A mortgage is essentially a loan specifically designed for the purpose of purchasing real estate. When you take out a mortgage, a lender provides you with the money you need to buy a home. In return, you agree to pay back the loan over a set period of time — usually 15 to 30 years — along with interest.
The home itself serves as collateral for the loan, which means if you fail to make your mortgage payments, the lender can foreclose on the home (in other words, take it back) to recoup their money.
How does a mortgage work?
When a buyer enters into a contract to buy a home but cannot — or does not want to — pay cash, a lender will provide a mortgage to finance the purchase.
The lender completes a process called underwriting.
During underwriting, the lender is confirming two things. First, they want to ensure the buyer is financially able to repay the loan. Second, they want to ensure the value of the property to be purchased is greater than the loan amount. To do this, the lender will obtain an appraisal of the property from a professional third-party appraiser.
If everything is in order, the lender approves the loan and tells the buyer they are “clear to close”. At the real estate closing, the buyer signs a contract, called a mortgage note, agreeing to make the agreed upon monthly payments and acknowledging the bank’s right to foreclose on the home if they do not pay.
The mortgage note is filed with a government office known as a registry of deeds. The mortgage note puts a lien on the house that affirms the lender’s legal interest in the property until the mortgage is repaid. After the paperwork is complete, the lender transfers the proceeds of the loan to the seller and the transaction is complete.
Going forward, the buyer will make monthly mortgage payments to the lender. Mortgage payments may include several things:
- Principal: The original sum of money borrowed from the lender.
- Interest: The cost of borrowing that money, expressed as an annual percentage rate (APR).
- Property taxes: An annual tax equal to a percentage of the appraised value of your home.
- Homeowner’s insurance: Insurance against fire, theft, storm damage and other threats to your property.
- Private mortgage insurance (PMI): Insurance to protect the lender if the property value falls below the loan amount. PMI is often required when borrowing more than 80% of the home’s appraised value.
Often, mortgage lenders include tax and insurance amounts in the monthly mortgage payment. The lender collects these funds on a monthly basis and holds the money in an escrow until the tax and insurance bills are due. Lenders do this because, legally, they own the house until the mortgage is paid off. If the homeowner’s insurance bill isn’t paid and the house burns down, it’s the lender who will suffer the greatest financial loss, not the homeowner. The same goes if property taxes aren’t paid and the city can foreclose on the home.
As the borrower repays the mortgage, they can — at any time — pay additional amounts to reduce their balance. They can also pay off the entire mortgage early with no penalty. Homeowners may also want to refinance their mortgage if interest rates drop. Even a 1% difference in your mortgage interest rate can add up to tens of thousands of dollars in additional interest payments. To refinance, the homeowner simply applies for a new mortgage and uses the proceeds of the new mortgage to pay off the old one.
When a homeowner finally pays off the last mortgage on a property, the lender will file a discharge with the registry of deeds that releases their legal interest in the property. The homeowner now owns their house free and clear.
Types of mortgages
There are two primary categories of mortgages: Fixed-rate mortgages and adjustable rate mortgages (ARMs).
- Fixed-rate mortgages: The interest rate remains the same for the entirety of the loan, making monthly payments predictable. It’s common for fixed-rate mortgages to have terms of either 15 or 30 years.
- Adjustable-rate mortgages (ARMs): The interest rate can change at specified times, which means monthly payments can go up or down. Most ARMs begin with a fixed rate for between 3 and 10 years.
All mortgages will be either fixed-rate or adjustable, but there are other types of mortgages for specific situations.
A conventional mortgage is a loan that is not insured or guaranteed by the Federal Government. Mortgages that are not considered conventional include FHA loans, which are insured by the Federal Housing Administration (FHA) or VA loans, insured by the Department of Veterans Affairs (VA). FHA and VA loans make it easier for qualifying home buyers to get approved for a mortgage by reducing the financial requirements including, most helpfully, the required down payment amount.
Conventional mortgages are sub-divided into two types: conforming and non-conforming.
Conforming mortgages are a subset of conventional mortgages that meet the specific funding criteria set by Fannie Mae and Freddie Mac. (Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that buy mortgages from lenders and sell them to investors.) One of the most important criteria is the loan amount. For 2023, the baseline conforming loan limit for a single-family home in most of the United States is $726,200, with higher limits in areas with expensive housing markets. Conforming loans must also meet other guidelines related to the borrower’s credit score, debt-to-income ratio, and the loan-to-value ratio.
Non-conforming mortgages do not meet standards set by the Federal Housing Finance Agency (FHFA), Freddie Mac, and/or Fannie Mae. Jumbo loans are a type of non-conforming loan used to buy properties more expensive than the conforming loan limit. Jumbo loans have higher interest rates and eligibility requirements than conforming mortgages.
Understanding mortgage rates
Mortgage rates vary based on the economic climate, your credit score, down payment size, loan type, and loan term.
Your mortgage rate makes a big difference in how much you’ll pay to purchase your home. For example, between 2020 and 2023 the average mortgage rate rose from around 4% to nearly 8%. For a $200,000 30-year mortgage — before taxes and insurance — you would pay:
- $1,468 a month at 8%
- $955 a month at 4%
That’s an amazing $513 per month difference. Over the life of the 30-year loan you would end up paying an additional $184,680 in interest at 8% compared to at 4%. Put another way, at a 4% APR the monthly payment on a $308,000 mortgage would be roughly the same as the monthly payment on a $200,000 mortgage at 8% APR.
You can use our mortgage calculator to see more examples of how interest rates change how much you pay and how much house you can afford.
It’s crucial to shop around and compare rates from multiple lenders to find the best deal. Read more about how your credit score affects mortgage rates.
Pre-approval vs pre-qualification
There’s a difference between mortgage pre-approval and pre-qualification:
- Pre-qualification is a quick assessment of your ability to afford a mortgage, usually based on self-reported financial information.
- Pre-approval is more involved and requires documentation of your financial history and credit rating. It gives you a better idea of the loan amount you might qualify for. A pre-approval is often required prior to going under contract to satisfy the seller that you will be able to obtain financing.
Down payment
A down payment is the upfront cash payment you make to buy a home.
While 20% is often cited as the standard down payment for conventional mortgages, many lenders offer loans that require as little as 3% down for first-time homebuyers.
Saving a 20% down payment is no easy task. At the end of 2023, the median home price in the United States was $417,700. That would require a 20% down payment of $83,540. A lower down payment can make it possible to buy a home much sooner, but comes with additional costs. Your interest rate may be higher and you will have to pay private mortgage insurance (PMI) until the loan-to-value ratio is less than 80%.
Mortgage points
Also known as discount points, mortgage points are, essentially, pre-paid interest. Points are fees paid directly to the lender at closing in exchange for a reduced interest rate.
If you plan on staying in your home — and keeping your original mortgage — for a long time, buying mortgage points can save you money. Buying points would not make sense — and could be more costly — if you sell your house or pay off your mortgage after only a few years.
Closing costs
Closing costs are fees and expenses you pay to finalize the mortgage and real estate transaction. They can range between 2% to 5% of the loan amount and can include appraisal fees, credit check fees, title searches, title insurance, and attorney fees.
Before shopping for a mortgage
- Check your credit score: A higher credit score can help you get a lower interest rate.
- Determine your budget: Use a mortgage calculator to estimate your monthly payments and how much you can afford.
- Save for a down payment: The larger your down payment, the less you’ll need to borrow.
- Gather financial documents: You’ll need to provide information about your income, assets, and debts.
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