What Is A Mortgage? Loan Basics For Beginners
Miranda Crace16-minute read
February 04, 2022
For many, owning a home is part of the American dream. For most homeowners in America, getting a mortgage is just one of the steps to getting there.
If you’re contemplating homeownership and wondering how to get started, you’ve come to the right place. Here, we’ll cover all the mortgage basics, including loan types, mortgage lingo, the home buying process and more.
A Simple Definition Of A Mortgage
Before we dive in, let’s talk about some mortgage basics. First, what does the word “mortgage” even mean?
A mortgage, also referred to as a mortgage loan, is an agreement between you (the borrower) and a mortgage lender to buy or refinance a home without having all the cash upfront. This agreement gives lenders the legal rights to repossess a property if you fail to meet the terms of your mortgage, most commonly by not repaying the money you’ve borrowed plus interest.
Who Gets A Mortgage?
Most people who buy a home do so with a mortgage. A mortgage is a necessity if you can’t pay the full cost of a home out of pocket.
There are some cases where it makes sense to have a mortgage on your home even though you have the money to pay it off. For example, sometimes mortgage properties to free up funds for other investments.
What’s The Difference Between A Loan And A Mortgage?
The term “loan” can be used to describe any financial transaction where one party receives a lump sum and agrees to pay the money back.
A mortgage is a type of loan that’s used to finance property. A mortgage is a type of loan, but not all loans are mortgages.
Mortgages are “secured” loans. With a secured loan, the borrower promises collateral to the lender in the event that they stop making payments. In the case of a mortgage, the collateral is the home. If you stop making payments on your mortgage, your lender can take possession of your home, in a process known as foreclosure.
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How Does A Mortgage Loan Work?
When you get a mortgage, your lender gives you a set amount of money to buy the home. You agree to pay back your loan – with interest – over a period of several years. The lender's rights to the home continue until the mortgage is fully paid off. Fully amortized loans have a set payment schedule so that the loan is paid off at the end of your term.
The difference between a mortgage and other loans is that if you fail to repay the loan, your lender can sell your home to recoup its losses. Contrast that to what happens if you fail to make credit card payments: You don’t have to return the things you bought with the credit card, though you may have to pay late fees to bring your account current in addition to dealing with negative impacts on your credit score.
How Do I Get A Mortgage?
The process of getting a mortgage is fairly straightforward if you have a regular job, adequate income and a good credit score.
There are several steps you’ll need to take to become a homeowner, so here’s a rundown of what you need to do.
Get Preapproved Or Be Ready To Show Proof Of Funds
You’ll need a preapproval to be taken seriously – by real estate agents and sellers – in today’s real estate market.
It’s a good idea to get an initial approval from your mortgage lender before you start looking for homes. Getting preapproved upfront can tell you exactly how much you’ll qualify for so you don’t waste time shopping for homes outside your budget. In some very hot seller’s markets around the U.S., you may not be able to get a real estate agent to meet with you before you have a preapproval letter in hand.
There’s a difference between prequalification and preapproval. Prequalification involves sharing verbal or written estimates of your income and assets with your lender, who may or may not check your credit.
You can use our home affordability calculator to get a sense of what you can afford as you begin thinking about buying a home, but the numbers you use aren’t verified, so it won’t carry much weight with sellers or real estate agents.
Mortgage preapproval, on the other hand, means that the lender has verified your financial information and issued a preapproval letter to show sellers and agents that you have essentially been approved, pending only a determination of the house’s value and condition.
Rocket Mortgage® offers Verified Approval1, which verifies your income, assets and credit upfront, giving you the strength and confidence of a cash buyer. Because our process is thorough and respected, our Verified Approval letters carry much more weight than other preapproval letters.
When you’re ready to make an offer, you’ll attach your preapproval letter to your offer so that the seller can be sure you’ll be able to get a mortgage.
In many real estate markets, sellers have the luxury of choosing a buyer from among several all-cash offers. That means that sellers avoid the uncertainty of waiting for the buyer’s mortgage to be approved.
In those situations, buyers should attach a Proof of Funds letter with their offer so that the seller is certain that the buyer has the money they need at the ready to complete the transaction.
Shop For Your Home And Make An Offer
Connect with a real estate agent to start seeing homes in your area. You may find that because of high demand and COVID-19 restrictions, many homes can be viewed online only. In fact, the number of sales completed online during the pandemic has skyrocketed.
In other words, your buyer’s agent today will likely be your eyes and ears like never before. Real estate professionals can help you find the right home, negotiate the price and handle all the paperwork and details.
Get Final Approval
Once your offer has been accepted, there’s a bit more work to be done to finalize the sale and your financing.
At this point, your lender will verify all the details of the mortgage – including your income, employment and assets – if those details weren’t verified upfront. They’ll also need to verify the property details. This typically involves getting an appraisal to confirm the value and an inspection to evaluate the condition of the home. Your lender will also hire a title company to check the title of the home and make sure there are no issues that would prevent the sale or cause problems later.
Close On Your Loan
Once your loan is fully approved, you’ll meet with your lender and real estate professional to close your loan and take ownership of the home. At closing, you’ll pay your down payment and closing costs and sign your mortgage papers.
Who Are The Parties Involved In A Mortgage?
There are up to three parties involved in every mortgage transaction – a lender, a borrower and possibly a co-signer.
A lender is a financial institution that loans you money to buy a home. Your lender might be a bank or credit union, or it might be an online mortgage company like Rocket Mortgage®.
