What is a mortgage and how does it work?

When you begin shopping for a home, looking at the cost can be overwhelming. Fannie Mae’s Home Price Index found home prices went up 1.7% at the start of 2024 — an increase from the prior year and a major hurdle for homebuyers. Mortgages help remove the upfront financial burden that comes with buying a home, allowing you to spread payments over a longer period, typically 30 years.

Lenders charge interest on your mortgage and calculate that into your monthly payment. Your lender should give you an amortization schedule, which contains a table that shows how much principal and interest you’ll pay each month over the loan term.

What is a mortgage?

A mortgage is a type of loan that allows borrowers to buy real estate, such as a home or commercial property. With these loans, borrowers will need to repay their lender (typically a bank, credit union, or private lender) in monthly installments, with interest. If you fail to repay the loan, your lender can take ownership of the property, since the property acts as collateral for the loan.

Mortgage terms you need to know

Before we dive into mortgage specifics, it’s important to know all of the industry jargon. Here are a few terms you’ll hear along the way:

• Down payment: An initial payment that a buyer makes toward the purchase price of the property. Lenders might require you to put down a minimum percentage of the home’s cost to qualify for a loan. 
• Principal: The amount of money you borrow from a lender, which doesn’t include your down payment.
• Interest: A percentage of your principal that you pay to your lender in exchange for borrowing money. 
• Escrow: A process where a neutral third party holds money for you during the home-buying process, which makes sure all parties fulfill their financial obligations. For example, you might see an escrow account used for homeowners insurance. The portion of your monthly mortgage payment that covers this will go into an escrow account, and the third party pays the insurance when it’s due. 
• Private mortgage insurance (PMI): A type of insurance that protects your lender should you default on your loan. Typically, you’ll need to pay this if you pay less than a 20% down payment.
• Closing costs: A collection of fees that are paid at the time of closing. These include title search fees, appraisal fees, attorney fees, and more. According to Redfin, you can expect closing costs to be 2% to 5% of your home’s price.
• Amortization: The process of gradually paying off your mortgage through regular payments over a period of time.
• Adjustable-rate mortgage: A mortgage with interest rates that fluctuate over time based on the federal rate and real estate market.
• Fixed-rate mortgage: A mortgage with an interest rate that stays the same over the life of the loan.

How does a mortgage work?

When you buy a home, a mortgage pays off the seller and gives you years to repay the loan. From start to finish, closing on the loan takes about a month to a few months. After you make an offer on a home and the seller accepts, here are the steps you can expect to follow:

1. Complete a loan application: You’ll provide the lender with your financial information, including income, credit history, assets, and debts. The lender will have an underwriter assess your creditworthiness and determine whether to approve you for the mortgage. Underwriting can take up to a week or two.
2. Enter into a mortgage agreement: If you’re approved, the lender will send you a mortgage agreement that outlines the full terms and conditions of the loan. Among other things, this agreement typically includes the loan amount, interest rate, loan term, and how much you pay each month. You’ll sign this agreement at closing. 
3. Make interest and principal payments: Each month, you make mortgage payments to your lender. Within this payment is the interest you’re paying for borrowing the money and the principal payment, which reflects your loan balance. 
4. Grow your equity: While you’re making payments, your equity slowly goes up. Your equity is the difference between your home’s market value and what you still owe. As your equity grows, your balance goes down and you gain more ownership of the home.
5. Pay off your mortgage: Once you have made your final payment, you’ll fully own the property. After this, you’ll pay property taxes and insurance costs yourself, instead of through an escrow account.

How much is a mortgage?

How much a mortgage will cost depends on the price of the home you’re buying and the interest rate you pay. According to data from the U.S. Census Bureau and the Department of Housing and Urban Development, the average sale price for a home was $513,100 in the first quarter of 2024. Prices will vary depending on the neighborhood you’re shopping in and whether you buy a home that needs repairs. 

Your lender will determine what interest rate to charge you based on economic conditions and your borrower profile. Borrowers with higher credit scores typically qualify for low interest rates, which can significantly lessen your monthly payment.

