Takeaways
- Mortgages are loans issued by lenders to support buying a home and other real estate.
- The total cost of your mortgage depends on your terms, interest rate, and fees.
- Mortgages are secured by your house and property, which act as collateral for the loan.
- The most common terms for mortgages are 30-year and 15-year terms.
- Mortgage rates change regularly based on prevailing market interest rates.
What is a Mortgage?
A mortgage is a loan used by borrowers to purchase a house, property, or other real estate. What makes a mortgage unique is that it uses your home as collateral, which means that the bank or financial institution lending you capital can take possession of the house if you fail to make mortgage payments. Mortgages often describe the document you sign stating the total selling price of your home, the principal amount of the loan, the agreed-upon interest rate, and the length of the loan or term.
Smart Money -> 9 Steps to Quickly Save for A Down Payment
You must apply with a bank or other financial institution to secure a mortgage. These mortgage lenders assess your creditworthiness and financial health. Securing a mortgage for your house can take several weeks or even months. Your relationship with a mortgage provider often starts with a pre-approval letter, which you take when you go house shopping. The relationship ends when you finally pay off your mortgage. Mortgages take on many forms and favors based on your needs, financial resources, and affiliations (more on that below).
How a Mortgage Works
You can use a mortgage to purchase a house or real estate property without having to fund the entire purchase price with cash. Most houses are bought using a combination of cash (down payment) and debt (mortgage). Mortgages inject credit into the housing system, allowing buyers and sellers to purchase or sell a house quickly. Mortgages are the backbone of the real estate industry.
Smart Money -> Need a Budget? Try the 50/30/20 Budget and Calculator
When you take out a mortgage, you agree to repay the principal balance plus interest over the life of the loan. Once you finish the mortgage payment schedule, you own your house outright. Of course, in today’s economy, most people move frequently, buying and selling multiple houses. If you are a first-time homebuyer, the hardest part of buying a home is usually coming up with the down payment (the cash part of the transaction). However, once you own your home and accrue home equity, you can roll that equity into your next purchase.
Smart Money -> Best High-Yield Online Savings Accounts
Common Mortgage Terminology
Mortgage terminology can seem complicated because of the unique vocabulary applied to specialized financial products. These specific terms, however, describe familiar words. Let's look at what we mean. Here are some fundamental terms you might encounter when you deal with a mortgage provider.
Principal: Your initial principal is the purchase price of the home minus your down payment. As you pay down your mortgage over time, part of your mortgage payment goes toward reducing the principal balance.
Interest Rate: Mortgage interest rates are locked during the closing process. For fixed-rate mortgages, the interest rate you qualify for stays constant over the term of the mortgage unless you recast your mortgage with a new interest rate or refinance your mortgage. Interest rates can be fixed or variable depending on the type of mortgage you secure. The interest rate determines how much interest you pay on your original loan amount for the life of the mortgage. Adjusting the interest rate by only a couple of percentage points affects home affordability tremendously.
Term: The term of your mortgage is the length of time you must repay your principal in full. Based on your loan’s amortization schedule, which shows the number of payments over the life of your loan and the monthly principal and interest amount, you will have no more mortgage payments at the end of the term. The most popular terms for fixed-rate mortgages include the 30-year fixed-rate mortgage and 15-year fixed-rate mortgage.
Down Payment: A down payment is the amount of cash the lender requires you to pay in conjunction with the purchase of a house. Depending on your credit background, the down payment for conventional loans usually ranges from 3%-20%. However, if you do not pay 20% down, you will likely have to pay private mortgage insurance (PMI).
Closing Costs: Have you heard of the 2% rule? Financial advisors and real estate agents want their clients to plan for closing costs between 2-6% of the sale price of the home. Closing costs commonly include appraisal fees, home inspection feeds, and legal fees. You pay these fees to your mortgage lender or bank to officially close your home.
Property Taxes: Do you live in a state with no property taxes? Unfortunately, there are no U.S. states without a property tax. Property tax rates vary by state but are generally a percentage of your home’s appraised or assessed value. These are annual taxes you must pay to be in good standing, and most mortgage providers will want you to pay your local property taxes as part of your mortgage payment.
Escrow: Speaking of property taxes, most bank and mortgage lenders provide you with an escrow account that is funded each month. Escrow is a fancy word for account that is held by a third party that does something only when a specific condition is met. In this case, it is paying your taxes and insurance. Part of your monthly mortgage payment includes an estimated amount that goes into escrow. Lenders leverage escrow accounts to pay insurance and property taxes for you.
Mortgage Payment = Principal + Interest + Escrow Payment (e.g., taxes and insurance)
5 Types of Mortgages to Know
Qualifying for a mortgage is a critical step toward home affordability. Financing your home purchase is a fundamental step toward getting the keys to the perfect home. You might be able to qualify for more than one type of mortgage. Here are six types of commonly used mortgages:
Conventional Mortgage
Conventional loans are issued by private financial institutions that meet the conforming loan limits established by Fannie Mae and Freddie Mac. Down payments for these loans have a floor of 3% and escalate to over 20%. To qualify for a conventional loan, you usually need a FICO credit score of at least 620, but credit scores north of 740 will get you better interest rates.
