What Is a Mortgage and What Can It Do for You?

Taking out a mortgage is a fundamental part of the homebuying process for most people. But if you're just getting acquainted with real estate, perhaps considering your first home purchase, you likely have plenty of mortgage-related questions.

We'll go over all the mortgage basics you need to know, including "what is a mortgage," the different types of home loans available, and what it actually takes to get approved by a lender.

What Is a Mortgage?

A mortgage is a type of loan used to finance real estate. Lenders provide borrowers with the upfront funds they need for their property purchase or refinance. In return, borrowers repay the loan with interest according to a set repayment schedule.

The word mortgage is said to date as far back as 14th century France, with the term’s origins in its root words “mort," which means death, and "gage," a pledge. Essentially, you're eliminating your debt (pledge) month-by-month until it's completely dead (paid off).

Mortgages are secured by the underlying piece of real estate. If a borrower fails to make their payments, the lender can take legal action to gain ownership of the property. They can then sell it to recoup their losses.

Without a mortgage, buying a home would require you to save up the entire purchase price. This could take decades for some prospective homebuyers. For others, it would eliminate the possibility of purchasing a home altogether.

Taking out a mortgage makes homeownership accessible to the average person. Conventional loans are available with a down payment as little as 3%. Some borrowers may even qualify to buy a home with zero money down.

So, what's in it for the lender? Lenders make money off of the interest payments on your loan. They can also charge upfront fees for processing and originating your mortgage, although these costs vary by company.

Are There Different Types of Mortgages?

Mortgages are not one-size-fits-all. There are a myriad of loan products available designed to meet various homebuying needs.

Conventional mortgages make up the bulk of all home loans. These mortgages meet the guidelines established by Fannie Mae and Freddie Mac. Conventional loans are widely considered the "gold star" of lending.

Borrower requirements can be stricter than with other types of mortgages. However, special conventional programs are available for first-time and lower-income homebuyers.

FHA loans are backed by the Federal Housing Administration. Borrowers who are unable to qualify for a conventional loan may be eligible for an FHA mortgage. Plus, thanks to the subsidized cost of mortgage insurance, buyers with a small down payment and lower credit score might find a better deal with an FHA loan.

VA loans are secured by the US Department of Veterans Affairs and are generally only available to active-duty and former US military service members. Qualifying borrowers can take out a loan for their full purchase price – zero down payment – and not be required to pay for monthly mortgage insurance. Thanks to the VA loan program's strong government backing, interest rates are generally lower than conventional loans.

USDA loans are insured by the United States Department of Agriculture. The USDA program improves housing affordability among lower-income borrowers in rural areas. You can get a USDA loan with no money down, lower mortgage insurance than FHA, and typically a better-than-average interest rate. Loans aren’t available in urban areas, but some lower-density suburban communities may qualify.

Non-qualified mortgages (non-QM) are loan products offered by lenders that are not backed by the federal government and don't fit within conventional lending guidelines. These loans will typically have less favorable terms than the other mortgage types mentioned, although buyers who can't get approved through other programs are likely to find a non-QM loan that they’re eligible for.

Fixed-Rate vs Adjustable-Rate Mortgages

In addition to the different types of loan programs, mortgages are commonly structured with either fixed or adjustable rates.

Fixed-rate mortgages (FRMs) are by far the most common type of home loan. According to the St. Louis Federal Reserve, fixed-rate loans comprise 92% of household mortgages. These FRM loans have a constant interest rate, established when you take out the mortgage, with payments that are the same every month.

Adjustable-rate mortgages (ARMs) have an interest rate that can change over time. ARMs typically have an initial period with a fixed interest rate, commonly 5, 7, or 10 years. However, you can expect your rate to change once or twice a year after the initial fixed period.

The adjustable rate is tied to a major financial index, typically the Secured Overnight Financing Rate (SOFR), and can fluctuate based on overall market conditions. If rates decrease, your monthly payment amount will decrease. If rates increase, your monthly payment will increase.

Who Can Get a Mortgage?

Adults who are 18 years or older can apply for a mortgage. The requirements, however, will vary depending on the lender and loan program for which you’re applying.

