In a market where houses go into contract seemingly as soon as they hit the marketplace, understanding how to buy a house is critical to successfully bidding — and ultimately closing — on your next home.
However, many potential homeowners are confused about how a mortgage works and what they need to get one. Both new and current homeowners overestimate the credit score needed to secure a mortgage, as well as the minimum down payment necessary, according to a 2019 survey by Fannie Mae. Without a good understanding of the necessary qualifications, the options available, and how the loan process works, the odds of securing a home can decrease significantly.
Knowing what a mortgage is, how it works compared to other types of credit, and the terms associated with your next home loan can make the process go smoothly — putting the keys to the front door in your hand with fewer problems along the way. Here is what every homebuyer needs to understand about mortgages and how they work.
Put simply, a mortgage is a loan agreement between a borrower and a financial institution to purchase real estate. The home — be it a single-family home, condominium, manufactured home, or a unit inside a co-op — is used as collateral to secure the loan. If the borrower fails to make payments, the lender can legally repossess the property.
How Does a Mortgage Work?
There are several different types of mortgages available, each with different attributes. Most homebuyers will choose between a conventional mortgage from a private lender and a government-backed mortgage, such as an FHA, VA, or USDA loan. Homebuyers who want to get a mortgage for a larger-than-normal amount may need to get a jumbo loan.
Homebuyers will also choose the term for their mortgage — typically 15 or 30 years, although other terms do exist. Fixed-rate mortgages, the most common type, have a fixed interest rate for the life of the loan. Adjustable-rate mortgages (ARMs) have a fixed interest rate for a certain number of years, and then the interest rate adjusts periodically, based on the schedule detailed in the loan agreement (usually every year).
The type of loan one gets, the term one gets, and the lender one uses can all affect one’s interest rate. A homebuyer’s personal financial details — including their credit score, income, and debt-to-income ratio — can also affect the rate they get. The best loan for any individual situation depends on one’s financial position and how long one plans to stay in the home.
Once the homebuyer decides on the right loan and has their offer on a home accepted, the lender will then move into the underwriting process. In underwriting, the lender will evaluate a buyer’s ability to pay for their home by analyzing their income, savings, debt, and how the buyer got their down payment. If everything checks out, the buyer will be cleared to close on the home.
At closing, the future homeowner will provide their down payment and any closing costs due, such as the cost of a home inspection, appraisal fees, and title insurance. Although this is referred to as “cash to close,” the actual payment is made via cashier’s check or wire transfer. After signing all the requisite paperwork, the homebuyer will receive their title deed and the keys to their new home.
Once everything is closed and completed, homeowners will start paying their mortgage per the agreed-upon terms. Every month, they will start by paying off the interest on their loan first, along with a small amount of the loan principal. Over time, a smaller percentage of the monthly payment will go toward the interest, while a larger percentage will go towards the loan principal. This is known as loan amortization.
Although lenders are not required to provide a loan amortization schedule, homebuyers can request one from their financial institution during the shopping process.
The homeowner will pay on their loan until the term is complete, or until they decide to refinance their mortgage.
Mortgages vs. Other Types of Loans
There are three key factors that make mortgages different from other types of loans: The collateral securing the loan, the qualification process, and the length of the term.
While it’s not uncommon for installment loans to be secured by a deposit or personal property (for example, an auto loan), a mortgage is secured by the combined value of the land and home structure – together known as the “real estate.” As a result, lenders take several different steps to protect their money during the loan process, such as ordering an appraisal and requiring the homeowner to purchase title insurance. While personal loans and auto loans can be processed and approved in minutes, a home loan can take over a month to close because of the necessary steps.
The property isn’t the only thing to go under additional scrutiny. During the underwriting process, homebuyers will be asked to submit multiple documents to prove their ability to pay for the property they wish to purchase. Documents may include tax returns, pay stubs or end-of-year income reports (W2 or 1099 forms), employment verification, and bank statements. This helps the lender qualify the statements made by the borrower during the process, and reduces the lender’s risk of losing money.
The length of the loan is also significantly longer than most other loans consumers will get. While credit cards remain in effect as long as the account is in good standing and auto loans can range anywhere between three and six years, home loans usually take up to 30 years to repay — sometimes even longer.
Key Mortgage Terms to Know
As with any financial product, mortgages have a vocabulary of their own. Before potential homeowners start looking for their next house, they need to have an understanding of the most important terms. Here are some of the most important phrases every homebuyer should understand:
- Amortization: Amortization is the rate at which the loan principal and interest are paid down. At the beginning of a loan, a larger percentage of the monthly payment will go toward interest compared to the principal, before transitioning to pay off more of the principal balance toward the end of the loan.
- Annual Percentage Rate: The annual percentage rate, or APR, represents the total cost of borrowing money from the lender. The APR includes the base interest rate, any mortgage points purchased, and any other fees wrapped into the loan.
