cost
How Much Does Title Insurance Cost? We Did the Math.

Disclaimer: This post contains references to products from one or more of our advertisers. We may receive compensation (at no cost to you) when you click on links to those products. Read our Disclaimer Policy for more information.

A mortgage is a loan to buy a home. Once you pay the mortgage off, you own your home free and clear.

Until then, the mortgage lender calls the shots, including requiring you to carry homeowner’s insurance and pay your taxes on time.

Here’s everything you need to know about a mortgage.

What Is a Mortgage?

A mortgage is a loan used to buy a home. A mortgage consists of principal and interest payments and usually lasts for a term of 15 to 30 years.

Lenders use the home you buy with the loan as collateral. If you default on the mortgage, the lender has the right to take possession of the house.

>> More: Best Mortgage Lenders

How Do Mortgages Work?

When you take out a mortgage, you borrow a large sum of money. Over the term, which is between 15 and 30 years, usually, you make principal and interest payments until you pay back the full amount of what you owe.

You make mortgage payments monthly, with the first few years of payments covering a large amount of interest, and as you get further into the term, you pay more principal than interest. The interest charges decrease as you pay the loan amount down.

The Different Types of Mortgages

Fixed-Rate Mortgage

A fixed-rate mortgage has the same rate over the life of the loan. For example, if you borrow a 30-year fixed-rate loan at 5%, you’d pay 5% for the entire 30 years unless you refinance the loan.

Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage has a rate that adjusts according to its index. The lender chooses the index the loan is tied to and also adds a margin. The margin is fixed. Common indices lenders use are the LIBOR or the prime rate.

An ARM loan is fixed for an introductory period and then adjusts annually. For example, a 3/1 ARM is fixed for 3 years and adjusts annually. ARM loans are usually available as 3/1, 5/1, 7/1, and 10/1 ARMs.

Balloon Mortgage

A balloon mortgage has fixed payments for a specified period, and then a lump sum is due at the end of the term.

For example, a 5-year balloon would have fixed payments for 5 years, and at the end of the 5 years, the remaining principal balance would be due.

FHA Loans

FHA loans are loans backed by the FHA. They are great for first-time homebuyers or borrowers with less than perfect credit.

FHA loans require only a 580-credit score and a 3.5% down payment. FHA loans have flexible underwriting guidelines but require mortgage insurance payments for the life of the loan.

The FHA doesn’t fund or underwrite FHA loans – but they guarantee them for lenders. If you default on your loan, the FHA will pay the lender back some of the money they lost.

This is why the FHA charges 1.75% of the loan amount upfront and 0.85% of the outstanding balance annually in mortgage insurance.

VA Loans

VA Home loans are loans backed by the Department of Veterans Affairs and are for veterans and/or their families.

VA loans have even more flexible guidelines as they allow 0% down payments, credit scores of 620 or higher, and debt-to-income ratios of 45% or more.

VA loans don’t charge mortgage insurance, but there is an upfront funding fee veterans pay, which is equal to 2.3% of the loan amount. This helps cover the cost of the VA guaranteeing loans should veterans default.

>> More: See the Best VA Mortgage Lenders

Conventional Loans

Conventional loans are loans backed by Fannie Mae or Freddie Mac. They are for borrowers with good credit and low debt-to-income ratios.

They have strict guidelines but offer low-interest rates and only charge Private Mortgage Insurance until you owe less than 80% of the property’s value.

Conventional loans are the most common type of loan, but since they’re harder to qualify for, some borrowers end up with an FHA loan first and then refinance into a conventional loan once they fix their credit and/or income.

Jumbo Loans

You can borrow up to $548,250 on a conventional loan. If you need to borrow more, you may need a jumbo loan.

These non-government-backed loans are written by individual lenders and may have stricter guidelines because of the higher risk of default.

Jumbo loans usually require 20% – 30% down and credit scores of 700+. Because of the higher risk of default, lenders are typically choosy about who they lend these loans to.

USDA Loans

If you plan to live in a rural area and are a low-income family, USDA loans are a good option.

They don’t require a down payment and only require a 640-credit score. They work a little differently than other loans, though.

You must first prove you are eligible for the loan, which means your household doesn’t make too much money.

The USDA offers a tool to help you determine if you qualify. Eligibility is based on household income, not just borrower’s income, so you must include income from anyone living in the house, including grandparents or working children.

It’s worth looking at the USDA boundaries, too, since what they consider ‘rural’ may not be the same definition you have of it.

You may find you can use this attractive financing option in a more populated area than you’d think.