Credit Score

Mortgage programs have minimum credit score requirements. Most conventional loans require a minimum score of 620, while FHA lenders accept borrowers with scores down to 580. VA and USDA loans have no official minimum, although lenders prefer borrowers with scores of 620 or higher. However, taking out a loan backed by the VA or USDA with a lower score may be possible.

Debt-to-Income Ratio

Lenders use a metric called the debt-to-income (DTI) ratio to determine whether a potential borrower can afford the mortgage payment they're applying for. This represents the portion of your income you can allocate to your home purchase and other obligations. Programs that allow for a higher DTI will let you purchase more home or buy with a higher level of existing debt.

Conventional mortgages allow for a maximum total DTI of 45% in most situations, with that figure increasing to 50% for FHA loans. USDA and VA mortgages have no maximum DTI, although you can expect lender-set caps ranging from 41% to 50%.

Down Payment

Your down payment is the amount of money you put toward your home purchase at closing. It is separate from closing costs, which you'll also be responsible for paying in most cases.

Loan programs generally require a minimum down payment, although you can put a larger amount down if you choose. In fact, a larger down payment can lead to lower interest rates and a more affordable mortgage.

Conventional loans are available with a 3% down payment for first-time and lower-income homebuyers. Other borrowers are typically required to put 5% down. The FHA requires a 3.5% down payment, although putting in 10% could allow you to qualify for an FHA mortgage with a credit score as low as 500.

Both the VA and USDA permit borrowers to purchase a home with no money down. However, neither of these programs requires mortgage insurance, which is mandatory on all FHA loans and on conventional loans with less than 20% down.

Other Requirements to Get a Mortgage

In addition to a good credit score and a healthy level of debt, you will also want to have:

• Two years of stable employment

• Income that remains consistent or increases slightly

• A credit history free of significant issues like bankruptcy

Also, the home you're planning to buy must undergo an appraisal and meet your chosen loan program’s minimum property standards.

How Long Do Mortgages Last?

Most mortgages last for a term of 30 years, but lenders typically offer a range of different loan lengths. The second most common term is 15 years, although you can also find 10-year, 20-year, and 25-year mortgages.

Certain lenders may even work with you to develop a custom-length loan tailored to your homebuying and financing needs.

The shorter your loan term, the less you'll pay in total interest over the life of the loan. Plus, shorter-term loans tend to have lower interest rates. The downside is that you'll need to make a larger monthly payment to repay your loan over fewer years.

Here's an idea of the principal and interest payments and lifetime interest cost for a $300,000 mortgage, choosing between a 30-year loan at 6.5% interest and a 15-year loan at 6.25% interest.

In this example, your monthly payment would be around one-third larger with a 15-year loan, although you would get your home paid off twice as fast and with less than half the total interest cost.

How Large of a Mortgage Can I Get?

There are two things to consider when calculating how large of a mortgage you can get: your individual borrowing capacity and the maximum loan limits of the mortgage program you’re applying for.

As we already mentioned, lenders use your debt-to-income ratio to determine how large of a loan you qualify for. Each loan program will have a maximum-allowed DTI, while individual lenders may impose their own more restrictive policies.

For example: Conventional lenders commonly allow borrowers to have a housing DTI of 36%. This means up to 36% of your monthly income can go toward your housing costs. If you earn $5,000 per month, you may qualify for a mortgage payment as large as $1,800.

The size of the loan that this equals can vary based on your interest rate, down payment, and mortgage length. Property taxes, homeowners insurance premiums, and any homeowners association dues can also impact it.

For example: If you put 5% down, an $1,800 conventional mortgage payment would equate to around a $235,000 home with a loan size of just over $223,000. This assumes monthly property taxes of $196 (1% of the home’s value annually), homeowners insurance premium of $125, and private mortgage insurance costing $71.

However, your maximum loan amount can shrink if you have too much other existing debt. A conventional lender allowing a housing DTI of 36% would likely put a cap on total DTI – your housing expenses plus other monthly obligations – at 45%.

On a monthly income of $5,000, this maximum debt limit would be $2,250. That means that in addition to an $1,800 mortgage payment, you could have up to $450 in other obligations – things like car payments and credit card minimums – before the size of the mortgage you qualify for begins to shrink.

