How Mortgages Work

Everything You Need To Know About Home Loans

A family has breakfast in a new home.
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A mortgage is a loan used to purchase a home or piece of property. Because the borrower and lender agree that the home itself serves as collateral—meaning the lender can take it from you if you don’t repay—a mortgage is considered a secured loan.

Mortgages usually refer to home loans, but can also be taken out for other types of land or property. Another type of mortgage, known as a refinance, lets you borrow money against the value of your existing home.

Learn more about how mortgages work, what’s included in a mortgage payment, the different types of mortgage programs, and how to apply for one.

Key Takeaways

  • A mortgage is a secured loan taken to purchase a home, in which the lender can claim the property if the borrower breaks the agreement.
  • Mortgage payments typically include principal, interest, taxes, and insurance (PITI).
  • A mortgage’s terms and annual percentage rate (APR) can impact the borrower’s monthly payment and overall cost of the loan.
  • There are several types of mortgage programs to meet different borrower needs, each of which have unique qualifications and benefits.
  • You must meet a loan program’s specific income and credit requirements—proven with documentation—to qualify for a mortgage.

Breaking Down Your Monthly Mortgage Payment

When deciding if you can afford a monthly mortgage payment, it’s important to include the four main housing costs: principal, interest, taxes, and insurance. This is sometimes referred to by the acronym PITI. In most cases, these four expenses will be lumped together into one monthly mortgage bill.

Principal

Principal is the actual loan amount you borrow to purchase the home. When you make a mortgage payment, however, only part of each payment goes toward the principal balance. Especially in the early years of your amortization schedule, you may not see the principal balance decrease all that much.

If you’re able, making extra payments toward your principal each month can help shorten your loan and save on interest.

Interest

A big part of your mortgage payment is the interest you pay to the lender each month. When people talk about the “cost of borrowing,” this is what they’re referring to. In the early part of your mortgage payoff schedule, most of your monthly mortgage payment will be put toward interest. The higher your mortgage interest rate, the more interest you will pay.

Taxes

Property taxes must be paid when you own a home, and they are often included in your monthly mortgage payment. Instead of paying once per year or quarterly, most homeowners pay a little each month toward an escrow account that the lender sets aside to cover the taxes and other expenses. Once the tax bill comes due, the lender pays the bill on your behalf from the escrow.

Insurance

Just like your taxes, homeowners insurance is another cost that is typically rolled into your monthly mortgage payment, then the lender pays your insurance company from the escrow.

You may also be required to pay another type of insurance if you don’t put at least 20% down on the home. This is called Private Mortgage Insurance (PMI), or if you take an FHA loan, you’ll pay a Mortgage Insurance Premium (MIP). This fee will also be incorporated into your monthly mortgage payment.

Many lenders require that taxes and insurance costs be rolled into the mortgage. Just be aware that changes in tax and insurance costs each year could cause your monthly payment amount to fluctuate (even if you have a fixed-rate loan). You may be given the option to accept a refund if you paid too much, or to make a lump-sum payment to cover any shortfalls.

Loan Terms and APR

A big part of how mortgages work has to do with the length of the mortgage (the term), and the APR and interest rate (what it costs to borrow the money).

Loan Terms

A loan term refers to the length of the mortgage payment schedule. The most common term is 30 years, but there are also mortgages that are 20, 15 or 10 years. The longer your term, the smaller your monthly payment, but the more you’ll pay in interest over the life of the loan.

Here’s an example using a $400,000 loan with a 4% fixed interest rate and a 3% down payment.

Term 30-Year Term 20-Year Term 15-Year Term
Monthly Principal and Interest Payment $1,852.37 $2,351.20 $2,869.99
Total Interest Paid $278,853.68 $176,288.88 $128,598.05

APR and Interest Rate

The other major factors impacting the cost of your mortgage are the interest rate and APR. The interest rate is a percentage that shows how much the loan costs annually. The APR is another important percentage to look at since it includes not only the interest rate, but also any additional fees and points you are paying toward the loan.

When comparing mortgages, be sure to look at both the interest rates and APRs. It could be that two lenders offer the same interest rate, but one has more fees and therefore a higher APR.

To demonstrate how even small differences in interest rate could affect your mortgage costs, take a look at a $400,000 fixed-rate 30-year loan with a 3% down payment.

Interest Rate 3% 3.75% 4.25%
Monthly Principal and Interest Payment $1,635.82 $1,796.89 $1,908.73
Total Interest Paid $200,896.51 $258,879.86 $299,141.64

Types of Mortgages

The two main categories of mortgages are fixed rate and adjustable rate.

Fixed-rate mortgages are simple, letting you pay the same principal and interest amount for the entire life of the loan. The most common fixed-rate terms are 30 years, followed by 15 years, with some lenders offering other terms.

With an adjustable-rate mortgage (ARM), your interest rate and monthly payment amount will change over time. Typically, you’ll start off with a fixed rate for a few years (which is usually lower than the average fixed-rate offer, to be more attractive). However, the rate will change each year thereafter.

For example, with a 5/1 ARM, you’ll pay a fixed rate for the first five years; then starting in year six, your rate will adjust annually. Some ARMs have longer initial fixed-rate periods, while others may change rates every six months.

Sometimes, adjustable rates could work in your favor if rates go low, but you may also end up paying more than your budget can handle if rates increase. In most cases, there is a cap on how much rates can fluctuate. As noted above, even small jumps in interest rate can make your payment much higher. Therefore, there may be more potential to get into financial hot water with ARMs than with a fixed loan.

Other Mortgage Types

Refinance: If you already have a mortgage, you can refinance by getting a new loan to replace your old one. People usually do this to take advantage of more favorable terms and/or lower interest rates.

