What Is A Mortgage And How Does It Work? A Complete Guide

Mortgage Definition

A mortgage is a loan used to buy real estate. Although you might hear it called a home loan or mortgage loan, they all fall under the same mortgage definition. When you take out a mortgage, you transfer the security interest in the home to the lender funding the loan. The security interest is the loan’s collateral. Lenders use it as leverage to offset the risk of lending you such a large amount of money. For example, if you stop making your payments, the lender can foreclose on the property, selling it to make back what they lost when you defaulted.

How A Home Loan Works

Home loans at first might seem overwhelming, but if you look at the big picture, you’re simply borrowing money to buy a home. You pay interest on the loan while you have a balance, which is the profit the lender earns for lending you money to buy a home.

Think of it like buying a car. You borrow money to buy the car, and the vehicle is the collateral. If you don’t make your payments, you could lose your car. The only difference with a mortgage is that the purchase price of a home is usually much higher than a vehicle, as is the monthly payment.

Interest Rates

Interest rates are a hot topic for borrowers. Everyone wants the lowest rate and wants to know how mortgage rates are determined.

There are many moving pieces involved in what affects interest rates, but overall, the economy's pressure drives them. Usually, when the economy needs stimulus, interest rates fall to spur more growth. But when the economy booms or inflation needs to cool down, interest rates increase to reduce demand.

There are three major players in your interest rates: the Fed, the state of the lending market and your financial risk factors.

The Fed

The Federal Reserve (the Fed) is the central bank of the U.S. They don’t directly set mortgage rates, but they do set the federal funds rate. This is the interest rate charged to banks and other lending institutions when they borrow from one another. Thus, the federal funds rate has a trickle-down effect on the interest rates lenders charge to borrowers to make a profit.

The Lending Market

Most lenders originate mortgages and then sell them to one of several major investors as part of a mortgage-backed security. This allows them to make money off the loan in relatively short order and get funds to make more loans without having to wait up to 30 years to see the full return. Still, some lenders keep mortgages on their books. These are portfolio lenders.

Remember that lending is a business. Lenders typically set their own prime rate based on the federal funds rate and then mark it up so they can take on the risks that come with lending money and also make a profit.

Not many borrowers will see the prime rate. It’s reserved for loans that carry the least amount of risk. Other loans, including long-term, uncollateralized and residential, are usually priced higher. It’s also important to note that because of the collateral home loans offer, lenders offer mortgage clients lower rates than other loans such as personal loans and credit cards, which don’t have collateral so they’re considered riskier.

Your Financial Risk Factors

One factor you can control regarding interest rates is your own financial health. For example, if you have a high credit score, a low debt-to-income ratio and a 20% down payment, you can likely secure a better rate from the lender.

Lenders look at your credit score, current debts and the amount you put down on the home to determine how much they’ll charge. If you have low credit scores, high debt ratios or a low down payment, your interest rate may be higher. If you’re in this situation, you may want to consider an FHA loan that caters to borrowers with lower credit scores or down payments and still offers competitive interest rates.

Loan Terms

A loan term is the amount of time you contractually have to pay off a loan. This may also be called the “duration of the loan” or “life of the loan.” This is the repayment period and it is established when you borrow money from a lender. For instance, a 30-year fixed-rate mortgage has a loan term of 30 years.

When you take out a loan, the loan term will be defined. This is the length of time you have to pay off the loan as well as the amount of your monthly payments. For mortgage loans specifically, your repayment plan, along with what will comprise your monthly payments in terms of principal and interest, is called an amortization schedule.

Down Payments

A down payment is a set percentage of the home’s purchase price that a buyer must pay upfront at the time of closing on the purchase of real estate. Down payments can come from savings, investments, gift money from close family members, home equity or assistance and grant programs.

Down payments reduce the amount that you’ll need to borrow from your mortgage lender. For example, if you decide to buy a home for $300,000 and put 20% down, your down payment will be $60,000 and you’ll borrow $240,000 from your mortgage lender.

Down payments are usually required (though there are exceptions, such as with VA loans) to show mortgage lenders that you’re serious about becoming a homeowner, and that you’re able to repay the money they’ve loaned you. The thought is that you are less likely to stop paying your mortgage if you already have a substantial amount of money invested in your home.

Underwriting

Loan underwriting involves a deep dive into your financial health that gives lenders the confidence that you’ll be able to repay any amounts that they lend to you. As a part of this, your lender will verify your income, assets, debt and property details. Until it’s completed, and the lender has final approval to issue a mortgage, you won’t have access to the funds needed to purchase your home.

