What Is a Mortgage? How Mortgage Loans Work

Let’s be real – mortgages can feel about as clear as a muddy puddle. Whether you’re a first-time buyer trying to understand the basics or just looking to level up your financial knowledge, we’ve got you covered. We’ll break down everything you need to know about mortgages into bite-sized pieces that actually make sense. And who knows? That dream house with the perfect kitchen for your TikTok cooking videos might be closer than you think.

What is a mortgage? 🏠

A mortgage is a loan used to purchase real estate, typically a home. The property serves as collateral for the loan, which is repaid over many years through monthly payments. 

These payments include both the principal (the amount borrowed) and interest charges. If the borrower fails to make payments according to the loan terms, the lender can take possession of the property through foreclosure.

How does a mortgage work?

When you get a mortgage, you’re entering a long-term agreement with a lender who provides the money to buy your home. You then repay this loan through monthly payments, typically over 15 to 30 years. These payments include the loan principal, interest, and often other costs like property taxes and insurance.

Think of a mortgage like a financial seesaw – at the start, you’re paying mostly interest, but as you continue making payments, the balance shifts toward paying more principal, gradually building your home equity over time. 

At the end of your mortgage, assuming you’ve made all your payments, you’ll own your home outright – meaning you’ll have 100% equity and no more mortgage payments.

Key components of a mortgage

Down payment

Your down payment is the initial amount you pay upfront when purchasing a home. While traditional mortgages often require 20% down, many loan programs now offer lower down payment options. The size of your down payment affects your monthly payments and whether you’ll need private mortgage insurance.

Principal

This is the actual amount you borrow to buy your home. For example, if you’re buying a $300,000 home and make a 20% down payment ($60,000), your principal would be $240,000. Each monthly payment reduces your principal balance.

Interest rate

The interest rate is the cost of borrowing money, expressed as a percentage of your loan amount. Your rate depends on various factors, including:

• Your credit score
• Market conditions
• Loan term
• Type of mortgage (fixed or adjustable)

Monthly payments

Your monthly mortgage payment typically includes several components:

• Principal and interest 
• Property taxes
• Homeowners insurance
• Private Mortgage Insurance (PMI) if required

Loan term

The loan term is the length of time you have to repay your mortgage. Common terms are:

• 30-year mortgage: Lower monthly payments but more interest paid over time
• 15-year mortgage: Higher monthly payments but less total interest paid

Amortization

Amortization describes how your loan balance decreases over time. In the early years of your mortgage, a larger portion of each payment goes toward interest. As you continue making payments, more goes toward the principal, helping you build equity faster.

Private mortgage insurance (PMI)

If your down payment is less than 20%, many lenders will typically require PMI. This insurance protects the lender if you default on the loan. Once you build enough equity (usually 20%), you can request to have PMI removed.

Types of mortgages

Mortgages are like shoes – one size definitely doesn’t fit all. Some are built for first-time buyers still building their credit, while others are perfect for those ready to flex their stellar credit scores. Let’s break down the different types of mortgages.

Conventional mortgages

Conventional loans are the most common type of mortgage, not backed by the government. They typically require good credit scores and a down payment of typically 20%, though you may be able to find some options with minimum requirements as low as 3% to 5%. These loans can have either fixed or adjustable rates.

Government-backed mortgages

Government-backed mortgages offer a pathway to homeownership for buyers who might not qualify for conventional loans. These mortgages are insured by federal agencies, which allows lenders to offer more flexible terms and lower down payments. The three main types are:

• FHA loans: Designed for buyers with lower credit scores or limited down payments
• VA loans: Exclusively for veterans and military families, offering no down payment options
• USDA loans: Help buyers purchase homes in rural areas with 100% financing

These loans often feature competitive interest rates and more forgiving credit requirements, making them particularly attractive for first-time homebuyers.

Fixed-rate mortgages

With a fixed-rate mortgage, your interest rate stays the same for the entire loan term, typically 15 or 30 years. This means predictable monthly payments, making it easier to budget long-term.

