A mortgage is a loan you take out on a piece of land or real estate when you don’t have all the cash-on hand to buy, improve or maintain it on your own. A bank or other financial institution will lend you the money under the condition that you repay the loaned amount by a set number of years and also pay interest on the borrowed amount during that time.
Since buying a home is most people’s largest purchase, a mortgage is likely to be your biggest debt but also a “good debt”. Homeownership is seen as a sign of financial stability, even if you’re a co-borrower. Being able to maintain a mortgage payment shows lenders and creditors that you are fiscally responsible. According to Zillow research, 78% of buyers used a mortgage to purchase a home and more than half (58%) of them used the mortgage to finance between 81% and 97% of the sale price — meaning borrowers put down less than 20% on the home.
How does a mortgage work?
A mortgage works by using the property as collateral for the loan. As the home buyer, you pay the upfront down payment on the house. The lender pays the difference between the down payment and the total sale price of the home. A mortgage gives many people the financial support they need to be able to afford a home and become a homeowner. Here’s an overview of the mortgage loan process.
1. Decide if you want to get pre-approved first: While a pre-approval is optional and not required in order to be approved for a mortgage, it can help you determine the loan amount you may qualify to borrow and also show sellers that you’re a serious buyer. According to Zillow’s Consumer Housing Trends Report 2022, 85% of sellers say that they prefer to accept an offer from a buyer that is pre-approved.
2. Apply for a mortgage: When you apply for a mortgage, the lender will likely start by using an automated underwriting system (AUS) to look at your credit score, income, assets and debt to make sure you’re likely to repay the loan. Before officially approving your loan, the lender’s underwriting department may require further information about the property you’re purchasing like its appraised value.
3. Receive a loan approval: If your mortgage is approved, you’ll receive a written commitment from the lender, documenting the loan terms and your mortgage agreement. At this time, you can review your expected mortgage costs and any conditions you must meet before closing.
4. Complete the closing process: When taking out a mortgage, you’ll need to sign a promissory note and security instrument at closing. These documents show that you acknowledge a debt exists and promise to repay the borrowed amount with interest by a set period of time, usually within 15 to 30 years of the loan start date.
5. Make on-time payments: You’ll need to make recurring mortgage payments until the loan is paid in full. While you technically own the home during this time, having a mortgage means your lender also has an interest in the property. If you fail to keep up with your payments, the mortgage gives the lender a right to take possession of the home and sell it to recover the debt owed through a process called foreclosure.
6. Start building equity: As you get further into paying off your mortgage, you build equity in your home — meaning you own a little bit more of the home and the lender owns less. When the mortgage is paid in full, the lender no longer has a security interest in your property — giving you full ownership of the home.
7 things to look for in a mortgage
When you go to close on your mortgage, you’ll sign a promissory note, saying you promise to follow all the agreed-upon terms of the loan in order to keep the property. Make sure you understand the terms you’re agreeing to, such as:
- The type of loan
- The loan amount (estimate your affordability)
- Whether the interest rate is fixed or adjustable
- The lender fees and loan processing costs that make up the annual percentage rate
- The repayment schedule (usually monthly payments are required)
- Any additional clauses or penalties (like a prepayment penalty)
- The number of years you have to repay the loan
Types of mortgage loans
There are two common types of mortgage loan programs: conventional and government-backed. Each one offers several different types of loans. Let’s explore the similarities and differences between conventional and government-backed loans.
Conventional
A conventional loan is a mortgage provided by a private lender, like a bank or credit union. This type of mortgage isn’t insured by the federal government, so lenders often set their own qualifying guidelines to balance the financial risk they take when loaning you money.
Conventional loans can be either conforming or non-conforming. A conforming loan meets Fannie Mae or Freddie Mac’s requirements, such as a max debt-to-income (DTI) ratio of 50%, a credit score minimum of at least 620, a down payment of no less than 3%, a loan max amount within the current loan limits and other qualifying credit history details. A non-conforming loan fails to meet these requirements. Jumbo loans are the most common type of conventional, non-conforming loan you’ll run into.
Government-backed
Government-backed loans are also a type of non-conforming mortgage that is financed by a private lender. The difference is that government-backed loans include additional insurance from the federal government. The insurance removes the risk of loan default on the lender, which makes these types of mortgages more accessible to borrowers who otherwise might not qualify for a conventional loan.
Government-backed loans have their own specific loan requirements that you must meet in order to qualify depending on the type of loan program you choose. Because of this, lenders who offer government-backed loans typically set more flexible requirements when it comes to credit, income and collateral. The most common types of government-backed loan programs you’ll find are FHA, VA and USDA — all of which are managed by different government-run agencies.
How long is a mortgage term?
A mortgage term is the length of time you have to repay the loan amount borrowed with interest. Most mortgage terms are either 30 or 15 years. However, mortgage terms may be as short as 10 years and as long as 50 years. Longer term loans generally have a smaller mortgage payment than shorter term loans, but you typically pay more in interest over the longer term.
What is interest on a mortgage?
