What Is a Mortgage? A Guide for Beginners
A mortgage is a loan you use to buy or refinance a home. When you take out a mortgage, you’re agreeing with your lender that they can take your property if you default on your loan. That means that your home serves as collateral.
A mortgage is a loan that allows you home ownership provided you follow the terms of the agreement made between you and the lender. Defaulting on a mortgage means you can lose your property.
MoneyGeek’s guide will help you to properly understand how a mortgage works, the types of mortgages available and how you can get one on your journey toward homeownership.
Most people cannot pay the full cost of a home upfront, so they take out a mortgage loan to cover the cost. A mortgage usually takes 15-30 years of regular monthly payments to pay off.
Mortgage payments are the regular installments that you’ll make toward your loan. These payments include the principal, interest, property tax and homeowners insurance.
There are several types of mortgages. Depending on your eligibility and needs, you may apply for a fixed-rate mortgage, adjustable-rate mortgage (ARM), reverse mortgage, government-backed mortgage (FHA loan, USDA loan or VA loan) or a jumbo loan.
What Is a Mortgage?
When you take out a mortgage, you’re borrowing money from a financial institution (like a bank or other lending company) to cover the costs of buying a property. By signing on for a mortgage, you agree to receive a loan that you’ll pay for in regular installments that could stretch up to 30 years. In exchange for the loan, the lender has the right to take your home if you stop making payments because the property is the collateral.
Mortgages come in several types, such as:
- Fixed-rate mortgage
- Adjustable-rate mortgage (ARM)
- Reverse mortgage
- FHA loan
- USDA loan
- VA loan
- Jumbo loan
The costs included in your payment are the principal and interest. And depending on the loan, mortgage insurance. You are also responsible for property taxes, if applicable, where you live, and homeowners insurance.
The minimum requirements vary depending on the type of mortgage. But generally, you need to provide a down payment and proof of financial capability, and the lender reviews your credit score, debt-to-income ratio, income, employment and cash reserves.
How Does a Mortgage Work?
Most people don’t have the money to pay the total cost of a property out of pocket, which makes getting a mortgage an essential component of homeownership.
Individual homebuyers aren’t the only ones who take out mortgages. Institutional investors also take advantage of this financial tool to grow their investment portfolio. Most of them flip properties or rent them out.
During the borrowing process, your lender will assess your qualifications to determine the type of mortgage you’re eligible for and its terms. You may get up to two simultaneous mortgages on a single home.
A mortgage has several features that you must understand to choose wisely among the available options. These include interest rate and repayment terms, as well as mortgage insurance and property taxes.
You’ll need to pay your mortgage in regular monthly installments starting on the first day of the following month after the home purchase was closed. If you miss a payment, your lender will send you a demand letter 90 days after your missed due date. If you’re still unable to make a payment, your lender may begin the foreclosure process.
Although there are many types of mortgages, not all are available to every borrower. There are qualifications that you need to meet — for instance, only eligible veterans and active military service members can apply for a VA loan.
Parties Involved in a Mortgage
- LenderThe financial institution (bank, mortgage loan company, credit union or other lending company) that provides the loan, with the property serving as collateral.
- BorrowerThe individual who gets a mortgage to purchase a property.
- Co-SignerSomeone who takes on the legal responsibilities of paying the mortgage if the borrower defaults on the loan. Note that not all lenders provide the option to have a co-signer on a mortgage application.
What’s Included in a Mortgage Payment?
A mortgage payment has several key components. Generally, your mortgage payment will include payments toward the principal and interest. You may also pay property taxes, mortgage insurance and homeowners insurance as part of your mortgage payment.
Each of these has an impact on the amount that you pay per month and, ultimately, on the total cost of your mortgage. That is why it’s important to have a firm grasp of these items so you can make choices that will let you save on the overall cost of your mortgage.
The principal is the amount of money that you borrow from the lender. For example, you intend to buy a $200,000 home, but you only have $40,000 and need to get a mortgage to borrow the remaining $160,000 to cover the cost. The $160,000 would be the principal that you owe on the mortgage.
The mortgage interest is the amount of money that your lender charges you for the loan. It allows them to make a profit, and it also covers the cost of their services.
Getting a high-interest rate on your mortgage means that you’ll have a higher monthly payment. As a consequence, your loan will have a higher total cost. That is because your monthly installments include an interest payment based on the principal on your loan. The more principal you owe and the higher the interest rate, the more interest you pay.
Some states and local governments use property taxes to fund public services. They charge property taxes to homeowners based on the tax rate for the city or county and on the home’s assessed value.
Depending on your locality, you may be required to pay property taxes annually, semi-annually or quarterly. Also, you can either make a direct payment to your local government or establish an escrow account with your lender. The lender will use the funds in escrow to pay the taxes for you.
Mortgage insurance protects your lender in the event that you default on your loan. It is typically required if you have a down payment of less than 20% of your home’s purchase price. Even some zero-down-payment loans like USDA loans and low-down-payment loans like FHA loans may require mortgage insurance.
Private mortgage insurance (PMI) may cost anywhere from 0.1% to 2% of your loan amount, but you might be able to cancel this once you’ve paid off a portion of your loan.
You may pay homeowners insurance through an escrow account with your lender.
Homeowners insurance is your financial protection in the event that your property is damaged. A home is a significant investment, and it is only wise to protect it.