Reverse Mortgages

A reverse mortgage allows seniors to tap into their home’s equity, using the earnings they’ve built up in it throughout their lives.

The reverse mortgage allows borrowers to age in place, remaining in their home without having a mortgage payment.

To qualify, you must be at least 62 years old, own your home free and clear, and be able to keep up with the home’s maintenance, taxes, and insurance. Your age and qualifications will determine how much of your home’s equity you can tap into.

Unlike a regular mortgage, you don’t have to make payments. Interest accrues on the loan, but the lender tacks it onto the loan balance.

You don’t have to pay the loan off until you move out, or if you die, your beneficiaries will pay the loan off by selling the house.

Conforming Mortgages

Conforming loans ‘conform’ to the Fannie Mae and Freddie Mac guidelines. Fannie Mae and Freddie Mac are the two largest investors of mortgage securities.

They buy loans that meet their guidelines, freeing up the lender’s funds, allowing the lender to fund more loans.

Government-Backed Mortgages

Government-backed home loans are backed by a government agency, such as the FHA, USDA, or VA.

These agencies don’t underwrite the loans or fund them. Instead, they guarantee them for lenders.

This enables lenders to offer more flexible guidelines because they know they have insurance should a borrower default.

>> More: Find Out How to Choose the Best Mortgage 

What Is Included In a Mortgage Payment?

Principal

The principal is the money you borrow. For example, if you borrow $100,000 to buy a home, your principal is $100,000. You pay a prorated amount of the principal back each month in your payment.

Interest

Interest is the fee the lender charges to lend you money. Since the lender has an opportunity cost by lending you money, they charge you interest to make up for the time they don’t have the money since you borrow funds for 15 – 30 years.

Taxes

Most mortgage payments include 1/12th of your annual real estate tax amount.

If you aren’t required to pay your taxes in your mortgage payment, you are responsible for paying them yourself.

It’s a good idea to put away 1/12th of the amount each month to make sure you have enough money to pay them.

Insurance

  • Mortgage: If you borrow more than 80% of the home’s value, or you borrow an FHA or USDA loan, you’ll pay mortgage insurance in your mortgage payment. The amount varies based on how much you borrow and the type of loan. Mortgage insurance protects the lender should you default.
  • Homeowners: All lenders require homeowners to carry homeowners insurance. This protects both you and the lender. If you have a total loss, the lender knows you have insurance to cover the cost of rebuilding the home, so the lender doesn’t lose their investment in you.

Extra Payments

You can make extra payments toward your loan’s principal without paying the penalty. Whether you pay $100 or more, note it on your coupon and make sure the money is credited to your principal balance to lower it faster. This will decrease the interest you owe, too, since you’ll pay the loan off faster.

Mortgage Terminology to Know

Amortization

Your loan is split into equal monthly payments. If you take a 30-year term, you have 360 payments, consisting of principal and interest.

The percentage of principal and interest varies based on the term and the amount borrowed. As you get further into your term, you’ll pay less interest and more principal, so you pay off the loan on time.

APR

The mortgage APR is the mortgage interest rate plus fees, including origination points, discount points, and other closing costs.

It’s the annualized rate based on the total cost of the loan.

Down Payment

The money you invest in the home is your down payment. Most loans require at least a 3% down payment, but some require as much as 20% – 30% down.

For example, if you are buying a $300,000 home and the lender requires a 10% down payment, you would need $30,000 to put down on it.

Escrow

If a lender requires that you set up an escrow account, it’s a separate account that holds the money you pay in your mortgage payment to cover 1/12th of your real estate taxes and homeowner’s insurance.

The lender pays your taxes and insurance for you using the money in your escrow account.

Mortgage Insurance

If you put down less than 20% on a property or you borrow a government loan, such as an FHA or USDA loan, you’ll pay mortgage insurance.

Conventional loans with a down payment lower than 20% only pay private mortgage insurance until they owe less than 80% of the home’s value.

The lender will cancel the insurance once you hit this point as long as you make your payments on time.

FHA and USDA loans require mortgage insurance for the life of the loan unless you refinance into a conventional loan when you owe less than 80% of the home’s value.

Underwriting

Underwriting is the process of evaluating if you’re eligible for a loan. Underwriters look at your credit score, income, total debts, debt ratio, and assets to determine if you can afford the loan and your likelihood of defaulting.

Promissory Note

The promissory note is a legal document you sign agreeing to the terms of the loan. It’s your promise to repay the loan.

If you don’t repay it, the lender has the right to repossess the home, as outlined in the mortgage deed.