- Mortgage Points: Mortgage points, also known as discount points, allow homebuyers to pay an upfront fee to the lender to get a lower interest rate. While each point is calculated as one percent of the loan, the ultimate interest rate reduction varies by lender, and will be listed on the loan estimate form and closing disclosure.
- Loan Estimate Form: After a homebuyer applies for a mortgage on a specific home, the first document they will receive is the loan estimate. This three-page form outlines all the most important information on the proposed mortgage, including the interest rate, estimated monthly payment, and projected closing costs. The loan estimate form may update several times between the initial application and closing, which is why it is important to read each loan estimate form provided by the lender.
- Closing Disclosure: When a buyer is ready to close on their mortgage, their lender will provide them with a mortgage closing disclosure. This five-page document outlines the mortgage’s final terms, projected monthly payments, closing costs, and any other associated fees.
- Debt-to-Income Ratio: One of the ways lenders determine if a buyer can afford a home is by looking at their debt-to-income ratio. To calculate debt-to-income ratio, divide total monthly debt payments by gross monthly income. Lenders look more favorably on borrowers who have a lower debt-to-income ratio.
- Escrow: With many mortgages, part of the monthly payment is set aside to pay for property taxes and homeowners insurance. The amount is deposited into an escrow account, with the mortgage administrator using the account to cover the expenses. If the financial institution does not offer escrow, the homeowner will be responsible for paying those expenses themselves.
- Private Mortgage Insurance (PMI): If a homebuyer has less than a 20% down payment on their home, the lender may require them to have private mortgage insurance. Also known as PMI, this insurance product protects the lender in the event the homeowner stops paying for their home. In most cases, the PMI premium is added to the monthly mortgage payment.
How Do You Apply for a Mortgage?
Once a buyer decides on the right loan for their situation, the first step in the mortgage application process is pre-qualification. During this process, prospective homeowners will meet with a loan officer to go over their situation, including their target buying price and their potential down payment. The lender will also run a credit check to get an understanding of the applicant’s current financial situation. If the loan officer believes the applicant could be approved for a loan, they will issue a pre-qualification letter.
Getting pre-qualified before you start shopping for a house can help you get a better sense of how much house you can afford and what your budget should be.
“When you go to get pre-qualified for a mortgage, the bank should tell you how much mortgage you qualify for,” says Melissa Cohn, regional vice president at William Raveis Mortgage. “ In order to get a real pre-qualification, the lender should run your credit so they understand your credit score, because your credit scores are a key factor in determining pre-qualification and interest rate.”
In most situations, a pre-qualification letter is good for 90 days from the date it was issued. This gives homebuyers plenty of time to shop for the right home for their needs, and bid on multiple homes. Once a bid is accepted, a prospective buyer can begin the formal mortgage application.
Mortgage applications can be completed online or over the phone with the lending institution’s loan officer. During this process, the lender will ask for personally identifiable information (such as the borrower’s name, income information, and Social Security Number for the credit check), and information about the home they want to purchase. The lender will then provide a loan estimate form within three days of the initial application.
If the borrower decides to move forward with the application, the lender will then ask for more detailed information. This can include tax returns, income information from non-employment sources, and other sources of money into their account. This information will be used in the underwriting process, which confirms statements in the application. If everything aligns, the lender will accept the application and move forward into closing.
How Much Mortgage Do I Need to Buy a Home?
When going through the home buying process, the first place to start is by understanding your potential down payment and setting a realistic budget. First-time homebuyers made an average down payment of 7% in 2021, while repeat buyers typically saved a down payment of 17% of the home price, according to data from the National Association of Realtors.
While some mortgages and lenders require a home down payment of as little as three percent of the home price, most conventional mortgages require at least five percent down. From there, the interest rate proposed by a lender will adjust based on down payments in increments of five percent. For example, someone who has a 15% down payment may get a better interest rate than someone who only has a five percent down payment.
Start the conversation with a loan officer with a realistic home payment in mind, as well as the maximum affordable down payment. Some states and counties offer down payment assistance programs through government or non-profit programs. Be sure to check all of the options available to determine if there are ways to boost your buying power.
While a lender may pre-qualify shoppers for an amount higher than their budget, experts say it may not always be best to use all the buying power. Instead, buying a less expensive home could increase the value of the down payment, resulting in a better rate. All potential homebuyers should look at their financial lifestyle, identify long-term goals, and determine how their down payment and monthly mortgage payment would affect those plans.
“There can be a difference between the higher mortgage loan amount that you may be approved for, versus the more conservative mortgage amount that may best fit your lifestyle, goals, and budget,” says Brielle Mabrey, founder and CEO of financial coaching firm Wisdom Then Wealth. “For example, if you have a goal to retire early with a set amount in your investment accounts, you may make an intentional decision to take on a smaller mortgage – so that you have more monthly cash flow available for other investments,” she says.
