How Mortgages Work

What Does It Mean to Use a Mortgage?

Couple sitting in their new home
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A mortgage is an agreement that allows a borrower to use property as collateral to secure a loan.

In most cases, the term refers to a home loan: When you borrow to buy a house, you sign an agreement saying that your lender has the right to take action if you don’t make your required payments on the loan. Most importantly, the bank can take the property in foreclosure — forcing you to move out so they can sell the home.

The sales proceeds will be used to pay off any debt you still owe on the property.

A Mortgage Is an Agreement: 

The terms “mortgage” and "home loan" are often used interchangeably. Technically, a mortgage is the agreement that makes your home loan possible — not the loan itself. For real estate transactions, agreements need to be in writing, and a mortgage is a document that (among other things) gives your lender the right to foreclose on your home.

Mortgages Make It Possible to Buy

Real estate is expensive. Most people don’t have enough cash in savings to buy a home, so they make a down payment of 20 percent or so and borrow the rest. That still leaves the need for hundreds of thousands of dollars in many markets. Banks are only willing to give you that much money when they have a way to reduce their risk.

Safer for banks: Banks protect themselves by requiring you to use the property you're buying as collateral.

To do so, you "pledge" the property as collateral, and that pledge is your "mortgage." In the fine print of your agreement, the bank gets permission to put a lien on your home so that they can foreclose if needed.

More Affordable Loans:

Borrowers also get some benefit out of this arrangement. By helping the lender reduce risk, the borrower pays a lower interest rate.

Mortgages are often used by consumers (individuals and families), but businesses and other organizations can also purchase property with a mortgage.

Types of Mortgages

There are several different types of mortgages, and understanding the terminology can help you pick the right loan for your situation (and avoid going down the wrong path).

Again, if you want to be a stickler, we’re talking about different types of loans — not different types of mortgages (because the mortgage is simply the part that says they can foreclose if you stop making payments).

Fixed-rate mortgages are the simplest type of loan. You’ll make the exact same payment for the entire term of the loan (unless you pay more than is required, which helps you get rid of debt faster). Fixed rate mortgages typically last for 30 or 15 years, although other terms are not unheard of. The math on these loans is pretty simple: Given a loan amount, an interest rate, and a number of years to repay the loan, your lender calculates a fixed monthly payment.

Fixed-rate loans are so simple that you can calculate mortgage payments and the payoff process by yourself (spreadsheets and online templates make it easier). These calculations are a valuable exercise to help you compare lenders and decide which loan to use.

You might be surprised to see how a longer term loan leads to higher interest costs over the life of your loan — effectively making a home more expensive than it needs to be.

Adjustable rate mortgages are similar to standard loans, but the interest rate can change at some point in the future. When that happens, your monthly payment also changes — for better or worse (if interest rates go up, your payment will increase, but if rates fall, you might see lower required monthly payments).

Rates typically change after several years, and there are some limits as to how much the rate can move. These loans can be risky because you don't know what your monthly payment will be in 10 years (or if you'll be able to afford it).

Second mortgages, also known as home equity loans, aren’t for buying a house — they’re for borrowing against a property you already own.

To do so, you’ll add another mortgage (if your home is paid off, you’re putting a new, first, mortgage on the home). Your second mortgage lender is typically “in second position,” meaning they only get paid if there’s money left over after the first mortgage holder gets paid. Second mortgages are sometimes used to pay for home improvements and higher education. In the financial crisis, these loans were notoriously used to "cash out" your home equity.

Reverse mortgages provide income to homeowners (generally over the age of 62) who have significant equity in their homes. Retirees sometimes use a reverse mortgage to supplement income or to get lump sums of cash out of homes that they paid off long ago. With a reverse mortgage, you don’t pay the lender — the lender pays you — but these loans are not always as good as they sound.

Interest only loans allow you to pay only the interest costs on your loan each month. As a result, you’ll have a smaller monthly payment (because you’re not repaying any of your loan balance). The drawback is that you’re not paying down debt and building equity in your home, and you’ll have to repay that debt someday. These loans can make sense in certain short-term situations, but they’re not the best option for most homeowners hoping to build wealth.

Balloon loans require that you pay off the loan entirely with a large “balloon” payment. Instead of making the same payment over 15 or 30 years, you’ll have to make a large payment to eliminate the debt (after five to seven years, for example). These loans work for temporary financing, but it’s risky to assume that you’ll have access to the funds you need when the balloon payment is due.

Refinance loans allow you to swap out one mortgage for another if you find a better deal. When you refinance a mortgage, you get a new mortgage that pays off the old loan. This process can be expensive because of closing costs, but it can pay off over the long term if you get the numbers to line up correctly. The loans don’t need to be the same type. For example, you can get a fixed-rate loan to pay off an adjustable rate mortgage.

How to Get a Home Loan

To borrow money, you’ll need to apply for a loan. Home loans require much more documentation than other types of loans (like auto loans or personal loans), so be prepared for a long process.

Credit and Income:

As with most loans, your credit and income are the primary factors that determine whether or not you’ll get approved. Before you apply for a home loan, check your credit to see if there are any issues that might cause problems (and fix them if they’re just errors). Late payments, judgments, and other issues can result in getting your application denied — or you’ll get a higher interest rate, which means you’ll pay more over the life of your loan.

Documentation and Ratios:

Lenders are required to verify that you have enough income to repay any loans that they approve. As a result, you’ll need to provide proof of income (get your Form W-2, your most recent tax return, and other documents handy so that you can submit them to your lender).