Types of mortgages

Mortgages come in several different types, each with its own advantages and disadvantages. These mortgages are some of the most common:

• Conventional: A conventional mortgage is a basic mortgage offered by private lenders such as banks, online lenders, or credit unions. These lenders may offer a better interest rate if you put down at least 20% on your mortgage. Conventional loans have a borrowing limit of $766,550 in most areas and $1,149,825 in high-cost areas.
• Federal Housing Administration (FHA) loan: FHA loans allow homebuyers to qualify with as little as 3.5% down and lower credit scores than other types of mortgages.
• USDA loan: USDA loans help those in rural areas with low to moderate incomes buy, renovate, or construct safe housing. To qualify, the property location must be in an area the USDA designates as rural. You can use the USDA’s website to look up an address or area to see if it qualifies.
• Jumbo loan: Jumbo loans, or non-conforming loans, are mortgages designed to cover high-priced real estate. These loans don’t conform to Fannie Mae, Freddie Mac, and the Federal Housing Finance Agency (FHFA) maximum loan amounts. Lenders usually have stricter requirements to qualify for jumbo loans than conventional loans.
• VA loan: VA loans are designed for veterans and their families, offering no down payment and low interest rates. The loans are backed by the Department of Veterans Affairs. 

Pros and cons of mortgages

A mortgage can help you finance the purchase of your home and begin building equity. At the same time, you’ll want to consider the risks before you take on a major debt. Here are some pros and cons to think through before deciding on a mortgage:

How to get a mortgage

Getting a mortgage is a long process, but it doesn’t need to be difficult. Having the documentation you need and the right team will help make your path to homeownership easier. Here’s what the process will look like:

1. Understand your budget: Before applying for a mortgage, assess your finances to determine what you can afford. If your credit score is less than stellar, improving it could help you land a competitive rate. To start, request a copy of your credit report and check to see if your credit score is in good standing.
2. Decide on a mortgage type: Consider which mortgage is the best fit for your situation. Homebuyers with a higher down payment and credit score might benefit more from a conventional loan, while a buyer who’s a veteran and has a smaller down payment may find a better deal from a VA loan. If you’re overwhelmed by your choices, connect with a loan officer who can advise you.
3. Start saving your down payment: When you decide on a mortgage type, you’ll find out what the minimum down payment requirement is. If you haven’t already, start saving up so you’ll be prepared. There are also down payment assistance programs available for first-time homebuyers.
4. Shop around: Comparing rates from different lenders ensures that you’re getting the best deal. Shop through a loan marketplace that can give you an estimate of what your rates may be from multiple companies.
5. Seek pre-approval: Once you have narrowed down your choices, apply for pre-approval from several lenders. A pre-approval letter eases sellers’ minds and demonstrates you’ll likely qualify for the necessary funding to buy the home. It will also show you the potential loan terms and amount.
6. Complete the full application: Once you’ve put in an offer that’s accepted, you know how much you officially need for a mortgage. Submit your lender’s application and the requested financial documents (e.g. tax returns, pay stubs, asset documents).
7. Close on your home: Once approved for your mortgage, you can get through the rest of the closing process. You’ll make your down payment, pay closing costs, and sign your loan agreement. After you get your keys, you’ll start making monthly payments.

Mortgage FAQ

Why do I need a mortgage?

Mortgages help non-cash buyers secure housing. If you’re interested in buying a home and don’t have the savings to cover the entire cost in cash, you need to take out a mortgage to make the process more affordable.

What credit score do I need to qualify for a mortgage?

To qualify for a mortgage, you need to meet the credit score requirements set forth by your lender or loan program. Here are common credit requirements:

• FHA: 500
• USDA: 640
• Conventional: 620 - 640
• VA: None

What is the minimum down payment required for a mortgage?

The minimum down payment required for a mortgage varies. For instance, FHA loans require a minimum of 3.5% down while USDA loans require no down payment at all. Check with your loan officer to determine the amount you should put down.

Also know that if you put less than 20% down for conventional loans, you’ll probably have to pay mortgage insurance that protects the lender if you stop making payments.

How can I get the lowest mortgage rate?

To get the lowest mortgage rate, start by comparison shopping with multiple lenders. Each will evaluate your credit and financial profile a little differently, and one may offer better rates than the others. In addition, focus on raising your credit score as much as possible, as this is a key factor in determining your interest rate.