The Basics of Home Loans and Mortgages: A Guide for Beginners

If you're shopping for a house, you'll probably need to get a home loan. The average home sells for hundreds of thousands of dollars, which is more than most people have in cash. Getting a home loan allows you to buy a property, put money down for only a small portion of its price upfront, and pay for the rest over several years while you're enjoying your new home.

Taking out a home loan, or mortgage, is a long-term financial commitment. So before you apply, it's a good idea to become familiar with how mortgages work, the process you go through to get one and the different types of mortgages you might choose from.

Here's a guide to the basics.

What is a home loan or mortgage?

The terms "home loan" and "mortgage" mean essentially the same thing. A home loan is a loan you take out to buy a house or to pay off a loan you previously used to buy a house. A mortgage is a loan for which a home is collateral — meaning that if you don't pay the loan back, the lender has a legal claim to the property. 

Home loans are also mortgages because generally, any lender that finances a home purchase is going to want collateral so they're protected in case the borrower doesn't repay the loan.

What are the costs of a home loan?

When you take out a home loan, you're borrowing money from a lender and agreeing to make monthly payments for a certain number of years. A few different costs are combined in your mortgage payments.

You also pay some one-time costs when you sign the loan. Let’s walk through those so you know what to expect: 

Monthly payments

Part of your monthly payments pays down your “principal,” which is the amount of money you borrowed. Your payments also cover interest, which is like a price you pay for borrowing money. Interest can be a larger or smaller chunk of a payment at different times, depending on where you are in paying off your loan.

If you owe mortgage insurance, it's included in your payment. If your loan is part of a government program that charges fees or premiums each year, your payments cover those expenses, too.

Also, you usually pay homeowners' insurance and property taxes as part of your mortgage payments. 

Closing costs

Closing on a home loan is when you finalize your loan and borrow money from the lender. It usually happens along with closing on the sale of the home, which is when you finish buying the property and become the new owner. At the loan closing, you pay taxes and fees to the government. You also pay fees to some service providers like appraisers. And you pay origination fees and other fees to the lender.

You can opt to pay your lender points, which are upfront fees that are each worth 1% of the value of your loan. Your lender lowers your interest rate by a designated amount for each point you pay when you close on the loan.

No closing cost loans

Some lenders offer no closing cost loans. These arrangements usually come with the same costs as other loans, just charged in different ways. For example, the size of your loan might go up by the amount you would have paid in closing costs, or the lender might charge you a higher interest rate. Although the costs add up to the same amount, you don't have to pay them all at once when you take out the loan. That could be helpful if you don't have much in savings and don't want to postpone buying a home until you have more cash.

What types of home loans are available?

There are a few different kinds of home loans. The features of the loan and the eligibility criteria can vary depending on which type of loan you're applying for.

Conventional loans

Conventional home loans are mortgages that aren't offered through a government program. Most mortgages are conventional, so there's a good chance you'll look at this kind of loan as you explore your options. Conventional loans can be either conforming or non-conforming.

Conforming loans

Conforming loans meet standards required by Fannie Mae and Freddie Mac, the companies run by the U.S. government that purchase mortgages from lenders. When Fannie Mae and Freddie Mac buy mortgages, they make it less risky for lenders to offer home loans. As a result, lenders may offer better interest rates or give borrowers more time to pay back mortgages.

A conforming loan is often less expensive than a non-conforming loan, and it might not require as high a down payment. Plus, you get the assurance that your loan doesn't come with any iffy arrangements — like the possibility that the amount you owe could get bigger even while you pay it off — that might make it hard to pay back what you owe.

A conforming loan can't be larger than the conforming loan limit for the county where the home is located. There's a baseline conforming loan limit that applies to most of the U.S., and there are higher limits for homes in Alaska, Hawai’i, Guam, the U.S. Virgin Islands and some counties in the mainland U.S. where housing prices are high. The Federal Housing Finance Agency updates these limits once a year.

If the down payment on a conforming loan is less than 20%, you usually have to pay for private mortgage insurance. This insurance is for the benefit of the lender and reduces their risk if you miss mortgage payments. 

To be approved for a conforming loan, you need to have sufficient earnings, a qualifying credit score, and an acceptable debt-to-income ratio, which shows how much you pay on debts like student loans, credit cards, and your mortgage each month compared with your income.

