What is a mortgage? Basics for first-time home buyers

What is a mortgage?

A mortgage is a loan used to buy a home. Mortgages let you borrow a large amount of money — often hundreds of thousands of dollars — and pay it back at a low interest rate over a long time. The funds you borrow with a mortgage can only be used to buy, refinance, or improve a home.

If you’re planning to buy a house (or a condo, rental property, or another type of real estate), odds are you’ll need a mortgage.

This is the biggest financial commitment most people ever make, so it’s important to understand how mortgages work before jumping in. Here’s what you’ll need to know.

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Mortgage basics

A mortgage loan lets you buy a home now and pay it off over time, rather than having to save up and pay the full purchase price in one lump sum.

For comparison, you can think about a mortgage like a car loan. You borrow a large sum for your purchase and then make monthly payments at a fixed interest rate until the loan is paid off.

Mortgages are useful because very few home buyers have enough cash on hand for such a large purchase.

Instead of paying out-of-pocket, a mortgage lets you spread out the cost of your purchase over many years and makes home buying much more affordable.

Key mortgage terms to know

Most home buyers put some of their own money toward their home purchase (this is known as a ‘down payment’). Then, they cover the rest of the sale price using a mortgage loan. That loan amount is paid off at monthly intervals, often over 30 years.

Mortgages might seem complicated. But really, you can understand how they work if you know these four simple terms:

• Down payment: The amount you pay toward the home purchase out of your own savings
• Loan amount: The amount you borrow to cover the rest of the purchase price. Your loan amount will be the home’s sale price minus your down payment
• Loan term: This is the amount of time you have to pay back your mortgage. If you make full payments on time every month, your loan balance will end up at zero during the last month of your loan term
• Interest rate: Your interest rate or “mortgage rate” is the cost of borrowing money expressed as a percentage. For instance, if you borrow $100,000 at 3%, you will pay $3,000 per year in interest. (Well, not exactly because you’re paying down principal throughout the year, but we’ll keep things simple.) This is your mortgage lender’s profit for lending to you. Mortgage rates are expressed as a percent of the borrowed amount, just like auto loan rates or credit card annual percentage rates (APRs)

There are other details you’ll want to know as you start applying for home loans, but these are the most important things to know about how a mortgage works.

Your down payment, loan amount, loan term, and interest rate determine how much house you can afford, how big your monthly payments will be, and how much interest you will have paid by the time your home is paid off.

How does a mortgage work?

Mortgages come in lots of shapes and sizes. But most home buyers use the same general loan type: a 30-year, fixed-rate mortgage (FRM).

Let’s break down what that means:

• You have 30 years to pay back what you borrow. Your loan amount will be broken down into 360 monthly payments (12 monthly mortgage payments per year x 30 years)
• Your loan has a fixed interest rate. This means the total interest cost is predetermined, so you know from the outset exactly how much interest you’ll pay over the life of the loan, and your lender can never increase your rate
• Your monthly payments are always the same. With a fixed-rate loan, the monthly payments never change. For instance, if you pay $1,000 per month in year 1 of your mortgage, you’ll pay $1,000 per month in year 30

In addition, most home loans are “fully amortized.” Amortization just means your payments are scheduled so that at the end of the loan term, your house will be fully paid off.

There are other common mortgage options, too, like 15-year mortgages and adjustable-rate mortgages. But most home buyers prefer the longer-term 30-year fixed-rate loan for its predictability and affordable payments.

If you’re shopping for mortgages as a first-time home buyer, this is the first loan type you should look at.

You can use a mortgage calculator to estimate how much mortgage you might qualify for based on your current income.

Do I have to keep my mortgage for all 30 years?

One important thing to note is that taking out a 30-year mortgage does not mean you’re committing to living in your home for 30 years.

You don’t have to keep the loan until its end date and pay it off in full. In fact, most homeowners don’t. They either sell or refinance the home before their mortgage term is up.

• If you move and sell your home before it’s paid off, part of the proceeds from the home sale will be used to pay off any remaining loan amount due to your mortgage lender
• If you decide you want a different type of loan or a lower interest rate later on, you can refinance your mortgage. This involves replacing your existing mortgage with a new loan that benefits you financially

You don’t need to worry too much about selling or refinancing right now.

Just know that taking out a mortgage doesn’t mean you’re stuck with the same loan for a 15 to 30 year period of time.

You can reevaluate your finances at any point down the road, and if your home or your mortgage no longer meet your needs, you’ll be able to move or get a new loan that suits you better.

Do I own my home when I have a mortgage?

In short, yes, you own your home. But that doesn’t exclude other parties from having some rights to it.

As long as you continue to make your mortgage repayments, keep the house in good condition, insure it, and pay taxes, no other party can take control of the property.

But if you neglect any of those items, the lender has the right to seize and sell the property. Likewise, if you don’t pay property taxes, your city or county can seize it to pay the taxes.

It may not seem like you “own” the house because of these third-party rights, but just keep in mind that there’s no need to worry about losing any control of the property if you hold up your end of the agreement.

