If you’ve never purchased a home or property, here’s a primer on how the process works. The majority of homebuyers take on a mortgage loan. Learning all you can about qualifying for and affording a mortgage will pay dividends over the coming years.
Taking out a mortgage means getting a loan for your home. While roughly one-third of homebuyers in the U.S. paid in cash for their home in 2022, that leaves another two-thirds of home purchases that used mortgages. Here’s how mortgage loans work.
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- The majority of homebuyers take out a mortgage, which is a loan used to purchase a house.
- Mortgage lenders determine interest rates and other terms of a mortgage.
- There are many different kinds of mortgages, such as conventional, adjustable rate, and government loans
- Borrowers make a monthly payment until they fully own their home.
- The monthly mortgage payment includes the loan principal, interest, insurance, and taxes.
What is a mortgage?
A mortgage is a loan you take from a bank to purchase a house. You'll likely put some money down and then borrow the rest.
The terms of the home loan, or mortgage, determine how much you'll pay in interest, how many years until you own the home free and clear, and what rights the mortgage lender has if you don’t make the payments on time.
Taking out a mortgage is a major financial obligation — the property is the collateral your lender uses if you default on the loan. There are several types of mortgages, and most come with certain requirements for credit scores, amounts you can borrow, and other guidelines.
Basic mortgage terms to know
Check out a few of the most common mortgage terms to know as you begin the process:
- Amortization: the process of paying off a loan with a set payment schedule, resulting in full payoff by the loan term’s end.
- Principal: the amount of the loan.
- Annual percentage rate (APR): the annual cost of the loan, including interest, mortgage points, broker fees, and other costs.
- Private mortgage insurance (PMI): amount paid to lenders on conventional loans with less than 20% down payment. This protects them if you default.
- Homeowner’s insurance: coverage in case of damage or loss to the home, property, or assets within
- Property taxes: taxes charged by the county or other local jurisdiction.
- Prequalification: an early step in which a lender estimates how much you can borrow.
- Preapproval: when your lender has examined your financial documents and issued a notice of the specific amount they will lend you.
- Down payment: the amount you pay upfront for your home.
- Conforming loan: a loan that meets the criteria of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
- Non-conforming loan: a loan that exceeds the loan limit of a conforming loan.
- Closing costs: a percentage-based fee charged at the time of closing on your home, usually 3% to 6% of the loan balance.
- Equity: the amount, or percentage, of your home’s value that you own.
Types of mortgages
Mortgages aren’t one-size-fits-all. Let’s dive into the various types of mortgages to consider.
A conventional mortgage is one backed by private institutions like banks and credit unions, not by the federal government. They typically come with more stringent criteria for borrowers, but along with that, there are distinct advantages.
Conforming home loans must follow guidelines set by the Federal Housing Finance Agency (FHFA). This agency sets maximum loan limits for borrowers. Fannie Mae and Freddie Mac, government-sponsored enterprises that purchase mortgages, can only purchase conforming loans.
The FHFA guidelines for loan limits and other mortgage factors don’t bind non-conforming mortgages. Some examples of non-conforming loans are USDA, VA, and FHA loans, which typically have more relaxed criteria for down payments and credit scores.
With a fixed-rate mortgage, your interest rate is fixed for the entire term of the loan. You can count on the same payments throughout the 15, 20, or 30-year term.
Adjustable-rate mortgages (ARMs) can have fluctuating interest rates. Some ARMs have specific guidelines about when or how often the rate may change.
Unlike conventional loans, several mortgage types are backed by the federal government. You can look into FHA loans, VA loans, and USDA loans through the U.S. government, which are often easier to obtain.
However, the term “easier” refers to the ability to take out a mortgage with a lower credit score or a smaller down payment. In other ways, government-backed mortgages are stricter and harder to qualify for.
- FHA loans are through the Federal Housing Administration, and since the FHA backs these loans, borrowers can qualify with lower credit scores and lower down payments. FHA loans are particularly appealing to first-time homebuyers.
- USDA loans are for buyers with a low-to-moderate income level. Buying a home in an eligible rural area could mean you don’t even need a down payment.
- VA loans benefit federal service members by facilitating the home-buying process. Some mortgage lenders don’t require a down payment for VA loans, and borrowers often receive lower interest rates and don’t have to pay private mortgage insurance (PMI).
Documents to gather before shopping for a mortgage
Before you get very far into the mortgage application process, you should gather your relevant paperwork. Banks and lenders will need to see evidence of your ability to take on such a large financial obligation and that the mortgage payment is within your budget. Your official records are key to helping you determine the type of mortgage you can handle.
Gather the following documentation:
- Income verification: pay stubs, W-2 income tax statements (usually for the past two years), names and contact information for employers
- Debt information: records and current student loan debt, credit cards, vehicle loans, etc.
