What Is A Mortgage? Loan Basics For Beginners
For many, owning a home is part of the American dream. For most homeowners in America, getting a mortgage is just one of the steps it takes to get there.
If you’re contemplating homeownership and wondering how to get started, you’ve come to the right place. Here, we’ll cover all the mortgage basics, including loan types, mortgage lingo, the home buying process,
A Simple Definition Of A Mortgage
Before we dive in, let’s talk about some mortgage basics. First, what does the word “mortgage” even mean?
A mortgage, also referred to as a mortgage loan, is an agreement between you (the borrower) and a mortgage lender to buy or refinance a home without having all the cash upfront. This agreement gives lenders the legal rights to repossess a property if you fail to meet the terms of your mortgage by not repaying the money you’ve borrowed plus interest.
Who Gets A Mortgage?
Most people who buy a home do so with a mortgage. A mortgage is a necessity if you can’t pay the full cost of a home out of pocket.
There are some cases where it makes sense to have a mortgage on your home even though you have the money to pay it off. For example, investors sometimes mortgage properties to free up funds for other investments.
To qualify for the loan, you must meet certain eligibility requirements. Therefore, a person who gets a mortgage will most likely be someone with a stable and reliable income, a debt-to-income ratio of less than 50% and a decent credit score (at least 580 for FHA loans or 620 for conventional loans).
What’s The Difference Between A Loan And A Mortgage?
The term “loan” can be used to describe any financial transaction where one party receives a lump sum and agrees to pay the money back.
A mortgage is a type of loan that’s used to finance property. A mortgage is a type of loan, but not all loans are mortgages.
Mortgages are “secured” loans. With a secured loan, the borrower promises collateral to the lender in the event that they stop making payments. In the case of a mortgage, the collateral is the home. If you stop making payments on your mortgage, your lender can take possession of your home, in a process known as foreclosure.
How Does A Mortgage Loan Work?
When you get a mortgage, your lender gives you a set amount of money to buy the home. You agree to pay back your loan – with interest – over a period of several years. You don’t fully own the home until the mortgage is paid off.
The interest rate is determined by two things: current market rates and the level of risk the lender takes to lend you money. You can’t control current market rates, but you can have some control over how the lender views you as a borrower. The higher your credit score and the fewer red flags you have on your credit report, the more you’ll look like a responsible lender. In the same sense, the lower your DTI, the more money you’ll have available to make your mortgage payment. These all show the lender you are less of a risk, which will benefit you by lowering your interest rate.
The amount of money you can borrow will depend on what you can reasonably afford and, most importantly, the fair market value of the home, determined through an appraisal. This is important because the lender cannot lend an amount higher than the appraised value of the home.
Parties Involved In A Mortgage
There are two parties involved in every mortgage transaction – a lender and a borrower.
A lender is a financial institution that loans you money to buy a home. Your lender might be a bank or credit union, or it might be an online mortgage company like Rocket Mortgage®.
When you apply for a mortgage, your lender will review your information to make sure you meet their standards. Every lender has their own standards for who they’ll loan money to. Lenders must be careful to only choose qualified clients who are likely to repay their loans. To do this, lenders look at your full financial profile – including your credit score, income, assets and debt – to determine whether you’ll be able to make your loan payments.
The borrower is the individual seeking the loan to buy a home. You may be able to apply as the only borrower on a loan, or you may apply with a co-borrower. Adding more borrowers with income to your loan may allow you to qualify for a more expensive home.
When you shop for a home, you might hear a bit of industry lingo you’re not familiar with. We’ve created an easy-to-understand directory of the most common mortgage terms.
Part of each monthly mortgage payment will go toward paying interest to your lender, while another part goes toward paying down your loan balance (also known as your loan’s principal). Amortization refers to how those payments are broken up over the life of the loan. During the earlier years, a higher portion of your payment goes toward interest. As time goes on, more of your payment goes toward paying down the balance of your loan.
The down payment is the money you pay upfront to purchase a home. In most cases, you have to put money down to get a mortgage.
The size of the down payment you’ll need will vary based on the type of loan you’re getting, but a larger down payment generally means better loan terms and a cheaper monthly payment. For example, conventional loans require as little as 3% down, but you’ll have to pay a monthly fee known as private mortgage insurance (PMI), to compensate for the small down payment. On the other hand, if you put 20% down, you’d likely get a better interest rate, and you wouldn’t have to pay for PMI.
