How Does a Mortgage Work?

Everything You Need To Know About Mortgages

A family has breakfast seated on the floor of their new home with boxes
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A mortgage is a loan that's used to purchase a home or a piece of property. It's a secured loan. The borrower and the lender agree that the home itself serves as collateral. This means that the lender can take it from you if you don’t repay the loan.

Mortgages usually refer to home loans, but they can also be taken out for other types of land or property purchases. A mortgage that's 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 that's taken to purchase a home. The lender can claim the property if the borrower breaks the loan 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 the overall cost of the loan.
  • Several types of mortgage programs are available to meet different borrower needs. Each of them comes with unique qualifications and benefits.
  • You must meet a loan program’s specific income and credit requirements to qualify for a mortgage.

Breaking Down Your Monthly Mortgage Payment

Include the four main components when you're deciding if you can afford a monthly mortgage payment: principal, interest, taxes, and insurance. These components are sometimes referred to as "PITI." They're lumped together into one monthly mortgage bill in most cases.

Principal

Principal is the loan amount you borrowed to purchase the home. Part of each monthly mortgage payment goes toward paying down the principal balance. Mortgage payments include less toward principal right after you take out the loan, so you may not see the principal balance decrease all that much in the first years of your loan's amortization schedule.

Making extra payments toward your principal each month can help shorten the duration of your mortgage and save on interest.

Interest

A big part of your mortgage payment is the interest you must pay to the lender each month. This is the “cost of borrowing.” Most of your monthly mortgage payment will be put toward interest in the early years of your mortgage's payoff schedule. The higher your mortgage interest rate, the more interest you'll pay.

Taxes

Property taxes must be paid when you own a home, and they're often included in your monthly mortgage payment. Most homeowners pay a little each month as part of their mortgage payment that goes into an escrow account the lender sets aside to cover the taxes. The lender pays the bill on your behalf from the escrow account when it comes due.

Insurance

Homeowners insurance is another cost that's typically rolled into your monthly mortgage payment. The lender pays your insurance company from the escrow as it does with property taxes.

Many lenders require that taxes and insurance costs be rolled into the mortgage. Changes in tax and insurance costs can happen periodically and would 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 you might have to make a lump sum payment to cover any shortfalls.

You may also be required to pay another type of insurance called private mortgage insurance (PMI) if you don’t put at least 20% down when you purchase the home. You’ll pay a mortgage insurance premium (MIP) if you take out an FHA loan.

Loan Terms and APR

A big part of how mortgages work has to do with the length of the mortgage (its 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 long. The longer your term, the smaller your monthly payment, but you’ll pay more 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 that impact the cost of your mortgage are the interest rate and the APR. The interest rate is a percentage that shows how much the loan costs annually. The APR is another important percentage to look at because it includes not only the interest rate, but also any additional fees and points you're paying toward the loan.

Be sure to look at both the interest rates and APRs when you're comparing mortgages. Two lenders might offer the same interest rate, but one may have more fees and therefore a higher APR.

Take a look at a $400,000 fixed-rate 30-year loan with a 3% down payment to see how even small differences in the interest rate can affect your mortgage costs,

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 loans.

Fixed Rate Mortgages

Fixed rate mortgages let you pay the same interest rate 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.

Adjustable Rate Mortgages

Your interest rate and monthly payment amount will change over time with an adjustable rate mortgage (ARM). You’ll typically start off with a fixed rate for a few years that's a bit lower than the average fixed rate offer being offered at the time. This makes the loan more attractive. But the rate will change each year after this period.

You’ll pay a fixed rate for the first five years with a "5/1" ARM. Then your rate will adjust annually beginning in year six. Some ARMs have longer initial fixed rate periods. Others may change rates every six months.

Adjustable rates can work in your favor if rates go low, but you may also end up paying more than your budget can handle if interest rates increase. There's a cap on how much rates can fluctuate in most cases, but even small jumps in your interest rate can make your payment much higher.

Other Mortgage Types

  • Refinance loans: You can refinance by getting a new loan to replace your old one if you already have a mortgage. Homeowners usually do this to take advantage of more favorable terms and/or lower interest rates.
  • Interest-only loans: These loans allow you to pay just the interest on your loan for a period of time, lowering your monthly cost. But you won’t make any progress on paying down your loan principal, and your payments will eventually include both principal and interest.
  • Balloon loan: You’ll make no or very small payments for a set period of time with a balloon loan, then the entire loan balance will come due in one lump sum after this time expires. Balloon loans are very risky because you’ll be faced with a significant one-time payment of the full amount you borrowed at the end of the loan's term.