Jumbo Mortgages
Jumbo loans are a "must have" if you plan to finance a home above the conforming loan limits. In 2024, the conforming loan limits for mortgages acquired by Fannie Mae and Freddie Mac are $766,550 for one-unit properties in most parts of the United States [1]. You might need a jumbo loan if you are purchasing a new home in a competitive real estate market (especially in the city or an expensive suburb).
FHA Mortgages
An FHA loan is a mortgage issued by the Federal Housing Administration (FHA) reserved for homebuyers who don’t meet the traditional lending standards for conventional or jumbo loans. FHA mortgages have lower down payment requirements and more relaxed standards on credit scores for applicants. For example, the FHA requires only a minimum credit score of 500 for loan eligibility. If you think you might qualify, it is worth checking out.
VA Mortgages
VA loans are reserved for service members or veterans and sometimes offer incredible benefits, like no down payment and lower interest rates. The VA loan program helps spur primary resident purchases for current and former military members. The Department of Veterans Affairs backs VA loans and has specific criteria for eligibility, including service requirements.
USDA Mortgages
The United States Department of Agriculture (USDA) sponsors USDA loans, a mortgage option built to encourage accessible financing in rural and suburban areas across the United States. USDA-guaranteed loans help service moderate- to low-income borrowers trying to buy a home in a rural area (deemed USDA-eligible). These loans can have reduced mortgage insurance premiums, below-market interest rates, and no down payments.
Can Anyone Get a Mortgage?
Most conventional mortgage lenders are in the business of making a profit. According to the National Association of Realtors, the average estimated home price will hover around $389,500 in 2024 [1]. Mortgage lenders carefully vet who they lend this bolus of capital.
Smart Money -> How to Boost Your Credit Score by 100 Points
This vetting process involves the mortgage lender taking a deep dive into your personal finances and assessing your overall financial health and ability to pay to make mortgage principal plus interest payments. This involves analyzing your credit score, debt-to-income ratio, and credit utilization. Lenders will also assess how much income you make and verify those income sources with W-2s and paystubs.
Smart Money -> Rebuild Your Credit With 5 Easy Steps
Do You Need a Mortgage?
You will probably need a mortgage unless you plan to purchase a house with cash. Homes cost hundreds of thousands of dollars, eclipsing what most people have saved. The need for a mortgage is acute for most first-time home buyers.
Smart Money -> Homebuying Process 101: 21 Steps to Buying a Home
A mortgage bridges the gap between how much cash you have available for your down payment and the asking price of the home you want to purchase. Mortgage lenders like banks and credit unions are willing to lend to prospective homeowners because the mortgage is secured by the house and property, giving the lender recourse to recoup lost income and capital if you default on your loan.
Smart Money -> 6 Ways to Improve Your Debt-to-Income (DTI) Ratio
Fixed vs. Variable Interest Rates
A mortgage has an interest rate assigned to the loan documents. Your mortgage interest determines how much interest expense you will pay as part of your monthly mortgage payment. Because the market for mortgage interest rates changes daily, you could have a different interest rate from someone else who signs the same mortgage one year later.
Depending on the structure of your mortgage, you can have a fixed or a variable interest rate. Fixed interest rates are more common and easier to understand. Fixed interest rates do not change during the life of your mortgage and help make your mortgage payments predictable. The most common fixed-rate mortgages are the 30-year fixed-rate mortgage and 15-year fixed-rate mortgage. For a fixed-rate mortgage, if you lock in an interest rate of 3%, you will only pay 3% interest for the term of your loan.
Variable or adjustable-rate mortgages, on the other hand, carry interest rates that can increase or decrease over the life of the mortgage. These interest rates fluctuate because they consist of two components: the index and margin. The index portion is pegged to an indexed interest rate (e.g., Prime Rate, LIBOR, or 1-Year U.S. Treasury Bill) that changes with the market. The margin is the fixed portion of the interest rate added to the interest rate by your mortgage lender. Variable or adjustable interest rates can make your mortgage payments unpredictable.
Smart Summary
Mortgages are a critical element of the homebuying process, which makes homeownership a reality for many borrowers. Unless you are sitting on piles of cash, taking out a mortgage is simply a matter of course. There is an array of mortgage types to choose from, and many borrowers tend to opt for conventional or jumbo loans. However, depending on your financial situation, you might be eligible to take advantage of government-back programs. Depending on where you stand, it could be the perfect time to buy a home!
(1) Federal Housing Finance Agency. FHFA Announces Conforming Loan Limit Values for 2024. Last Accessed February 6, 2024.