- Assets: documentation of checking and savings accounts, brokerage accounts, stocks, gifts
- Personal information: Social Security information and other personal data for credit inquiries
Related: How to get a mortgage
What to look for when getting a mortgage?
As with many types of loans, when shopping for a mortgage, you’ll want to consider the interest rate, down payment, and loan term. You'll also want to be clear on what fees will be charged.
You also need to closely examine your own finances to understand what’s reasonable for you. Getting a mortgage is a huge financial step, and it’s not one to take lightly, especially if it’s your first time buying a home.
Take the time to research your options and find out both what you qualify for and what you can financially manage. For example, you don’t necessarily want to go with the lender that offers you the highest loan amount, if the mortgage payment is going to overextend your budget.
Once you’ve gathered your key documents for potential lenders, you can compare loan offers. You should talk to multiple lenders to gain a fuller picture of what you can afford and what they will approve.
Discuss with lenders the types of mortgages they offer, the interest rate they would charge you for a home loan, whether it’s a fixed or adjustable rate, the loan term, closing costs, and other fees they may charge. Some lenders charge prepayment fees, for example, or if you buy certain types of homes, there may be homeowner association (HOA) fees to consider.
There’s a lot to examine about your finances and goals before taking on a mortgage. For instance, if deciding between a 15-year and a 30-year term, look realistically at the options. Certainly, a 15-year mortgage is appealing because you’ll own your home in less time and pay less in overall interest, but you’ll also need to pay much more each month.
Pay attention to each aspect of choosing a mortgage, asking yourself key questions about your financial situation and how the loan agreement would impact you over many years.
What is included in your mortgage payment?
Most property buyers put a certain amount down, called the down payment, and then spread the remainder of the loan balance over a set period of years. Your monthly payment doesn’t just include the amount borrowed, though. In particular, first-time home buyers need to be aware of the components of a mortgage payment, so you aren’t caught off-guard when mortgage payments begin.
Four main parts are generally rolled into your monthly mortgage payment: principal on the loan, interest, taxes, and insurance.
The loan principal is the remaining loan balance after you’ve made your down payment, if any. If you put 20% down on a $300,000 house, for example, your remaining balance would be $240,000.
Your interest rate is calculated as a percentage of the loan principal. Lenders charge different interest rates based on a number of factors, including economic conditions and personal qualifications. Your credit score, loan-to-value ratio (how much you’re borrowing compared to the full property value), and down payment percentage all affect how high your interest rate will be.
When you make your mortgage payment you'll also pay into an escrow account for property taxes and homeowner's insurance.
An escrow account is just a holding account for funds. The lender estimates the annual cost of property taxes for your home and then divides it across your monthly payments equally. The mortgage provider holds the funds until the taxes are actually due, then makes the full tax payment on your behalf.
It works the same with your homeowner's insurance. Many lenders collect payment for insurance each month and retain the funds in an escrow account throughout the year. Mortgage providers usually require borrowers to have this type of coverage, as it helps protect their investment.
Private mortgage insurance, or PMI, may also be factored into your monthly payments. PMI isn’t required for all mortgages but is required for conventional mortgages if you don’t put down 20% initially.
PMI is one reason that if you want a conventional mortgage, it’s best to wait until you can make a 20% down payment. That fee increases your monthly payment significantly, and it’s there to protect your lender in the event of you defaulting on the loan.
If you do put less than 20% down on a conventional loan, once your principal drops to 80% of the original property value, you can request to have PMI dropped from your payments. In other words, once you’ve reached 20% equity in your home, you no longer have to pay private mortgage insurance.
What credit score do you need to get a mortgage?
The credit score required to get a mortgage varies depending on the type of mortgage (for example, FHA loans enable borrowers with lower credit scores to qualify). However, your credit score affects important aspects of your mortgage, such as the down payment and interest rate.
Per Experian, these are generally the minimum credit scores to qualify for a mortgage:
- Conventional mortgages: 620
- First-time homebuyer (FHA) loans: 580 with 3.5% down, 500 with 10% down
- USDA loans: typically 580
- VA loans: typically 620
However, having a minimum credit score of 670 is best to secure a mortgage with favorable terms and interest rates.
What do buying points mean?
If you’re concerned about the interest rate you’ll pay over the term of your mortgage, you may consider buying points. This is a tactic that requires you to spend more money at closing, but it offers the benefit of a lower interest rate throughout the years you’re paying on the mortgage.
One point is the equivalent of 1% of your loan amount when buying points, so a point on a $200,000 loan would cost $2,000. You can choose to pay this additional amount at closing in exchange for a reduction in the interest rate, and you may purchase a percentage of a point rather than a round number.
Be sure to clarify with your lender how much buying points would lower your interest rate, as this isn’t a fixed rule across lenders or loan types.