Different Types of Mortgages
Just as there are many different types of homes available, there are multiple types of loans to fit every budget and situation. From the popular government-backed options for first-time homebuyers to jumbo loans for the most expensive properties, it’s critical to understand the various types of loans available, and how they may apply to your home search.
Conforming vs. Jumbo Loans
The most common type of home loan available is the conventional conforming mortgage. Governed by rules set by Freddie Mac and Fannie Mae, conforming loans are limited to a total mortgage of $484,350 in most counties, and require homeowners to hold private mortgage insurance if their down payment is under 20%.
For properties that cost more than $726,000, homebuyers may be looking at a jumbo loan. Jumbo mortgages may allow borrowers to take up to $2 million in a mortgage, but require a strong credit score and high down payment to qualify. Each lender may set their own rules for a jumbo loan, so it’s important to ask up front about eligibility and terms.
Fixed-Rate Mortgages vs. ARMs
Mortgages can also vary in terms of interest rate structure as well. While the vast majority of buyers will select a long-term, fixed-rate mortgage for their home, some may choose the adjustable-rate mortgage, or ARM.
As the name suggests, a fixed-rate mortgage comes with a term typically between 15 and 30 years, with a fixed interest rate throughout the life of the mortgage. While the monthly mortgage payment may change annually based on property taxes and homeowner insurance rates, the principal and interest payments outlined by the amortization schedule remain the same.
An ARM also features a fixed interest rate, but only for a limited time. During the fixed-rate period — usually between five to ten years — the interest rate won’t change, and the payment schedule will remain stable. Once the fixed interest period is over, the interest rate will adjust based on market conditions on a regular interval, usually once per year.
Conventional Loans vs. Government-Backed Loans
Most mortgages are conventional loans, offered by private lenders and not backed by a government agency. But for qualified buyers, there are also certain government-backed programs that can help you secure the home loan that’s right for your needs. These special programs include:
- FHA Loans: FHA Loans are offered by private financial institutions under regulation and insurance from the Federal Housing Administration. An FHA Loan requires a minimum credit score of 500 and a down payment as low as 3.5% of the home value. While this may be a good opportunity for first-time buyers who don’t have a deep credit file, it could be more expensive for those who have a higher down payment and a good credit score.
- VA Home Loans: VA Loans are administered by the Department of Veterans’ Affairs, and are only available to current service members, eligible veterans, and certain surviving spouses. With a VA Loan, homeowners can get into their home with little to no down payment, no private mortgage insurance payments, and streamlined refinancing if borrowers experience difficulty affording their home later on.
- USDA Home Loans: Borrowers with lower income in rural areas can take advantage of the rural development loan program, administered by the U.S. Department of Agriculture. While these loans offer a zero down payment option and have fewer fees than FHA Loans, borrowers need to live in a qualified area to get the mortgage.
How to Shop for a Mortgage
Shopping for a mortgage is not an easy task, and potential homebuyers should not take the process lightly. Instead, they should start well in advance of anticipating purchasing a home, and talk to several potential lenders before agreeing to work with one.
The first step involves doing research on potential financial institution partners. Getting referrals from friends and family, as well as doing independent research with independent resources, like the Better Business Bureau and the Consumer Financial Protection Bureau, can help shed light on how the lender works with homebuyers, experts say.
“Taking on a mortgage is often the biggest financial decision that most people make in their lifetime,” says Mabrey. “As such, potential homeowners should spend as much time preparing for and understanding the mortgage process as they do on finding and selecting their desired home.”
Just doing background research often isn’t enough. Potential homeowners should also be prepared to evaluate their first impressions of connecting and working with a lender. Some of the most common red flags include not having enough experience to work with a buyer’s financial profile, not responding to communications in a timely manner, or being unable to provide interest rates in writing.
“You want to make sure you’re dealing with someone who is going to be responsive to you. It’s not always best to just shop for the best rate,” says Cohn. “If you’re closing in 30 days, you need to make sure you find a lender who will close you in 30 days. You have to find a lender that creates the right relationship with you.”
Finally, experts say homebuyers only need to be pre-qualified with one lender to start the home shopping process. After a bid has been accepted on a home and buyers know how much they could be financing, they can then shop around for a better interest rate with different lenders. However, buyers have a limited shopping window before multiple credit checks could hurt their credit score. The FICO score model allows for multiple mortgage credit checks to be counted as a single inquiry if they are all pulled within 45 days of the first application. If the shopping window extends past that, a buyer’s score could decrease due to multiple hard credit checks.
Shopping for a mortgage is one of the biggest financial decisions anyone can make for their financial life. By understanding the process ahead of time, understanding the key terms being discussed in the process, and anticipating costs prior to closing, the process can be less stress-inducing and proceed more smoothly — getting every homebuyer one step closer to receiving the keys to their new home.