A mortgage calculator can help you see how your down payment amount affects your monthly payments.
Part of owning a home is paying for property taxes and homeowners insurance. To make it easy for you, lenders set up an escrow account to pay these expenses. Your escrow account is managed by your lender and functions kind of like a checking account. No one earns interest on the funds held there, but the account is used to collect money so your lender can send payments for your taxes and insurance on your behalf. To fund your account, escrow payments are added to your monthly mortgage payment.
Not all mortgages come with an escrow account. If your loan doesn’t have one, you have to pay your property taxes and homeowners insurance bills yourself. However, most lenders offer this option because it allows them to make sure the property tax and insurance bills get paid. If your down payment is less than 20%, an escrow account is required. If you make a down payment of 20% or more, you may opt to pay these expenses on your own or pay them as part of your monthly mortgage payment.
Keep in mind that the amount of money you need in your escrow account is dependent on how much your insurance and property taxes are each year. And since these expenses may change year to year, your escrow payment will change, too. That means your monthly mortgage payment may increase or decrease.
An interest rate is a percentage that shows how much you’ll pay your lender each month as a fee for borrowing money.
There are two types of mortgage interest rates: fixed rates and adjustable rates.
- Fixed Rates. Fixed interest rates stay the same for the entire length of your mortgage. If you have a 30-year fixed-rate loan with a 4% interest rate, you’ll pay 4% interest until you pay off or refinance your loan. Fixed-rate loans offer a predictable payment each month, which makes budgeting easier.
- Adjustable Rates. Adjustable rates are interest rates that change based on the market. Most adjustable rate mortgages begin with a fixed interest rate period, which usually lasts 5, 7 or 10 years. During this time, your interest rate remains the same. After your fixed interest rate period ends, your interest rate adjusts up or down every 6 months to a year. This means your monthly payment can change based on your interest payment.
ARMs are right for some borrowers. If you plan to move or refinance before the end of your fixed-rate period, an adjustable rate mortgage can give you access to lower interest rates than you’d typically find with a fixed-rate loan.
The loan servicer is the company that’s in charge of providing monthly mortgage statements, processing payments, managing your escrow account and responding to your inquiries.
Your servicer is sometimes the same company that you got the mortgage from, but not always. Lenders may sell the servicing rights of your loan and you may not get to choose who services your loan.
Mortgage Loan Types
There are many types of mortgage loans. Each comes with different requirements, interest rates and benefits. Here are some of the most common types you might hear about when you’re applying for a mortgage.
- FHA Loans. FHA loans are a popular choice because they have low down payment and credit score requirements. You can get an FHA loan with a down payment as low as 3.5% and a credit score of just 580. These loans are backed by the Federal Housing Administration; this means the FHA will reimburse lenders if you default on your loan. This reduces the risk lenders are taking on by lending you the money; this means lenders can offer these loans to borrowers with lower credit scores and smaller down payments.
- Conventional Loans. The phrase “conventional loan” refers to any loan that’s not backed or guaranteed by the federal government. Conventional loans are often also “conforming loans,” which means they meet a set of requirements defined by Fannie Mae and Freddie Mac – two government-sponsored enterprises that buy loans from lenders so they can give mortgages to more people. Conventional loans are a popular choice for buyers. You can get a conventional loan with as little as 3% down. If you put down less than 20% for a conventional loan, you’ll usually be required to pay a monthly fee called private mortgage insurance, which protects your lender in case you default on your loan. This adds to your monthly costs but allows you to get into a new home sooner.
- USDA Loans. USDA loans are only for homes in eligible rural areas (although many homes in the suburbs qualify as “rural” according to the USDA’s definition.). To get a USDA loan, your household income can’t exceed 115% of the area median income. USDA loans are a good option for qualified borrowers because they allow you to buy a home with 0% down. For some, the guarantee fees required by the USDA program cost less than the FHA mortgage insurance premium.
- VA Loans. VA loans are for active-duty military members and veterans. Backed by the Department of Veterans Affairs, VA loans are a benefit of service for those who’ve served our country. VA loans are a great option because they let you buy a home with 0% down and no private mortgage insurance.