While mortgage underwriting happens behind the scenes, it is a critical part of any mortgage-based real estate transaction, including the home buying process. Although your mortgage lender will be the one who drives this process, you can expect to be at least somewhat involved. For example, your lender may ask specific questions and request additional documents to verify income, assets and employment. This helps the mortgage lender confirm that you can afford the home you want to buy.

Monthly Mortgage Payment

The four components of a mortgage payment are broken down into the acronym PITI: principal, interest, taxes and insurance. Every month, borrowers will make payments on the principal balance and interest to pay off their home loan. When the amounts for taxes and insurance are added, that constitutes your whole monthly payment.

During the home buying process, your mortgage lender should break down the principal, interest, taxes and insurance you will have to pay for each house you’re considering purchasing. As a borrower, it’s important to review these estimates carefully to ensure you’ll be able to afford your entire monthly mortgage payment.

Mortgage Amortization

Mortgage amortization is the loan’s repayment schedule. It represents a balance between your interest payment and your principal payment. Every time that you make a mortgage payment, the amount that goes toward your loan’s principal balance increases and the total interest amount decreases.

Mortgage Insurance

Private mortgage insurance (PMI) is a type of mortgage insurance that is usually required for borrowers of conventional loans. Typically, if you make a down payment of less than 20% on a house, you’ll be required to pay for PMI until you reach 20% equity.

Private mortgage insurance protects your lender in the case that you stop making payments on your mortgage loan. Borrowers who make lower down payments are considered more of a risk to lenders, and thus must pay PMI until they reach 20% equity in the home and are considered less of a risky buyer.

Parties To A Mortgage

A mortgage is a legally binding contract between a homeowner and a lender. The mortgage states the terms of the contract: how much borrowers must repay the lender each month, what interest rate they’ll pay and how long they have to repay the loan.

The lender is known as the mortgage loan originator. Your originator may choose to sell your loan to a different loan servicer after funding your loan. The loan servicer is the company you deal with when making payments or when you have questions about your loan.

In a mortgage contract, you, the borrower, are the mortgagor, and the lender is the mortgagee. You own the property and agree to pay the mortgage as assigned, and the lender agrees to follow your rights and responsibilities according to the agreement.

You may also see these terms pop up in your mortgagee clause on your homeowner’s insurance policy. The mortgagee clause is the wording on your homeowner’s insurance policy that guarantees the lender will receive payment from the insurance company if you had a total loss versus the insurance company sending the money to you while you still have a mortgage on the property.

Different Mortgage Types

There are various types of home loans. You will want to choose the loan type that you qualify for and offers you the best terms for your specific purchase.

Conventional Loans

A conventional loan is a mortgage offered through a private lender without backing from a government agency. Requirements will vary but they generally require:

• Credit score of at least 620
• Down payment of at least 3% (PMI required under 20%)
• Loan limit of $726,200 (except in certain high cost of living areas)
• Debt-to-income ratio of 50% or less

Government Loans

There are several government loan programs aiming to make mortgages more affordable for home buyers. They include:

FHA loans

An FHA loan is a mortgage backed by the Federal Housing Administration, a part of the U.S. Department of Housing and Urban Development (HUD). This means the government will protect the lender’s investment against default, which can make qualifying easier.

Requirements will vary but they generally require:

• Credit score of at least 500
• Down payment of at least 3.5%
• Loan limit of $472,030
• Debt-to-income ratio of 45% or less

VA loans

A VA loan is a mortgage specifically for veterans, active service members and eligible spouses who are backed by the U.S. Department of Veterans Affairs (VA).

VA loans typically require no down payment and no mortgage insurance. Closing costs are very limited and they offer discounted interest rates.

Requirements will vary but they generally require:

• You must be a service member on active duty, an honorably discharged veteran or an eligible surviving spouse
• Credit score of at least 580
• Loan limit of $726,200
• Debt-to-income ratio of 45% or less
• Must be used for a primary residence

USDA loans

A USDA loan initiative helps create a sustainable housing market that provides safe, modern homes for those who live in less urban areas. The goal is to help low-income home buyers in rural areas get a loan with no down payment required and a favorable interest rate.

Requirements will vary but they generally require:

• Home must be in a designated rural area
• Credit score of at least 640
• No down payment
• Income limit of 115% of the median income in the area
• Debt-to-income ratio of 41% or less

Fixed-Rate Mortgages

A fixed-rate mortgage has a set interest rate that will not change over the life of the loan. This is great because it allows borrowers to predict pretty accurately what their payments will be for the duration of the loan repayment schedule. However, if interest rates go down, you do not get the benefit of the new rate unless you choose to refinance.

