How does a mortgage work?

88% of Americans take out a mortgage to help them achieve their homeownership goals. Even though mortgages are common, they can be confusing for first-time home buyers and seasoned homeowners alike.

What is a mortgage?

A mortgage, also known as a home loan, is a type of loan used to finance the purchase of real estate. Like other varieties of loans, a lender will advance the borrower a predetermined sum with the property as collateral. In exchange, the borrower agrees to pay the lender in installments until the loan is paid off or they decide to sell the home.

The mortgage process

To obtain a mortgage, borrowers must go through an application process. During this process, lenders will review the borrower’s financial health to confirm that they can repay the loan. Borrowers will have to submit evidence of income, tax returns, investment statements, and other documents. Lenders generally conduct a credit check and review debt-to-income ratios, too.

Once an application is approved, the lender will grant the borrower a letter of preapproval. This letter details the tentative amount the lender is willing to lend you and is generally valid for 60 to 90 days. It gives house hunters, and their real estate agent, a clear idea of their purchasing power and can help determine a realistic budget.

After prospective homebuyers find their dream home, put an offer in, and have it accepted, they will enter closing. During this phase of the mortgage process, the lender will finalize the mortgage in a process known as underwriting. It’s the last step of the loan application process, where a risk-evaluation expert has the final say as to whether or not a borrower qualifies for a mortgage.

Once they are approved, the borrower will make the following upfront payments to the lender before the seller transfers ownership of the home:

Down payment

A down payment is the portion of your home’s purchase price that you pay out of pocket. The minimum down amount will depend on your home buying scenario, your mortgage type, and your lender's requirements

You might have heard that a 20% down payment is the gold standard, but for people with strong credit and a steady income, a down loan payment as low as 3% to 5% may also be an option. But a higher down payment means a lower principal, which means paying less in interest over the lifespan of your mortgage. If you can make a higher down payment, it’s something to consider.

Wondering how much house you can afford? Use a mortgage calculator to find out.

Closing costs

In addition to your down payment, you’ll also need to cover the upfront fees associated with the home purchase. As the buyer, you’ll typically cover costs including:

• Appraisal and inspection fees
• Prepaid interest, homeowners insurance, and property taxes
• Lender origination/application fees
• Lender points, if applicable (paid to your lender in exchange for a lower rate)
• Lender’s title insurance and related fees
• Government recording and transfer charges
• HOA transfer fees and dues, if applicable

Tip: It’s common for buyers to ask the seller to cover some of their closing costs – this is called a “seller concession” or “a credit toward closing costs.”

Types of mortgages

Home loans come in many different forms. The most common ones are 30-year fixed and 15-year fixed rate mortgages, but some can be shorter or longer. Here are the most popular types:

Fixed-rate mortgage

The interest rate of fixed-rate mortgages remains the same for the loan’s lifetime, as do the borrower’s monthly payments towards the mortgage. Fixed-rate mortgages are considered standard.

Adjustable-rate mortgage (ARM)

Adjustable-rate mortgages offer variable interest rates over the loan term. Typically, the interest rate is fixed for an initial period, after which the rates change periodically based on the prevailing rates of the time. While these mortgages typically offer lower rates than fixed-rate mortgages, they can become unaffordable in the long term if rates rise substantially.

Interest-only mortgage

The repayment plan for interest-only mortgages is broken into two stages: In the first stage, the borrower makes payments only towards the accrued interest. In the second, the borrower makes payments towards the principal and interest. These mortgages can be more affordable with lower monthly payments during the first stage of repayment, but may become unaffordable during the second stage if homeowners aren’t careful.

Jumbo loan

Jumbo loans are for a greater amount than the conforming loan limits dictated by the Federal Housing Finance Agency (FHFA). They typically carry higher interest rates — around one or two percentage points — than conforming loans and require better credit scores and higher down payment.

Conventional mortgage

These loans are not offered through a government program and are the most common type of mortgage. Their eligibility criteria are more flexible than their government-backed counterparts, but they do  

Government-backed loans

These loans are insured by the government with the aim of making homeownership more affordable and attainable for borrowers who otherwise wouldn’t qualify for a conventional mortgage.