How are mortgages different from other loans?

Mortgages are similar to other loans in that there is a certain amount borrowed, an interest rate paid to the lender, and a set number of years over which the loan must be repaid.

In this regard, a mortgage functions a lot like a car loan or any other installment loan that you pay off on a predetermined schedule.

However, there are some key differences that set mortgages apart from other loan types.

• A mortgage is specifically used to purchase (and sometimes renovate) real estate. The funds you borrow cannot be used for any other purpose — except in the case of some refinance mortgages, which don’t apply unless you have a mortgage already
• You don’t handle the money yourself. Your mortgage lender will pay the home seller directly, so you don’t actually receive the money from your mortgage at any point
• Mortgages are flexible. You have a lot of control over your down payment amount, loan term, loan program, and other features of the mortgage
• Mortgages have strict requirements for borrowers. Most mortgages have loan amounts in the hundreds of thousands. Since you’re borrowing so much money, a mortgage lender wants to be extra sure you can pay it back. To make sure you can repay the loan, lenders set minimum requirements for things like your credit score, income, existing debts, and assets

Mortgage requirements are put in place to protect lenders and borrowers.

A mortgage is a ‘secured loan,’ meaning the home you purchase is used as collateral for the money borrowed.

If you can’t repay your mortgage, you could face foreclosure, meaning the mortgage lender takes back the home and sells it to recoup the money it lent you.

Lenders scrutinize your personal finances during the mortgage application process and ask for lots of documents. But in the end, this benefits you and the lender both, because it helps ensure you’ll get an affordable loan and make a sound investment in your new home.

Why do home buyers use mortgages?

Mortgages make home buying accessible to all types of home buyers. Using a mortgage loan, you can buy a home even if you don’t have a huge savings account, high income, or great credit score.

Consider that the median home price in the U.S. hit $346,900 in 2021. And most home buyers don’t have $350K lying around that they can hand to a home seller.

Instead, they pay a smaller amount upfront (the down payment) and borrow the rest of the money needed to buy the home.

Some buyers can even get into a new home with $0 out of pocket if they play their cards right.

Mortgage loan benefits

Using a mortgage eliminates the need to come up with hundreds of thousands of dollars in cash. And it lets homeowners pay off their houses in affordable monthly installments.

Here’s an example of how using a mortgage makes home buying more accessible.

• Home purchase price: $350,000
• Out-of-pocket down payment: $50,000
• Loan amount: $300,000
• Loan term: 30 years
• Fixed interest rate: 3.5%
• Monthly payment for loan principal and interest: $1,300
• Loan balance at the end of year 30: $0
• Total interest paid by the end of year 30: $185,000

In this case, the home buyer pays only $50,000 upfront on a $350,000 home. And their monthly mortgage payment is around $1,300 — which is comparable to monthly rent payments in many big cities.

And this is just one example. Many home buyers have even smaller loan amounts and lower mortgage payments.

Mortgage loans provide flexibility

In addition, home loans are flexible, so you have a lot of control over your mortgage terms and your monthly costs.

For example, you could choose to save up and make a big down payment. This would lower your monthly housing payments and reduce the amount of interest you pay in the long term.

Or, if you don’t have a lot of savings and want to buy a home soon, you could make a small down payment. Most home buyers can qualify with just 3% to 3.5% down.

Your loan amount and payments would be a bit bigger in this case, but you can get into your home and start paying it off sooner.

Each home buyer can explore their mortgage options and find a unique loan structure that best fits their needs.

Mortgage loan drawbacks

The obvious downside to using a mortgage loan is that you end up paying a lot of interest to your lender. Although, you can pay additional amounts to the principal each month to pay off the mortgage faster. This strategy will lower the total interest paid over the life of the loan.

Mortgage rates are much cheaper than other forms of borrowing, like personal loans or credit cards. However, you’re paying interest on a very large loan amount over a long period of time. So the cost adds up.

But if the alternative is buying a house with a lump sum of cash, a mortgage looks a lot more attractive.

Saving up hundreds of thousands of dollars in cash just isn’t realistic for most people. So a mortgage becomes the best and only option.

Paying interest isn’t ideal. But for most of us, it’s a necessary tradeoff for being able to buy our own homes and enjoy the personal and financial benefits that come with homeownership.

Types of mortgage loans

There are various mortgage types to choose from. Each one offers different benefits and requirements for home buyers.

Here are the four main mortgage loan types, three of which are backed by the federal government:

• Conventional loans: Conventional loans are offered by just about every lender, and they have flexible terms and requirements. Conventional mortgages are not backed by the federal government. These loans are typically preferred by borrowers with good credit and moderate or large down payments (5% to 20% down)
• FHA loans: FHA loans are backed by the Federal Housing Administration. This mortgage program is generally meant for home buyers with poor or fair credit and low to moderate income, although those with good credit often choose FHA for its low down payment requirement and other flexibilities
• VA loans: The VA mortgage program is backed by the Department of Veterans Affairs. These loans make home buying very affordable for veterans and service members. You must have an eligible service history to qualify. But those who do have access to zero-down loans at very low rates
• USDA loans: USDA loans are backed by the U.S. Department of Agriculture. This mortgage program offers affordable loans at zero down for low and moderate-income borrowers in rural areas

Conventional loan basics

Conventional loans are also referred to as ‘conforming loans’ because they must conform to standards set by Fannie Mae and Freddie Mac — two government agencies that help keep mortgage rates low for American home buyers.