Lenders charge interest on the money you borrow. This interest is represented by a percentage of your loan amount like 6.25% of $300,000. Your interest rate may be higher or lower than this, depending on your credit history and worldly factors outside of your control like the health of the housing market and the economy. While your lender decides the interest rate you receive on a mortgage, rates are ultimately influenced by the Federal Reserve Board who determines the rate at which banks can borrow money from other banks. Depending on the type of mortgage you choose, your rate may be fixed or adjustable.
After applying for a mortgage, you can find an estimate of your interest rate on the loan estimate. Until you lock in your rate or finalize your loan, keep in mind that your interest can change daily. Once you close on a home, your exact interest rate will be listed on your loan disclosure, along with your annual percentage rate (APR).
Fixed-rate vs adjustable-rate mortgages
If you plan on staying put until the mortgage is paid off, a fixed-rate loan will give you stability. The interest rate is a little higher than an adjustable-rate mortgage (ARM). But it won’t go up like an ARM can. The only things that will change your house payment over time are property taxes and insurance rates, but those will change regardless of which type of loan you get.
On the other hand, if you know you will be selling in the not-too-distant future, the lower interest rate that comes with an ARM might make sense. Even if rates jump in a few years, you’ll be selling anyway so it won’t impact you. You can also select a hybrid ARM that is fixed for a certain number of years (3, 5, 7 or 10) then adjusts annually for the remainder of the loan. The risk with an ARM is that if you don’t sell, your payments may go up and you may not be able to refinance.
Fixed-rate mortgages
Fixed rates stay the same for your mortgage term, meaning if your interest rate is 6.5% in the first year, it’ll be 6.5% in the final year of your mortgage. The most common type of mortgage interest rate for first-time home buyers is a 30-year fixed rate mortgage.
Adjustable-rate mortgages
Adjustable rates stay the same for a fixed number of years and then change annually based on the market after the fixed period ends. For example, if you have a 5-year ARM with a fixed 6.5% interest rate, your rate may go up or down after the first 5 years. Most ARMs have a cap on how much a rate can increase each year and over the initial interest rate. The cap is 5%, meaning the interest rate can never be 5% higher than the initial interest rate. Also, if overall rates go down, your rate could go down as well.
Lender fees and borrowing costs (APR)
Lenders generally charge fees and other costs that are reflected in the annual percentage rate (APR). The APR includes your interest, along with any mortgage points you purchase and credits you receive from your lender. Unlike interest rates, the APR provides a more complete picture of your annual cost of borrowing money. You can look up current mortgage rates online or speak to a lender to get a rate personalized for you.
How to pay back your mortgage debt
In order to pay back your loan, you’ll need to make mortgage payments either monthly or bi-weekly, depending on the terms of your agreement. Mortgage payments are primarily made up of a percentage of the actual loan balance (known as the principal) and the interest owed for borrowing the loan. Your lender may collect your property tax and homeowners insurance premiums along with your principal and interest each month to ensure the bills are paid on time. The sum of these payments are often referred to as PITI.
| Mortgage payments = Principal + Interest + Taxes + Insurance |
| Principal: The remaining balance owed on the amount you borrowed. Interest: An annual percentage of your principal that you pay your lender monthly. Taxes: Annual cost paid to the county treasurer based on the property’s current value. Insurance: Annual premiums that you pay monthly to insure the property and/or loan. |
Additional monthly mortgage expenses
Note, that in addition to homeowners insurance, your lender may also require you to pay what’s called mortgage insurance on conventional and FHA loans depending on your down payment amount. This insurance protects the lender if you fail to make your payments. When you put a down payment of less than 20% on a conventional loan, you’ll pay private mortgage insurance (PMI) until you reach 20% equity. FHA loans have mortgage insurance premiums (MIP) for the life of the loan. VA and USDA loans do not require mortgage insurance.
You may have other monthly costs associated with owning a home that are your own responsibility, such as homeowners association (HOA) fees and home warranty premiums. Make sure to stay on top of these expenses to avoid any late fees or penalties. You can use Zillow’s online mortgage calculator to estimate your mortgage payment, including any PMI, property tax, homeowners insurance and HOA dues.
How to read your mortgage statement
At first, most of your mortgage payment will go to interest. As you pay off more of your mortgage, you’ll owe less interest and more of your payment will go to paying off your principal loan balance. Your loan servicer will provide you with a mortgage statement each year that includes up-to-date information about your loan, such as:
- Your current mortgage balance
- Your current interest rate
- The remaining loan balance owed
- Your amortization schedule for paying off your mortgage
- The amount of funds paid into and remaining in your escrow account
- Any late fees or prepayment penalties
If you make extra payments on your mortgage, make sure the money is used to pay the principal not the interest on your loan. The more principal you pay, the more equity you build — meaning you’ll own a little bit more of the property and the lender will own a little bit less. Any time you make an extra payment, your mortgage loan servicer will re-amortize the loan accordingly to reflect the new principal and the new interest amount owed over the remainder of your loan term. You can do the same using Zillow’s amortization calculator to show you how much of your mortgage payment is going toward principal and interest each month.