Adjustable-rate mortgages (ARMs)

ARMs start with a fixed rate for a specified period, then adjust periodically based on market conditions. They often begin with lower rates than fixed-rate mortgages but carry the risk of rate increases over time.

The mortgage process explained

The entire mortgage process typically takes 30 to 45 days from application to closing, though timing can vary based on various factors including the type of loan, property issues, and document requests.

Getting a mortgage might look like a mountain of paperwork and endless waiting (spoiler: it kind of is 😅). But don’t let that scare you away from your dream home! These steps to getting a mortgage are totally doable when you know what’s coming.

Step 1: Pre-approval: This first crucial step involves a lender reviewing your credit score, income, debts, and assets to determine how much you can borrow. Getting pre-approved can help give you a clear budget for house hunting and shows sellers you’re a serious buyer.

Step 2: House hunting: With your pre-approval in hand, you can confidently shop for homes within your budget. Work with a real estate agent to find properties that meet your criteria and coordinate viewings.

Step 3: Mortgage application: Once you’ve found your dream home and your offer is accepted, you’ll submit a formal mortgage application. This requires detailed documentation including pay stubs, W-2s, tax returns, bank statements, and employment verification.

Step 4: Loan processing: During this stage, your lender’s team verifies all your financial information, orders a professional appraisal of the property, checks the title history, and requests any additional documentation needed.

Step 5: Underwriting: The underwriter conducts a thorough evaluation of your financial profile, the property’s value and condition, title search results, and all supporting documentation. They determine if the loan meets the lender’s requirements and may request additional information.

Step 6: Final approval and closing: After loan approval, you’ll receive a Closing Disclosure detailing final loan terms, arrange for homeowner’s insurance, schedule a final walkthrough, and attend the closing to sign documents and receive your keys.

➡️ Complete Guide on How to Buy a House

Qualifying for a mortgage

Before you start dreaming about paint colors and kitchen backsplashes, let’s talk about getting mortgage approval. We’ll break down what most lenders are looking for when they’re deciding whether to approve your home loan. 

Credit score: Most conventional loans require a minimum credit score of 620, however, it can vary depending on your type of mortgage. 

• FHA loans: Minimums may be as low as 500 for some
• VA loans: No official minimum, but lenders often prefer 620 or higher
• USDA loans: No official minimum, but lenders typically look for 640 or higher

Income and employment: Lenders want to see a stable employment history, typically at least two years in the same field. They’ll verify your income through pay stubs, W-2s, and tax returns to ensure you can afford the monthly payments.

Debt-to-income (DTI) ratio: This compares your monthly debt payments to your gross monthly income. Most lenders prefer a DTI ratio below 45%. Your DTI includes:

• Proposed mortgage payment
• Car loans
• Student loans
• Credit card payments
• Other recurring debt obligations

Down payment: While traditional mortgages often require 20% down, many loan programs now offer lower options:

• Conventional loans: As low as 3% to 5%
• FHA loans: As low as 3.5%
• VA and USDA loans: May require no down payment.

Assets and reserves: Some lenders may want to see that you have enough savings to cover at least several months of mortgage payments.

Documentation: Be prepared to provide:

• Recent pay stubs
• W-2s and tax returns
• Bank statements
• Investment account statements
• Information about other assets or debts

Shopping Around to Find Your Mortgage Match

Rushing into a mortgage without shopping around is like buying the first pair of shoes you see (except this decision sticks with you for 30 years! 😱). That’s why it’s crucial to compare offers from multiple lenders to find the best interest rates and terms for your situation. 

Even a seemingly tiny difference in interest rates can save you thousands over the life of your loan.

One of the easiest ways to compare personalized mortgage offers is to work with a marketplace, such as MoneyLion. Simply input some basic details and you’ll be matched with personalized home loan offers from our network of providers. Compare terms, interest rates, and more to choose the best fit!

FAQs