Debt to Income Ratio:

Lenders will look at your existing debts to make sure you have sufficient income to pay off all of your loans — including the new one you’re applying for. To do so, they calculate a debt to income ratio, which tells them how much of your monthly income gets eaten up by monthly payments.

Loan to Value Ratio:

Although it’s possible to buy with very little down, your chances of getting approved are better when you make a large down payment. Lenders calculate a loan to value ratio, which shows how much you’re borrowing compared to how much the property is worth. The less you borrow, the lower the risk for your lender (because they can quickly sell the property and recover all of their money).

Preapproval:

It’s best to know how much you can borrow long before you start shopping for houses (or loans). One way to do that is to get preapproved by a lender. This is a preliminary process where lenders evaluate your credit information and your income. With that information, they can give you a maximum loan amount that they’re likely to approve. This doesn’t necessarily mean that you’re approved — especially not for a particular property — but it is helpful information, and a preapproval letter can help strengthen your offer. Once you’re under contract, lenders will take a closer look at everything and issue an official approval (or rejection).

How Much to Borrow:

Lenders always tell you how much you can borrow, but they don’t discuss how much you “should” borrow. The responsibility falls on you to decide how much to spend on a house, what type of loan to use, and how large of a down payment you want to make (affecting your loan to value ratio). All of those factors determine how much you’ll pay every month, and how much interest you’ll pay over the life of your loan (smaller loans lead to smaller monthly payments and smaller interest charges). It’s risky to borrow the maximum amount available, especially if you prefer to have some “cushion” in your monthly budget.

Where to Borrow

Home loans are available from several different sources. Get quotes from at least three different lenders, and pick the one that works best for you.

Mortgage brokers offer loans from numerous lenders. They have access to loans from multiple banks and other sources of financing, and they will help you select a lender based on the interest rate and other features. Mortgage brokers might charge an origination fee that you pay, or they might get paid by the lender (or a combination of both). If you don’t know any mortgage brokers, ask your real estate agent or other people you trust for a recommendation.

Banks and credit unions offer loans to customers. The money in checking and savings accounts needs to be invested, and lending that money out is one way to invest that money. These institutions also earn revenue from origination fees, interest, and other closing costs.

Online lenders can fund loans themselves (using investor money, for example), or they can function as mortgage brokers. These services are convenient because you can handle everything virtually, and you can often get quotes more or less instantly.

Each lender should provide you with a Loan Estimate, which helps you compare the cost of borrowing from different lenders. Read through these documents carefully, and ask questions until you understand everything you see. The CFPB explains several sections of the Loan Estimate to help you understand the features of your loan.

Loan Programs

It may be possible to get help with your loan using loan programs from government and local organizations. These programs make it easier to get approved, and some offer creative incentives to make home ownership more affordable and attractive. In addition to buying a house, it may be possible tor refinance with these programs (even if you owe more than your home is worth).

Government loan programs are among the most generous. In most cases, a private lender (like a bank) provides funding, and the federal government promises to repay the loan if you fail to do so. There are a variety of programs, and some of the most popular ones are listed below.

FHA Loans:

Loans insured by the Federal Housing Administration (FHA) are popular for homebuyers who want to make a small down payment. It’s possible to buy with as little as 3.5 percent down, and they’re relatively easy to qualify for (if you don’t have perfect credit, for example). Learn more about FHA loans.

VA Loans:

Veterans, Servicemembers, and eligible spouses can buy a home with a loan guaranteed by the Department of Veterans Affairs (VA). These loans allow you to borrow with no requirement for mortgage insurance and no down payment (in some cases). You can borrow with less-than-perfect credit, closing costs are limited, and the loan may be assumable (allowing somebody else to take over the payments if they’re eligible).

First-Time Homebuyer programs make it easy to own your first home, but they come with strings attached. Often developed by local governments and nonprofit organizations, these programs can help with down payments, approval, interest rates, and more. However, they are hard to find (and qualify for), and they may limit how much you can profit when you sell your home.

4 Ways to Save Money

Home loans are expensive, so saving even a little (in percentage terms) can lead to hundreds or thousands of dollars in savings.

1. Shop Around 

Again, it’s essential to get at least three quotes from different lenders — preferably different types of lenders (a mortgage broker, an online lender, and your local credit union, for example). Everybody has different pricing, and you’ll learn a lot in the process.

2. Watch the Rate

The larger (and longer) your loan, the more your rate matters. You pay interest on your loan balance year after year, and those interest costs can be tens of thousands of dollars. Sometimes it makes sense to pay more up front — even buying “points” on your loan — if you can lock in a low rate for the long term.

3. Pay Attention to Mortgage Insurance 

If you put down less than 20 percent, you’ll most likely have to pay mortgage insurance. This insurance isn’t for your benefit — it protects the lender in case you stop making payments and they can’t recover their funds — so it’s best to avoid this expense. Evaluate alternative ways to come up with 20 percent, and find out how to remove mortgage insurance as soon as possible. With some loans, like FHA loans, you can’t really get rid of that cost unless you refinance.

4. Manage Closing Costs

When you get a home loan, you’ll need to pay numerous expenses. There are application fees, credit check fees, origination fees, appraisal costs, and more. Some lenders charge higher and lower costs, but you always end up paying one way or another. Be wary of “no closing cost” loans unless you’re sure you’ll only be in the home for a short period.