Standard homeowners insurance covers your home’s structure and your belongings within it. You are also protected, through liability insurance, for any legal costs arising from an accident in your home, property damage you accidentally cause to another’s property or accidental injuries of others that occur on your property.
What Are the Types of Mortgages?
There are many types of mortgage loan options. The more common include fixed-rate mortgages, adjustable-rate mortgages (ARMs), reverse mortgages, FHA loans, USDA loans, VA loans and jumbo loans.
Although it may seem that there’s a wealth of options, you might not qualify for all of them. There are certain eligibility requirements that you’ll have to meet to qualify. For instance, you can only apply for a USDA loan if you’re purchasing a property in an eligible rural area.
A fixed-rate mortgage has a specific interest rate for the lifetime of the loan and is provided by most banks and mortgage companies. It is a very popular loan due to its predictability, which assists borrowers in sticking to a strict monthly budget. That is because you’ll be charged the same payment amount every month. Locking in an interest rate can also protect you from increases in market rates.
But be forewarned that this loan has more stringent eligibility criteria, especially in regard to credit score, income and cash reserves.
An adjustable-rate mortgage (ARM) charges an interest rate that changes based on market conditions. During the initial fixed-rate period, this type of loan may give you a lower rate than a fixed-rate mortgage. But after that, if market rates fluctuate or skyrocket, you might find it difficult to factor in how much to budget for your mortgage payment.
We recommend this type of mortgage to homebuyers who are planning to sell their home within five years or before the adjustment period kicks in. But check the terms carefully, as some have a penalty if you pay the loan off or refinance within a certain period.
With a reverse mortgage, open to seniors aged 62 and above; the borrower doesn’t make monthly payments toward the loan — they receive them based on the equity in their home. As a result, interest and fees grow each month and are added to the loan balance.
The mortgage is repaid when the borrower no longer lives in the property. Usually, this is done by the borrower (or heirs) by selling the home.
To be eligible, borrowers must use the home as their principal residence, keep the property in good condition and pay homeowners insurance and property taxes.
An FHA loan is insured by the Federal Housing Administration (FHA) but is issued by a private lender, such as a bank. This type of mortgage tends to have more relaxed requirements compared to conventional loans. To get this loan, you only need a low down payment of at least 3.5% of the home’s purchase price, a fair credit score of 580 and a maximum debt-to-income ratio of 43%. If your credit score is 500 to 579, you must have a 10% down payment.
The U.S. Department of Agriculture, through its Rural Development Program, offers USDA loans to give low- to moderate-income borrowers in eligible rural areas a much-needed shot at homeownership. With this type of loan, there are no down payment and minimum credit score requirements to stress about.
To qualify, you must meet the income requirements for where you live, use the property as your primary residence and purchase a property that is no more than 2,000 square feet in size and located in an eligible rural area.
The U.S. Department of Veterans Affairs provides VA home loans through private lenders. Aside from often having zero down payment, a VA loan may also come with generous terms, very low rates, no loan limit, no private mortgage insurance (PMI) requirement, limited closing costs and no prepayment penalties.
A borrower must be either an active or retired military member or an eligible surviving spouse of military personnel to qualify for this mortgage. Eligibility also depends on duty status, length of service, income and credit score. A valid Certificate of Eligibility (COE) is also required.
You’ll most likely need a jumbo loan if the home that you have set your sights on is in a state or area with an expensive housing market. Jumbo loans are also called non-conforming loans because they exceed the loan limits that are set by the Federal Housing Finance Agency (FHFA).
Because of the higher loan amount, requirements tend to be stricter. Most lenders will require a minimum credit score of 700 and a debt-to-income (DTI) ratio lower than 45%. Also, lenders typically require a 20% down payment for a single-family home and higher down payments for multifamily units.
How Do I Get a Mortgage?
Getting a mortgage need not be a complicated process. MoneyGeek gives a quick rundown of the general process for a good overall picture of the steps and requirements. Note, however, that there may be extra steps and requirements for certain mortgages that are beyond the scope of this beginner’s guide.
Work on Your Credit
Most mortgage loans require a minimum credit score. Improving your credit will let you access more mortgage types and qualify for lower rates.
Find the Right Mortgage
To find the right mortgage for your situation, have a look at the minimum requirements that we’ve outlined above and check which you qualify for based on your profile.
Research & Compare Lenders
Dig deeper into the lenders on your shortlist and compare their mortgage interest rates and terms. That will help you secure the best deal for your situation.
We recommend applying to multiple lenders to compare the actual rates and terms that they’re willing to offer you. During the review process, the lender will evaluate your credit, income and assets to check if you qualify for the loan.
Choose an Offer
Pick the offer that provides the best balance between low rates, affordable down payment and other factors that you consider important.
Submit Mortgage Application
Complete the loan application with your chosen lender. You may be asked to submit additional documents (income or employment history) depending on your situation.
Proceed With the Underwriting Process
Your lender will verify your income and assets to determine your creditworthiness. It will also conduct an appraisal of the house you want to purchase to get an accurate estimate of its value, as well as a title search to make sure that there are no legal claims on the property.
Close on the New Home
Once your mortgage is approved, you’ll have to settle the closing costs and sign the final paperwork before moving into your new home.
Frequently Asked Questions About Mortgages
A mortgage can make homeownership more affordable for many people, but it is also a significant financial commitment. MoneyGeek equips you with the necessary knowledge of what a mortgage entails by addressing the most common questions about this topic.