Home Loan Programs

Conventional, non-government-backed mortgages are the most common, but it could be worth investigating if a special home loan program is a better fit for you depending on your circumstances.

  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 Mortgages

Conventional loans come from private lenders rather than government programs. They aren’t as highly regulated, so there are a lot of competitive options and offers in the marketplace for homebuyers to consider. But borrowers typically have to meet more stringent credit and income requirements to qualify for these mortgages because they're not backed or insured by a government entity. The minimum required credit score is usually 620.

FHA Loans

FHA loans are backed by the Federal Housing Administration. They're geared toward those who don’t have a large down payment or who have less-than-stellar credit. Buyers with credit scores of 580 or higher are eligible. Down payment requirements are as low as 3.5%. The drawback with taking an FHA loan is that you’ll have to pay mortgage insurance premiums upfront as well as with each monthly payment.

VA Loans

The Department of Veterans Affairs (VA) guarantees a portion of VA loans to eligible veterans, servicemembers, and their spouses. The loans are issued by private lenders. There are many benefits 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 Loans

USDA loans are issued or insured by the U.S. Department of Agriculture. These mortgages are designed to promote home buying in rural areas. USDA loans have favorable interest rates and can be taken out with no money down. Borrowers must meet low-income eligibility and although there is no credit score requirement by the USDA, most lenders prefer a minimum credit score of 640.

Other Mortgage Terms to Know

  • Conforming vs. non-conforming loans: Most mortgages are conforming loans. 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 doesn't follow government loan limits and rules. Home loans that are above the 2022 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 rather than 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. Then you can begin researching the various loan programs and comparing mortgage lenders to find a loan that meets your needs.

Preapproval

You can request a preapproval letter after you find a potential lender. The letter will state the maximum loan amount you're likely to qualify for. Being preapproved helps demonstrate to sellers that you're a serious home shopper, but it doesn’t mean that you're guaranteed to receive an actual loan.

The Application

You can begin the home loan application process after you've found a property and have agreed to a sales price with the seller. 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

The application will move into the mortgage underwriting phase after the lender has all your paperwork. 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'll be able to afford to pay back the loan.

They'll also take other factors into consideration, such as your savings and assets, as well as how much of a down payment you’ll be making. A home appraisal will be ordered, as well as a title search to make sure that there are no outstanding claims or liens against the property.

The Decision

The lender will either approve or reject your loan request after your entire application has been reviewed. You can move on to the closing if you're approved for the mortgage.

What Happens If You Can't Pay Your Mortgage?

You may have some options if you find yourself struggling to keep up with your monthly mortgage payments. The most important thing is to be proactive and seek help right away before you miss any payments and risk going into foreclosure.

Contact your lender to ask about hardship programs such as forbearance, deferment, or loan modification. These will all give you a temporary break from making your full payments until you get back on your feet. You may want to discuss selling the home in a short sale if you don't foresee your financial situation improving.

Frequently Asked Questions (FAQs)

How long is mortgage preapproval good for?

The time a mortgage preapproval lasts varies by lender, but it should be good for 30 to 60 days.

How much mortgage can I afford?

The Balance has an online mortgage calculator to help you figure out how much home you can afford based on your income and your debt situation. Enter your information into the 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 as part of the preapproval process.

Article Sources

  1. Chase. “What Is PITI?

  2. Freddie Mac. “Homeownership Costs: PMI, Taxes, Insurance and HOAs.”

  3. Department of Housing and Urban Development. “Upfront Mortgage Insurance Premium.”

  4. Consumer Financial Protection Bureau. “What Is Private Mortgage Insurance?

  5. Rocket Mortgage. “Average Mortgage Length In The U.S.

  6. Bank of America. “​​With an Adjustable-Rate Mortgage, Your Interest Rate May Change Periodically.”

  7. Fannie Mae. “Selling Guide,” Page 471.

  8. Experian. “How To Qualify for An FHA Loan.”

  9. Department of Housing and Urban Development. “Let FHA Loans Help You.”

  10. U.S. Department of Veteran Affairs. “VA Home Loans.”

  11. U.S. Department of Agriculture. “Single Family Housing Programs,” Pages 5-6.

  12. Federal Housing Finance Agency. “FHFA Announces Conforming Loan Limits for 2022.”

  13. Consumer Financial Protection Bureau. "Get a Prequalification or Preapproval Letter."

  14. Discover Home Loans. “Common Mortgage Documents,” Page 4.

  15. Consumer Financial Protection Bureau. “Get a Prequalification or Preapproval Letter.”