Related:

Income Needed for a $200k, $300k, and $400k House
Income Needed for a $600k, $700k, and $800k House

Program-Specific Maximum Loan Limits

Even if you earn a lot of money and have little to no debt, you'll still run into loan size limitations. Each type of mortgage has its upper limits. The one exception is VA mortgages with no maximum loan limit for borrowers with full entitlement, which generally applies to first-time VA homebuyers.

Most loan programs have a standard loan limit and a high-cost area loan limit for borrowers in more expensive markets. Some places will have a limit between these two figures.

Here’s what the current 2024 limits for a single-family home look like by program:

How to Get a Mortgage

The process of getting a mortgage can seem overwhelming at first. There are several steps you'll need to take and plenty of things that can come up along the way.

An experienced lender can help you navigate the process from start to finish, but in general, you'll need to:

Step #1: Check current mortgage rates

Mortgage rates constantly change based on financial market trends. A lender will likely offer different rates from one day to the next. The first step in the mortgage process is to check current interest rates and find the lenders offering the best deals in your area.

Step #2: Apply for pre-approval

Once you've found a lender, you'll want to apply for mortgage pre-approval. This requires submitting information about yourself and your finances. In return, the lender will offer you a pre-approval letter outlining your potential interest rate and the loan size that you could qualify for.

Most real estate agents require a pre-approval to begin showing you homes. This helps to ensure the properties you're considering are within your budget. Plus, home sellers generally want to know that a buyer is capable of obtaining a mortgage before accepting an offer and taking their property off the market.

Step #3: Make an offer on a property that’s accepted by the seller

Shop for homes. Include your pre-approval letter when you make an offer on a home you want to buy. With some luck, the seller will accept your offer. However, there’s a good chance that you’ll need to make offers on many homes before one is accepted.

Step #4: Complete the full mortgage application process

Once you have a signed purchase agreement, you can begin the full mortgage application process. This will be more in-depth than the pre-approval and can take up to three days once you’ve submitted the necessary documentation.

After processing your application, the lender will give you a detailed loan estimate that outlines the specifics of the mortgage they're offering, including any lender-associated fees.

This is the point where you'll want to shop around with at least three companies to compare loan quotes. Having already applied for pre-approval with multiple lenders can save you time here, which may be helpful if you're trying to close quickly or have a unique situation that could cause underwriting to take longer than usual.

Step #5: Accept a lender’s loan estimate and begin underwriting

Applying with at least three lenders will yield three loan estimates. Don’t be afraid to negotiate lower interest rates and closing costs between competing lenders. Once you've settled on a final loan quote and accepted the loan estimate, the lender will begin the complete underwriting process, which includes ordering an appraisal of the home you’re purchasing.

Step #6: Close on your new home

Your purchase contract will outline the timeframe for closing on the property. In most cases, final loan approval can be completed within a few weeks. However, actual mortgage processing times will vary depending on the lender and appraiser.

Once you get the go-ahead to move forward, your title company or closing agent will set up a meeting for you to sign all of the paperwork and officially close on your new home.

Related: What Happens After a Mortgage Pre-Approval?

Why Are Mortgage Rates Lower than Credit Card Rates and Other Loans?

After rising throughout the pandemic, mortgage rates have dropped slightly from their October 2023 peak. Current average 30-year conventional rates are hovering around or just below 7%. While this is much higher than the sub-3% rates available a few years ago, interest costs remain consistently lower than other types of loans.

It's not uncommon for credit cards to have interest rates ranging from 25% to 30% or even higher. According to Bankrate, the average personal loan in June 2024 had an interest rate of 12.22%.

Even the average interest rate on a used car was 11.91% during the first quarter of 2024, according to Experian.

So why are mortgage rates lower? It's because your mortgage is a type of secured loan. If you stop making your payments, the lender can take possession of the asset securing the loan – your home – and liquidate it to recoup their funds. This safety net allows lenders to offer you a lower interest rate.

Auto loans work the same way, although the asset securing them – your vehicle – depreciates over time rather than go up in value like a home. As a result, these secured loans are riskier than mortgages and therefore come with higher rates.