There are rules about how a conforming loan amortizes, which means that your mortgage payments follow a regular schedule and reduce the amount you owe over time.

Non-conforming loans

Conventional loans that don't adhere to the conforming loan regulations are called non-conforming. A loan might fall under this category because it's larger than the conforming loan limit, in which case it's known as a jumbo loan. 

A loan can also be non-conforming if it's below the conforming loan limit but doesn't follow the other rules for conforming loans. For example, a lender might approve you for this type of mortgage even if you have too much debt for a conforming loan or if you have bad credit. 

It may be easier to qualify for a non-conforming loan, but this kind of loan can be risky and is often more expensive.

FHA loans

FHA loans are backed by the Federal Housing Administration and offered by lenders that the FHA has approved. Down payment requirements start at 3.5%, which can make these loans an attractive option for homebuyers who don't have a large amount of cash saved up. 

Borrowers have to pay mortgage insurance through an upfront payment and an annual premium. 

To be eligible for an FHA loan, a home has to meet standards for safety and quality set by the Department of Housing and Urban Development. And there's a limit for how large the loan can be that depends on where the house is located.

If your credit score is low, you might be able to get an FHA loan even if other lenders have turned you down. But you'll still need to demonstrate that you have enough income to repay the loan.

Many lenders have their own requirements for FHA loans on top of the basic eligibility criteria, so to find out if you're eligible for this type of loan, you'll need to ask some lenders. But you can get guidance on whether you have a good chance of qualifying and what kinds of homes meet the standards by talking to a Department of Housing and Urban Development-approved housing counselor.

USDA loans

Like the FHA, the USDA guarantees loans that are offered by private lenders. This means that the USDA doesn’t extend you the loan itself, but encourages those private lenders to lend to you. USDA loans are for homebuyers with limited income who are buying property in a qualifying rural area.

These mortgages have strict eligibility criteria. Your household income can't be more than 115% of the median income, and you have to be unable to get a conventional loan without private mortgage insurance. 

But there's no minimum credit score requirement set by the USDA, and you don't even need a traditional credit score if you can provide other evidence that you're responsible with money — like a good track record paying your rent and utilities or steadily adding to a savings account. If you qualify, you don't have to make a down payment.  

Borrowers don't have to pay mortgage insurance, but there are annual fees.

The USDA also has a separate program lending money to homebuyers directly. You may be eligible if you have low income and don't otherwise have access to housing. Typically, no down payment or mortgage insurance is required. And this program offers subsidies that can bring the interest rate borrowers are charged down to just 1%.

VA loans

The Department of Veterans Affairs guarantees mortgages offered by private lenders to veterans and members of the military. To qualify, you'll need a Certificate of Eligibility from the VA showing that you're a veteran or a member of the Armed Forces, Reserves or National Guard, that you haven't been dishonorably discharged, and that you meet requirements for length of service. Some surviving spouses are eligible, too.

VA loans offer favorable interest rates and low closing costs, and they don't usually require a down payment if you're borrowing up to the conforming loan limit. You owe a funding fee when you get the loan, but you aren't charged any mortgage insurance premiums. You can also use a VA loan to buy a home more than once.

The VA also lends to some homebuyers directly through its Native American Direct Loan program.

How does the mortgage process work?

There are a few steps to getting a mortgage, starting with taking stock of your finances. You’ll also seek preapproval for your loan, shop for the best rates, and eventually close on the best deal. And after you close on your mortgage, you might have a chance to get a better loan at some time down the road through a process called refinancing.

1. Create a budget

First, you'll want to get an idea of how large a loan to shop for. It's usually recommended that your mortgage payment be no more than 25% of your monthly income before taxes. This often translates to a loan that's about two or three times as large as your annual earnings.

You should also see how much you can spend on a down payment. And it's smart to check your credit report at this stage to make sure everything is accurate before lenders take a look at it.

2. Get preapproved

Next, you can apply for preapproval from several lenders. This involves filling out an application and sharing some information about your income, assets and how large of a loan you're seeking. 

Preapproval doesn't guarantee you'll be approved for a particular loan, but it can give you a pretty good idea of which loans you'll qualify for and can help you plan.