However, not all conventional loans are conforming loans. For example, jumbo loans are even larger mortgages used to purchase multi-million-dollar homes. Since, by nature, they cannot conform to Fannie and Freddie standards, jumbo loans are non-conforming conventional loans.

Government-backed loan basics

FHA, VA, and USDA loans are all insured by the federal government. But they’re offered by private lenders. So you can get them from most banks, credit unions, and mortgage companies.

Within each program, there are also various loan options.

• For instance, you can get a 30-year fixed-rate FHA loan or a 15-year fixed-rate FHA loan
• Conventional loans are typically the most flexible, with a wide range of loan terms, loan amounts, and interest rates
• Government-backed loans tend to be a little less flexible, but they have looser requirements intended to help borrowers who might have trouble qualifying for a conventional mortgage

You can learn more and compare the different mortgage types here.

You’ll also be assigned a loan officer when you apply for a mortgage. This individual will help you compare loan options in more detail and find the right one for your needs.

How do I qualify for a mortgage?

To qualify for a mortgage, you must meet the minimum standards of whichever loan type you determine is best for needs.

Each loan type is different, with varying qualification standards. But the steps to get mortgage-qualified are similar among the four programs.

1. Credit score
2. Debt-to-income ratio
3. Down payment
4. Closing costs

What credit score do I need for a mortgage?

First, you will need to meet a minimum credit score requirement.

Specific requirements can vary by lender, but the minimum score required for each program is:

• FHA loan: 580
• VA loan: 580-620
• Conventional loan: 620
• USDA loan: 640

Next, you will be asked to verify your income using W-2s, pay stubs, and federal income tax returns. Your debts will be verified, too, using a recent copy of your credit report.

If your credit report happens to include errors or omissions, which sometimes happens, you can provide documentation to your lender to correct such mistakes.

Your lender will also want to verify your employment history and your savings.

Lenders typically want to see you’ve been steadily employed with reliable income for at least two years. But there are exceptions to the 2-year rule, so it’s often possible to get a home loan even if you’re in a new job.

What should my debt-to-income ratio be for a mortgage?

Your debt-to-income ratio (DTI) is your total monthly debt repayments divided by your gross monthly income — your income before taxes are withheld.

• Total monthly debt repayment: $350
• Gross income: $3,500
• DTI: 10%

Lenders use your DTI to determine whether or not you can manage a mortgage’s monthly payments and repay your loan. As a rule of thumb, a lower DTI is always better. Yet the Consumer Financial Protection Bureau recommends a DTI of 43% or lower.

How big of a down payment do I need?

When you’re buying a home, the amount of money you bring to closing is known as your down payment.

You can think of your down payment as the part of the home purchase price that you’re not borrowing from the bank.

Many home buyers think they need 20% down to buy a house. But in reality, the minimum down payment required is a lot lower.

• VA loan: 0% down payment required
• USDA loan: 0% down payment required
• Conventional loan: 3% down payment required
• FHA loan: 3.5% down payment required

Keep in mind these figures are just minimums. You can choose to make a larger down payment if you want.

When you make a larger down payment, your monthly payment is reduced because you’re borrowing less money.

And, if you use a conventional loan — which most home buyers do — larger down payments are linked to lower mortgage rates.

Don’t forget closing costs

The down payment isn’t your only out-of-pocket expense when you buy a house. You also need to pay for closing costs.

Closing costs include all the various fees to set up your mortgage and officially transfer ownership of the home from the seller to you. These are additional charges on top of your down payment.

On average, closing costs come out to about 3% to 5% of the loan amount. So on a $300,000 mortgage, closing costs could easily be $9,000 or more.

This is a hefty amount of money that many first-time home buyers overlook when they’re just starting to think about a mortgage.

You should estimate closing costs for the home you want and include them in your budget, as they’ll have a big impact on the amount of money you need to save.

Mortgage FAQ

Here are answers to some of the most frequently asked questions about mortgage loans.

Do you qualify for a mortgage right now?

Online mortgage calculators can help you determine whether you might qualify for a mortgage. They can also help you estimate your home buying budget.

But, when you’re ready to get serious about home buying, you’ll need to get a mortgage pre-approval from a lender.

The pre-approval process involves filling out a loan application and letting a lender look at your credit and finances. The lender can then verify your mortgage eligibility and let you know how much you’re able to borrow.

Most home sellers and real estate agents won’t accept an offer if the borrower hasn’t been pre-approved, so this step is essential.

Luckily, getting pre-approved is generally free and can be done online pretty quickly.

If you’re ready to take the next step toward buying a home, you can start your pre-approval using the link below or by contacting a mortgage lender directly.