Credit cards and personal loans are types of unsecured debt. Unlike your mortgage or auto loan, no asset backs their repayment. You would harm your credit if you default on an unsecured loan, but the lender would have fewer avenues for recouping their funds. As a result, unsecured interest rates tend to be much higher.

Getting the Best Deal on a Mortgage

Are you considering taking out a mortgage and want to get the best deal possible? Here are some things you should consider:

• Your credit score has the most significant impact on the interest rate lenders quote. If you're planning ahead and are not quite ready to buy a home yet, taking steps to improve your credit score is one of the best things you can do to get a good deal on a mortgage.

• Having fewer monthly debt obligations can lower your quoted interest rate even further. We discussed how lenders cap your overall allowable debt, but it's helpful to keep your total monthly payments as low as possible. Having a lower DTI makes you a less risky borrower.

• What about when you're ready to begin applying for mortgages? The absolute most effective way to get the best deal on a mortgage is to shop around with multiple lenders. Not all companies will offer the same rate, and you'll likely see closing costs differ from lender to lender.

• As a rule of thumb, you will want to apply with at least three different mortgage providers to compare quotes accurately. You can even use these loan estimates to pit lenders against each other to earn your business with the lowest rate or cheapest closing costs.

• To reduce the upfront costs of buying a home, consider options like asking a family member for gift funds or applying with a down-payment assistance program.

What’s Included in a Mortgage Payment?

At a minimum, your monthly mortgage payment will go toward reducing your principal balance – the amount you owe – and paying interest to your lender.

In most cases, however, borrowers also pay for their property taxes and homeowners insurance policy as part of their mortgage payments. These annual expenses are divided evenly between the monthly payments, and the allocated amounts are held in escrow to ensure the bills get paid.

For example: If you took out a $350,000 30-year mortgage at an interest rate of 6.5%, your monthly principal and interest (P&I) payment would be $2,212. Annual taxes for your home are estimated at $3,600 ($300 per month), and your homeowners insurance policy is $2,400 annually ($200 per month). In this scenario, your total monthly mortgage payment would be $2,712.

How Do Lenders Calculate the Principal and Interest Payment?

The process for determining your monthly principal and interest payments can be complex. Thankfully, loan calculators are widely available, which makes things a whole lot easier. But if you're interested in the more technical side of it, here's how loan amortization works.

First off, the formula for calculating the monthly P&I payment on a fully-amortized fixed-rate mortgage is:

Here, P is your monthly P&I Payment, a is the total balance of your loan, r is your monthly interest rate (your annual rate divided by 12), and n is the total number of payments (360 for a 30-year mortgage).

This formula establishes a fixed payment amount that extinguishes your debt and pays off your interest costs in accordance with the length of your loan. But even though your payments remain the same, the amount that goes toward principal and the amount that goes toward interest changes over time.

During the early years of your loan, most of your payment goes toward interest. For the last few years of repayment, the lion's share goes toward reducing your principal.

Nowadays, you can use an online loan calculator to see a complete amortization schedule in just a few clicks. This will tell you how much of your payment is going toward principal reduction and how much is paying off interest based on how far along you are in your repayment.

However, once you learn your monthly payment (or calculate it using the formula above), you can use that figure to determine how your payment is being applied.

For your first payment, multiply your total loan balance by your annual interest rate. Then, take that total and divide it by 12. This is the amount of interest you'll pay during the first month. Subtract this from your monthly payment – what's left over will be the amount that goes toward reducing your principal.

For example: A $250,000 loan at an interest rate of 6% would have a monthly P&I payment of around $1,500. During the first month, $1,250 of the payment would go to interest, and you'd see a principal reduction of approximately $250. This would leave your new loan balance around $249,750.

For month two, take your newly reduced principal balance and complete the calculation again. This process can be repeated for the entire length of your loan to provide you with a full breakdown of how your debt will be extinguished over time.

Finding the Right Mortgage for You

The process of getting a mortgage can be confusing, but it doesn't need to be. An experienced lender will help you better understand how a mortgage works and what size loan you could qualify for based on your unique individual situation.

To discover more about how a mortgage can help you accomplish your homeownership goals, check today’s current interest rates and apply with a reputable lender serving the area you want to buy in.