• FHA loan: These loans are backed by the Federal Housing Administration but are offered through private lenders. They are designed to help those who might not otherwise qualify for a loan obtain a mortgage and are particularly good for first-time homeowners.
• VA loan: The Department of Veterans Affairs guarantees VA loans for eligible current and former members of the U.S. Armed Services. They typically carry a lower interest rate and closing costs than conventional loans.
• USDA loan: The United States Department of Agriculture backs these mortgages for borrowers buying a home in a rural area with a moderate or low income. 

Learn more about the different types of mortgages here.

What's included in a mortgage payment?

Your mortgage payment has four main components, commonly known as “PITI.” This stands for the principal, interest, taxes, and insurance.

Principal

This is the amount you borrowed from your lender to purchase your home. For example, if you purchased a $450,000 home with a 20% down payment of $90,000, the principal amount of your mortgage would be $360,000.

The interest you pay on your loan is determined by the principal amount. Your first payments will pay down the accrued interest and the principal. However, paying down the principal is the only way to reduce the interest that accrues each month.

→ Find out when your first mortgage payment is due

Interest

Borrowing money comes at a cost: that cost is typically charged as interest. This fee is generally expressed as a percentage and is determined by market factors as well as the circumstances of the borrower. Interest accrues each month, and the borrower's monthly payments will apply to the interest first and then the principal. Fortunately for homebuyers, a certain amount of mortgage interest is tax-deductible.

Historically, interest rates for home loans have varied drastically — with an all-time high of over 18% in 1981 and lows nearing 2.5% in 2021 for 30-year fixed-rate mortgages.

Learn more about what affects mortgage rates here.

Property taxes

Property taxes are typically lumped into your mortgage payment, which your lender puts into an escrow account before paying off your property tax bill when taxes are due.

Your property tax rate will depend on where your home is located. Hawaii has the lowest property tax rate of just 0.28%, while New Jersey has the highest at 2.49%. Property taxes are often used by local governments to support schools, public safety, and infrastructure.

Homeowners insurance

Most lenders require homebuyers to acquire property insurance. After all, your home is collateral for the home loan. The monthly fee for homeowners insurance is included in your monthly mortgage payment 

Mortgage insurance

If your down payment was less than 20%, your lender may require you to get private mortgage insurance (PMI). While the borrower is required to purchase the policy, it protects the lender’s investment. PMI usually costs from 0.5% to 2% of the loan balance annually, and borrowers will have to pay until they’ve accumulated at least 20% equity in the home. 

How do I qualify for a mortgage?

When you apply for a mortgage, your lender will look at your finances to ensure that you’re buying a home that you can afford both now and in the future. To do so, they’ll typically request financial documents, like your tax returns and bank statements, as part of your application. Here are some of the things they’ll be looking for:

Loan-eligible income

Your lender will use your tax documents to understand your various sources of income so they can calculate how much of that income can be used for your mortgage. They’ll also be looking to see that your income is stable and likely to continue into the future.

Debt-to-income ratio (DTI)

Your DTI helps lenders understand how much you can afford to pay for a mortgage each month given your existing monthly debt payments. The maximum DTI allowed can vary, but borrowers are typically accepted with a DTI below 35 percent.

To calculate your DTI, add up your monthly debt once you have your new home (e.g., any monthly payments for student loans, car loans, credit card bills, etc. plus your future mortgage payment) and divide it by your gross monthly income (i.e., how much money you earn before taxes).

Credit score

Your credit score gives your lender an idea of your previous borrowing history. You’ll need to meet a minimum credit score requirement to qualify for your mortgage. That being said, a higher credit score is usually better since it can help you qualify for lower mortgage rates.

→ Learn more about how to qualify for a mortgage

How do I find the best mortgage?

The first step to finding the best mortgage is to learn about all of the components of a mortgage and the process for applying for one. With this knowledge in hand, you'll be better able to understand the terms of the loan and implications of those terms on your financial health.

Once you've done so, shop around at different lenders. Review their preapproval letters to assess which might be the best match for you. And remember, just because you obtain preapproval for a loan doesn't mean taking out the maximum amount is the best option.