If a lender preapproves you, you'll get a document estimating how much you might be able to borrow and what interest rate you'll likely be charged. 

3. Choose a loan

Now that you have an idea of what you can afford, you can find a home within your budget and make an offer to the seller. If the seller accepts your offer, you need to decide on a loan. 

Home loans are not all the same — they come with different features and costs, so it's important to shop around and select a loan that's a good fit for you.

Shopping for a loan

Go back to the lenders that preapproved you and ask for loan estimates. These documents summarize the basic information about a loan and allow you to compare your options.

As you're reading loan estimates, pay attention to these details:

• The annual percentage rate (APR): This figure shows how much the loan costs on a yearly basis. It includes interest and other expenses, like fees. Because APR includes all loan costs, it’s a better way to do an apples-to-apples comparison of loan prices than just looking at the interest rate. 
• Whether the interest rate can change: If you have a fixed-rate mortgage, you're charged the same interest rate over the life of the loan. With an adjustable-rate mortgage, your interest rate can vary over time, and you might owe larger payments if the rate goes up.
• The length of the loan, or “loan term”: It's common for a mortgage to be 15 or 30 years, but other terms are possible. With a longer loan, you might pay less each month, but you're usually charged a higher interest rate and the total cost of the loan is often higher as well.
• Whether the rate is locked in: When a lender offers a rate lock, it's agreeing to give you the offered rate if you close on the loan by a deadline that's usually one or two months out. If you don't have a rate lock or if you miss the deadline, the rate could go up by the time you take out the mortgage.
  

Once you select a loan, you can complete a formal application. You'll show your lender pay stubs, tax returns, and other documents. If you're approved, you can close on the mortgage and buy your new home.

4. Close on the loan

At this stage, you and the lender sign paperwork to finalize your loan, you pay closing costs, and you make a down payment, which is the part of the home's price that you're paying out of pocket when you close on your home purchase. After closing on both your mortgage and the sale of the property, which usually happen together, you now own your new home.

5. Pay off your loan

Once you’ve taken out your loan, you'll receive statements each month and make payments to your loan servicer. A loan servicer collects your payments, keeps track of how much you owe, and responds to any questions you have about your loan. Your lender could act as the loan servicer, or the servicer might be a different company that the lender chose. 

As you pay off your mortgage, you build equity in your home. Equity is the difference between your home's value and what you still owe on your home loan. When you have enough equity, you have the option to take out a home equity loan or open a home equity line of credit to borrow against your equity.

6. Decide if you want to refinance

After you've been making payments on your home loan for some time, you might choose to refinance. Refinancing means taking out a new home loan and using it to pay off your previous mortgage all at once. You then make payments on the new loan.

You might be able to get a better interest rate or a lower monthly payment by refinancing, especially if your credit has improved since you took out your original loan or if rates have gone down. But it's often not worth it to refinance if you're nearly finished paying off your home or if you plan to move soon, so don’t rush to refinance if you don’t need to. 

What should you do if your mortgage becomes unaffordable?

If you think you're going to fall behind on payments, get in touch with your mortgage servicer to let them know what's going on. It's also a good idea to meet with a Department of Housing and Urban Development-approved counselor or to call the HOPE™ Hotline at (888) 995-HOPE to get help with the next steps.

Depending on your situation, your lender might offer forbearance, which gives you a short-term break from mortgage payments while you cope with a temporary hardship. Other possible solutions are to change the terms of your loan so that it's affordable for you or to refinance with a more manageable loan.

What happens to your mortgage when you move?

When you sell your home, the money that the buyer pays covers the costs of closing the sale and pays off what you still owe on your mortgage, plus any fee you might be charged for paying off the mortgage ahead of schedule, also known as a prepayment penalty. If you also have a home equity loan or home equity line of credit, that's paid off with the money that remains. Then, the money that's left over after these debts are taken care of goes to you.

When you're getting ready to sell, you can ask your loan servicer for a payoff quote that tells you how much it will cost to pay off the mortgage. 

Mortgages can be complex, but it’s worth digging into the details to make sure you’re choosing the loan that’s best for you. Now that you’ve got the basics, you can continue learning about the different kinds of home loans or get started on an application.