Adjustable-Rate Mortgages

On the other hand, an adjustable-rate mortgage will have an interest rate that changes over time. Typically, the rate is set for a period of time at the beginning of the loan, and once that time passes, it will fluctuate with the market.

This is a risky choice because the rate could increase substantially, causing your monthly payment amount to skyrocket. Of course, if rates decrease, your payment would decrease as well.

Conforming Loans

Conforming loans are loans that “conform” to or satisfy the funding requirements of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Conforming loans are often bundled with other similar loans and sold to investors as investment portfolios. Because of this value, lenders love them. Because of that, this type of loan sometimes has lower fees and costs associated with it for buyers.

Nonconforming Loans

On the other hand, a nonconforming loan is any mortgage loan that doesn’t satisfy, or “conform” to, the funding requirements of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Typically, nonconforming loans are for either too high of a total amount, a higher debt-to-income (DTI) ratio, a lower credit score or a smaller down payment compared to the set limits. Because they don’t conform to GSE guidelines, nonconforming loans are typically harder to sell than conforming loans. This makes them riskier and less valuable to lenders and may therefore mean that they have higher interest rates or fees associated with them.

Jumbo Loans

A jumbo loan is a type of mortgage that exceeds conforming loan limits – which the Federal Housing Finance Agency (FHFA) determines. Each year, the FHFA sets limits on conforming loans. These limits represent the maximum loan amount for a mortgage that government-sponsored enterprises Fannie Mae and Freddie Mac can buy. In 2024, the maximum conforming loan amount for a one-unit property will be $766,550.

Historically, jumbo loans have had higher interest rates than conforming loans to account for the increased risk the lender takes on. But in recent years, the gap between jumbo and conforming loan rates has narrowed. In fact, jumbo loans today have mortgage rates that are quite competitive with other mortgages. Often the difference is anywhere from 0.25% to 1%.

As with other types of loans, the interest rate on a jumbo loan will depend on various factors, including the loan amount, size of the down payment and creditworthiness of the borrower.

Reverse Mortgages

A reverse mortgage offers homeowners who are 62 or older the chance to borrow against their home’s equity. Essentially, you’re borrowing from the equity you’ve built up in a home. The reverse mortgage will first pay off your existing mortgage, if you have one, then the remaining money is given to you in the form of a lump sum payment, monthly payments, a line of credit or any combination of the three.

No monthly payments are required, and the loan balance doesn’t come due until you sell the home, move out of the home or pass away. Keep in mind that you’ll still be responsible for keeping up with the property taxes and homeowners insurance and must maintain the home.

How The Mortgage Process Works

Here is a basic idea of how the mortgage process works:

1. Check your credit score. Your credit score will have a significant impact on the interest rate that you are charged and therefore the amount of mortgage that you can afford. You can check your credit score online, but not all reports match the official report that a lender will pull.
2. Calculate your debt-to-income ratio (DTI). Add up all your monthly debt payments and divide them by your gross monthly income. This percentage is your DTI.
3. Shop around and compare rates. Once you are armed with your credit score and DTI, you are ready to reach out to lenders. Speak to at least 3 lenders and compare the rates and terms that they can offer you to find your best deal.
4. Apply for preapproval. Once you find terms you are happy with, you will want to apply for mortgage preapproval. Once you are preapproved, you will have a better idea of the value of home that you should be looking at.
5. Submit a full application. Speak to your lender about when in the process you will need to complete a full application for a mortgage and follow their steps completely.
6. Wait to hear back from your lender. It may take a little time for your application to be processed. Stay in contact with your lender in case they need any additional information from you.
7. Accept funds and begin repayment. Once you have signed your mortgage and it is official, you will receive a repayment schedule. Begin making payments and repeat for the duration of the loan.

FAQs About Mortgage Loans

Here are some common questions about mortgage loans:

Do I really need a mortgage?

Unless you have enough cash saved up to purchase a home outright, you will need a mortgage to be able to afford to buy a home.

How long is a mortgage?

Mortgage terms can vary but are typically between 10 and 30 years.

How long can I go without paying my mortgage?

Typically, foreclosure proceedings will not start until you are 120 days behind on your mortgage. This means that it’s not the end of the world if you miss one payment. However, if you are having trouble making your payments, it is always best to reach out to your lender to see if there are any options to assist you, pause repayment, or lower your monthly payments.

The Bottom Line

Buying a home can be an overwhelming process. However, knowledge is power. Understanding the loans you are considering and knowing what the process looks like makes it a lot less intimidating.

Once you are ready, start the process today with Rocket Mortgage^®.