Second Mortgage

A second mortgage is a separate loan taken out of the home’s equity. Usually, you can take out a second mortgage when you have over 20% equity in the home.

Lenders typically require borrowers to keep 20% untouched but can tap the remaining equity out using a second mortgage such as a home equity loan or HELOC.

Mortgage Term

  • 30-Year Fixed-Rate Mortgage: A 30-year fixed-rate mortgage has a fixed rate (doesn’t change) for 30 years. The loan is amortized over 30 years, so you have 30 years to pay off the principal, and in that time, you’ll pay interest charges too.
  • 15-Year Fixed-Rate Mortgage: A 15-year fixed-rate mortgage has a fixed rate for 15 years. The loan is amortized over 15 years, so you have half the time to pay it off, and you pay less interest since you only borrow the money for 15 years.

What Parties Are Involved in the Mortgage Process?

Lender

The lender is the entity giving you the money. The lender has underwriters and other professionals working for them to determine your eligibility for the loan.

A loan officer will work with you and the underwriter as the ‘middleman’ to get your loan from application to closing.

Borrower

You are the borrower – the person borrowing the money. You are also the person that promises to pay the money back as agreed.

Applying for a Mortgage

#1. Decide On Your Budget

Figure out how much you can afford. Look at your monthly spending and income.

Figure out how much you can afford to pay each month for a mortgage, remembering that you’ll have the loan for 15 to 30 years.

Think about future plans, such as going down to one income or changing jobs so you choose a loan you can afford long-term and not just today.

#2. Get Pre-Approved

Apply for pre-approval with several online mortgage lenders. Compare your options, looking closely at the interest rate, fees, and total loan cost.

Choose the loan with the lowest fees, best rates, and the most attractive terms for your financial situation.

#3. Shop Around for the Perfect Home

With your pre-approval letter from a lender, you can shop for homes. Sellers will accept bids from borrowers with a pre-approval letter.

It gives you the edge on the competition since not everyone gets pre-approved before shopping for a home.

#4. Get Final Approval on Mortgage

After you find a home, give the executed sales contract to your lender. The lender will order an appraisal and title search on the home.

The lender will make sure the home is worth enough, and it doesn’t have any existing liens. In the meantime, you may need to provide documentation to clear any conditions.

#5. Close on Your Mortgage

After you clear all conditions and the lender determines the home is a good buy, they will clear your loan to close.

At the closing, the lender pays the seller and any third parties involved in the sale. You get possession of the keys and now owe a mortgage payment every month to pay off the loan.

>> More: Read our Full Guide on How to Apply for a Mortgage

What Is Mortgage Refinance?

A mortgage refinance pays off your existing loan with a new loan. Some people refinance to get a lower interest rate, and others refinance to tap into their home’s equity, using the cash for other purposes such as home renovations or debt consolidation.

Who Can Apply for a Mortgage?

You must be at least 18 years old, have a job, have money to put down on the home, and have a credit score to apply for a mortgage.

What Personal Information Do I Need to Provide When Applying for a Mortgage?

You’ll provide a lot of personal information when you apply for a mortgage. The personal information includes:

  • Name
  • Address
  • Employer
  • Income
  • Amount of assets
  • Amount of debts
  • Reasons for any negative credit issues
  • Previous addresses or employers
  • Previous names you’ve gone by

Why Do I Need a Mortgage?

If you want to buy a home and you don’t have the cash to pay for it, you’ll need a mortgage. No other loan option will provide you with the amount of money needed to buy a home.

Where Can I Get a Mortgage?

You can get a mortgage from a bank (like Chase), an online mortgage lender (like Better or LoanDepot), or a mortgage broker. There are thousands of options if you look online.

Just make sure you’re dealing with a legit company that is authorized to do business in your state.

What is the Difference Between a Mortgage and a Loan?

A mortgage is a secured loan against a house. A loan could be a secured car loan or a secured personal loan using other collateral.

It can also be an unsecured loan with no collateral but typically has higher interest rates.

Bottom Line: What Is a Mortgage?

If you’re ready to buy a home, you’ll need a mortgage. Do the legwork to get the mortgage first before looking at homes.

You’ll feel more secure when you look at homes, knowing you are approved for the financing needed to buy your dream home.

Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer , Editor, & Product Analyst with a Bachelor’s degree in Finance from the University of Illinois at Chicago. She has been a professional writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Kim is committed to helping people take charge of their personal finance. Her areas of expertise spans mortgages, credit cards, credit, and loans.