Interest-only: These loans allow you to pay just the interest on your loan for a period of time, thus lowering your monthly cost. However, you won’t make any progress on paying your loan principal.

Balloon: For a set amount of time, you’ll make no or small payments, but after that period, the entire loan balance will come due. Balloon loans are very risky since you’ll be faced with one lump-sum payment at the end of the loan.

Home Loan Programs

Although conventional (non-government-backed) mortgages are the most common, depending on your financial situation, it could be worth investigating if a special home loan program is a better fit for you.

  Conventional FHA VA USDA
Minimum down payment 3% 3.5% 0% 0%
Credit score 620 or higher 580 or higher No minimum score requirement 640 or higher
Other characteristics Can be fixed or adjustable rate Low closing costs; must pay MIP (mortgage insurance premiums) No mortgage insurance required; must meet military/veteran eligibility Must meet income and property eligibility

Conventional Loans

Conventional loans come from private lenders rather than government programs. Because they aren’t as highly regulated, there are a lot of competitive options and offers in the marketplace for homebuyers to consider, including a minimum down payment of only 3%. However, since they are not backed or insured by a government entity, borrowers typically need to meet more stringent credit (minimum credit score: 620) and income requirements to qualify.

FHA

FHA loans are backed by the Federal Housing Administration. These loans are geared toward those who don’t have a large down payment or who have less-than-stellar credit; people with a credit score of 580 or higher are eligible. Although they have easier qualifications and lower down-payment requirements (as low as 3.5%), the drawback is you’ll have to pay mortgage insurance premiums upfront as well as with each monthly payment.

VA

The Department of Veterans Affairs (VA) guarantees a portion of VA loans to eligible veterans, servicemembers, and spouses. The loans are issued by private lenders. There are many benefits with these loans for those who qualify, including competitive interest rates (some even at 0%), no mortgage insurance requirement, and no down-payment or minimum-credit-score requirements.

USDA

Issued or insured by the U.S. Department of Agriculture, these mortgages are designed to promote homebuying in rural areas. USDA loans have favorable interest rates and can be taken with no money down. But to qualify, borrowers must have a 640 credit score and meet low-income eligibility.

Other Mortgage Terms To Know

Conforming vs. non-conforming loans: Most mortgages are conforming loans, meaning they adhere to loan size limits set by the Federal Housing Finance Agency (FHFA), as well as additional rules established by Fannie Mae and Freddie Mac, the two government-sponsored entities that buy mortgages from lenders. A non-conforming loan does not follow government loan limits and rules. So for example, in 2022, home loans that are above the conforming loan limit of $647,200 would be considered non-conforming (with exceptions made for loans taken in higher-cost areas).

Conventional vs. non-conventional: A conventional loan is any mortgage that comes from a private lender, as opposed to a government-sponsored loan program. A non-conventional loan is a government-backed loan (such as an FHA or a VA loan).

How To Qualify and Apply

The mortgage application process can take months to complete, starting with making sure your finances and credit meet minimum lender requirements (see chart above). Once you’re in solid shape, begin researching the various loan programs and comparing mortgage lenders to find a loan that meets your needs.

Preapproval

After you identify a potential lender, you can request a preapproval letter, which will state the maximum loan amount you are likely to qualify for. Being preapproved helps demonstrate to sellers that you are a serious home shopper, but it doesn’t mean you are guaranteed approval for an actual loan.

Application

Upon finding a home and agreeing to a sales price with the seller, you can begin the actual home loan application. To get ready for this process, be prepared to submit documentation including photo ID, W-2 forms, your last tax return (or two), pay stubs, bank statements, business statements, and other income and asset verification.

Underwriting

Once the lender has all your paperwork, the application will move into the mortgage underwriting phase. You may be asked for additional information during this time. The underwriter will examine your employment history, credit, and finances more closely, and calculate your debt-to-income ratio to determine if you will be able to afford to pay back the loan. They will also take into consideration other factors, such as your savings and other assets, as well as how much of a down payment you’ll be applying. In the meantime, a home appraisal will be ordered, as well as a title search to ensure there are no outstanding claims on the property.

The Decision

Once your entire application has been reviewed (and reviewed some more), the lender will either approve or reject your loan request. If approved, you can move on to the closing.

What Happens if You Can't Pay Your Mortgage?

If you’re struggling to keep up with your monthly mortgage payments, you have some options available to you. The most important thing is to be proactive and seek help before you miss payments and risk going into foreclosure.

Contact your lender to ask about hardship programs such as forbearance, deferment, or loan modification if you need a temporary respite from making your full payments. If you don’t foresee your financial situation improving, you may want to discuss selling the home in a short sale.

Frequently Asked Questions (FAQs)

How long is mortgage preapproval good for?

Once you get a mortgage preapproval, the time it lasts varies by lender. However, you should expect that it will be good for between 30 and 60 days.

How much mortgage can I afford?

There are numerous online mortgage affordability calculators to help you figure out how much home you can afford based on your income and debt situation. Just input your key data points into a calculator, and you’ll get an idea of the monthly payment and total loan amount you can aim for. A mortgage professional can also help you determine how much you can afford via the preapproval process.

How do you get a mortgage loan?

To get a mortgage loan, get your finances in order and review your credit to make sure you’ll meet minimum qualifications. Next, shop around for loans. Once you’ve found a mortgage type and lender that’s a good fit, request a preapproval letter and begin house hunting. When you find a home and your offer is accepted, you can submit an official home loan application. It will go through the mortgage underwriting process, and if approved, you can purchase your new home.