Your mortgage payment is the amount you pay every month toward your mortgage. Each monthly payment has four major parts, principal, interest, taxes and insurance:
- Principal. Your loan principal is the amount of money you have left to pay on the loan. For example, if you borrow $200,000 to buy a home and you pay off $10,000, your principal is $190,000.Part of your monthly mortgage payment will automatically go toward paying down your principal. You may also have the option to put extra money toward your loan’s principal by making extra payments; this is a great way to reduce the amount you owe and pay less interest on your loan overall.
- Interest. The interest you pay each month is based on your interest rate and loan principal. The money you pay for interest goes directly to your mortgage provider. As your loan matures, you pay less in interest as your principal decreases.
- Taxes And Insurance. If your loan has an escrow account, your monthly mortgage payment may also include payments for property taxes and homeowners insurance. Your lender will keep the money for those bills in your escrow account. Then, when your taxes or insurance premiums are due, your lender will pay those bills for you.
Your mortgage term refers to the number of years it will take you to pay off your mortgage. The two most common terms are 30 years and 15 years. A longer term typically means lower monthly payments spread over a longer period. A shorter term usually means larger monthly payments spread over a shorter period, but shorter terms can result in huge interest savings.
Private Mortgage Insurance
Private mortgage insurance is a fee you pay to protect your lender in case you default on your conventional loan. In most cases, you’ll need to pay PMI if your down payment is less than 20%. The cost of PMI can be added to your monthly mortgage payment, covered via a one-time upfront payment at closing or a combination of both. There’s also a lender-paid PMI, in which you pay a slightly higher interest rate on the mortgage instead of paying the monthly fee.
A mortgage note (or promissory note) is a written document that details the agreed-upon terms for the repayment of the loan being used to purchase a property. It's like an IOU that includes all of the guidelines for repayment. These terms include:
- Interest rate type (adjustable or fixed)
- Interest rate percentage
- Amount of time to pay back the loan (loan term)
- Amount borrowed to be paid back in full
Once the loan is paid in full, the promissory note is given back to the borrower. If you fail to uphold the responsibilities outlined in the promissory note (i.e. pay back the money you borrowed), the lender can take ownership of the property.
The Mortgage Process
There are several steps you’ll need to go through to become a homeowner, so here’s a rundown of what you need to do.
It’s a good idea to get an initial approval from your mortgage lender before you start looking for homes. Getting approved upfront can tell you exactly how much you’ll qualify for so you don’t waste time shopping for homes outside your budget.
Mortgage lenders use a variety of terms – including approval, preapproval and prequalification – to describe the initial approval process. It’s important to look for a lender that verifies most of your information upfront so you can make a strong offer. Only Rocket Mortgage offers the Verified ApprovalSM1, which verifies your income, assets and credit upfront, giving you the strength and confidence of a cash buyer.
Shop For Your Home And Make An Offer
Now, the fun part begins! Connect with a real estate agent to start seeing homes in your area. Real estate professionals can help you find the right home, negotiate the price and handle all the paperwork and details.
Get Final Approval
Once your offer has been accepted, there’s a bit more work to be done to finalize the sale and your financing.
At this point, your lender will verify all the details of the mortgage – including your income, employment and assets – if those details weren’t verified upfront. They’ll also need to verify the property details. This typically involves getting an appraisal to confirm the value and condition of the home. Your lender will also hire a title company to check the title of the home and make sure there are no issues that would prevent the sale or cause problems later.
Close On Your Loan
Once your loan is fully approved, you’ll meet with your lender and real estate professional to close your loan and take ownership of the home. At closing, you’ll pay your down payment and closing costs and sign your mortgage papers.
The Bottom Line
A mortgage is a type of loan you can use to buy a home. It’s an agreement between a lender and a borrower.
Knowing some of the basic mortgage lingo ahead of time can help you understand exactly what you’re signing up for. There are different types of mortgages and different types of interest rates.
The biggest steps in the home buying process are getting approved, shopping for your home and making an offer, getting final approval, and closing.
To understand how much you can afford and what loans you might be eligible for, use Rocket Mortgage®. Our online application is a fast way to get approved for a home and get expert mortgage recommendations.