If you’re planning to buy a property in the near future, it’s essential that you understand what a mortgage is. This short guide covers everything you need to know about mortgages: what they are, how they work, and how to increase your chances of getting approved with favorable terms.
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What is a mortgage?
Let’s start with the basics: a mortgage is a secured loan used to buy a house, land, or any other property.
When you take out a mortgage, a bank loans you money to buy a particular property. In return, you must repay the loan with any added interest, typically over the course of 15 or 30 years. The property itself serves as collateral for the loan, meaning the lender could take the property away if you, the borrower, fail to make timely payments (default).
How does a mortgage work?
A mortgage allows potential homebuyers to acquire real estate without paying the full amount upfront. Instead, a borrower will usually pay a down payment at the start, and then repay the principal and added interest over time.
Here’s a basic breakdown of the main mortgage elements:
- Down payment: This is a portion of the home’s price that the borrower pays up front (usually 3–20%). Some mortgage loans don’t require a down payment.
- Principal: This is the amount being financed (or borrowed) to cover the rest of the property’s price. Note that this doesn’t include any interest or fees. For example, if the cost of your home is $400,000 and you put down $100,000, the principal will be $300,000.
- Interest: This is the cost of borrowing money from the bank, counted as an annual percentage of the loan balance. Interest depends on the type of loan, its amount, the real estate market and overall economic conditions, and your financial situation (e.g., credit score).
- Monthly payments: This is the amount the borrower has to pay each month for the life of the loan. This payment, which may fluctuate or be fixed, covers principal, interest, and other expenses, such as property taxes and homeowners insurance.
Each payment reduces your debt and increases the portion of the property you actually own, also called equity.
What do lenders assess to approve a mortgage?
When lenders decide whether you qualify for a mortgage and under what terms, they evaluate various items. Here are some key factors to keep in mind:
- Credit score: As a general rule, the higher your credit score, the better your interest rate may be (and the more you’ll be approved for). Different lenders and loans have varying requirements, but you’ll typically need a credit score of at least 620 to apply for a conventional mortgage.[1]
- Debt-to-income (DTI) ratio: This figure compares your monthly debt payments to your gross monthly income. For example, if your gross monthly income is $5,000 and your debt payments are $2,000, your DTI ratio is 40%. It’s difficult to qualify for any mortgage with a DTI ratio higher than 50%; the lower this number, the better your loan terms.[2]
- Financial stability: Lenders will assess whether you can make monthly payments consistently, so your income and employment will be scrutinized.
- Down payment: A larger down payment can potentially result in lower interest rates and reduce your monthly payments. What’s more, those putting down at least 20% can avoid paying private mortgage insurance (PMI) required for many loans, lowering the overall monthly payments due.
- Additional assets: Lenders will likely evaluate your assets, such as savings, stocks, and retirement accounts, to ensure you have a financial cushion in case of emergency.
What are the common types of mortgages?
Multiple types of mortgages exist to suit the needs of different borrowers and circumstances. Here’s a quick overview of the most popular types of home loans you’ll likely encounter when shopping around for a mortgage.
Government-backed mortgages
These types of loans are available from many large banks or well-known lenders but are insured by federal agencies. The goal of these loans is to make homeownership more accessible for regular Americans. For this reason, they come with lower credit score and down payment requirements, as well as more relaxed qualification criteria. The three main types of government-backed loans include:
- FHA (Federal Housing Administration) loan: Favored by many first-time homebuyers, these mortgages come with a low down payment (3.5% with a credit score of 580 or higher).[3] However, it’s available for borrowers with credit scores as low as 500.
- VA loan: Available to eligible veterans and active-duty members, this loan doesn’t require a down payment and comes with better terms and interest rates than many other loans.[4]
- USDA loan: Designated for low- and moderate-income buyers in rural areas, it comes with no down payment necessary, flexible credit score requirements, and lower interest rates.[5]
Conventional loans
Conventional loans are all other loans that are not insured by government agencies. Typically, they require a credit score of at least 620 and a minimum down payment of 3% (some lenders may require 5% or more).
Fixed-rate mortgages
A fixed-rate mortgage is a loan in which the interest rate stays the same throughout the entire life of a loan. This type of loan offers more stability for the borrower, but it may come with higher initial interest rates than adjustable-rate mortgages (ARMs).
Adjustable-rate mortgages
ARMs usually start with a fixed initial interest rate; however, after the introductory period ends, the interest rate will adjust periodically (every half year to a year). This type of loan requires a higher down payment but typically comes with lower payments during the initial period.
What to look for when comparing mortgages?
As you try to decide which type of loan is right for you, these are the essential aspects to consider:
- Interest rate: The basic cost of borrowing from a lender, typically measured as a percentage.
- Annual percentage rate (APR): The total cost of your loan per year, which includes interest as well as fees that come with the loan. This number will give you a better understanding of the overall mortgage cost.
- Term length: A mortgage can range from 10 to 30 years, with the most common options being 15 and 30 years. Short-term loans have lower overall costs but come with higher monthly payments.
- Expected homeownership timeline: Consider how long you’re planning to stay in the property. For example, many borrowers find that ARMs work out better financially if they plan to sell a few years after purchase.
- Lender’s reputation: With numerous lenders to choose from, do your research, check online reviews, and opt for a trustworthy, reliable option (e.g., national bank).
💡Pro tip: You can negotiate with lenders to get the best terms for your mortgage. Compare a few lenders and their offered terms and consider asking your preferred lender to match their competitor’s quote.
What happens if I fail to pay my mortgage?
The consequences of failing to pay your mortgage (defaulting on your loan) include late fees, a possible decrease in your credit score, and even foreclosure. There may also be potential issues with buying your next home.
Most mortgages have a 15-day grace period, after which a lender can charge a late fee and send a reminder letter. If you miss three or four payments in a row, the lender could start a pre-foreclosure process.
First, they typically send a notice of default, which outlines the instructions on how to reinstate your loan. If no action is taken, the home goes into foreclosure, where a lender can take possession of the property and sell it to cover the debt owed to them.
Can I pay off my mortgage early?
In most cases, you can pay your mortgage off earlier. However, check your specific loan terms to see if there are any restrictions or penalties.
Most conventional loans come with a prepayment penalty, which is supposed to offset the loss of interest a lender would otherwise collect. Also, many states limit the amount and duration of prepayment penalties—usually, they can apply only in the first few years of your loan’s life.
Final take: Get a good agent on your side before you apply for a mortgage
Mortgages are inevitable for most buyers. For many people, they’re the only way to make their dream of homeownership a reality. So, it’s essential to understand the basics of mortgages to make sure you choose the best option.
If you’re only starting your homebuyer’s journey, you’ll need a strong team by your side to help you navigate the real estate world and its many complicated concepts. A knowledgeable real estate agent can assist you throughout the process, from helping to choose your future home to preparing documents for closing. Get started with a top-rated Clever agent near you.