When you apply for a mortgage, your lender will review your information to make sure you meet their standards. Every lender has their own standards for who they’ll loan money to. Lenders must be careful to only choose qualified clients who are likely to repay their loans. To do this, lenders look at your full financial profile – including your credit score, income, assets and debt – to determine whether you’ll be able to make your loan payments.
The borrower is the individual seeking the loan to buy a home. You may be able to apply as the only borrower on a loan, or you may apply with a co-borrower. Adding more borrowers with income to your loan may allow you to qualify for a more expensive home.
Sometimes, because of a negative credit history or no credit history, a lender may ask a prospective borrower to find a co-signer for the mortgage. This is also synonymous with a co-borrower. A co-signer isn’t merely vouching for your character. They are entering into a legally binding contract that will hold them responsible for paying for the mortgage with or without any rights of ownership, should the borrower default on the loan.
Are There Different Types Of Mortgages?
There are many types of home loans. Each comes with different requirements, interest rates and benefits. Here are some of the most common types you might hear about when you’re applying for a mortgage.
Conventional Conforming Loans
The phrase “conventional loan” refers to any loan that’s not backed or guaranteed by the federal government. Conventional loans are often also conforming loans. The term “conventional” means that a private lender is willing to make the loan without government support, and “conforming” means that the mortgage meets a set of requirements defined by Fannie Mae and Freddie Mac – those are two government-sponsored enterprises that buy loans to keep mortgage lenders liquid, so they can continue making loans.
Conventional loans are a popular choice for buyers. You can get a conventional loan with a down payment of as little as 3% of the purchase price of the home. If you put down less than 20% for a conventional loan, you’ll usually be required to pay a monthly fee called private mortgage insurance, which protects your lender in case you default on your loan. This adds to your monthly costs but allows you to get into a new home sooner.
Non-Conforming Loans: Government-Insured Mortgages
In addition to conventional loans, most private lenders also offer government-backed mortgages. These mortgages are geared toward helping first-time, low- to median-wage earners and those with past credit difficulties buy a home. These are loans that lenders might deny without government insurance.
FHA loans are a popular choice because they have low down payment and credit score requirements. You can get an FHA loan at most lenders with a down payment as low as 3.5% and a credit score of just 580. These loans are backed by the Federal Housing Administration; this means the FHA will reimburse lenders if you default on your loan. This reduces the risk lenders are taking on by lending you the money; this means lenders can offer these loans to borrowers with lower credit scores and smaller down payments.
VA loans are for active-duty military members, qualified reservists, eligible members of the National Guard, qualifying surviving spouses and veterans. Backed by the Department of Veterans Affairs, VA loans are for those members of the U.S. armed forces, as a benefit of service. VA loans are a great option because they let you buy a home with 0% down and an upfront fee that can be built into the loan instead of private mortgage insurance.
USDA loans are only for homes in eligible rural areas (although many homes on the outskirts of the suburbs qualify as “rural” according to the USDA’s definition). To get a USDA loan, your household income can’t exceed 115% of the area median income. USDA loans are a good option for qualified borrowers because they allow you to buy a home with 0% down. For some, the guarantee fees required by the USDA program cost less than the FHA mortgage insurance premium.
Rocket Mortgage doesn’t offer USDA loans at this time.
Conventional Non-Conforming Loans: Jumbo Mortgages
Conforming mortgages are subject to lending limits. In 2022, the conforming loan limit in most of the U.S. is $647,200, while in areas of the country with high-cost housing, the limit is as high as $970,800. If you want to buy a house that costs more than that and you need financing, you’ll have to apply for a jumbo loan.
Because jumbo mortgages exceed the conforming loan limits and are offered by private lenders without government incentives, they’re considered conventional non-conforming loans. Traditionally, a jumbo loan required at least a 20% down payment, and tons of paperwork to get approved.
Rocket Mortgage offers the Jumbo Smart loan. With a Jumbo Smart loan, you can borrow up to $2.5 million. To qualify, you’ll need a down payment of 10.01% for a loan amounts up to $2 million. (or 15% if you’re buying a home with two units.) Beyond $2 million, you’ll need a down payment of 25%. You’ll need a qualifying credit score of at least 680 and a debt-to-income ratio no higher than 45%.
One money-saving feature here is that Rocket Mortgage does not require private mortgage insurance on Jumbo Smart loans. Insurance is typically anywhere between 0.5 – 1% of the loan amount annually. On a $1 million loan, this alone could save you anywhere between $416.67 – $833.33 per month.
How Are Interest Rates Set By Lenders?
Interest rates are the charges for the mortgage you’re seeking. Mortgage rates are determined by analyzing a wide variety of factors, some of which have nothing to do with either the lender or the borrower.
The interest rate is determined by two factors: current market rates and the level of risk the lender takes to lend you money. You can’t control current market rates, but you can have some control over how the lender views you as a borrower. The higher your credit score and the fewer red flags you have on your credit report, the more you’ll look like a responsible borrower. In the same sense, the lower your debt-to-income ratio (DTI), the more money you’ll have available to make your mortgage payment. These all show the lender that you are less of a risk, which will benefit you by lowering your interest rate.
If you’re shopping around – Freddie Mac’s research shows that soliciting even one additional offer can save borrowers $1500 on average – you’ll want to get the best rate possible for your mortgage. But lenders sometimes offer very low rates but charge a number of fees. To meaningfully compare mortgage offers, you’ll need to look at their annual percentage rate (APR).
The amount of money you can borrow will depend on what you can reasonably afford and, most importantly, the fair market value of the home, determined through an appraisal. This is important because the lender cannot lend an amount higher than the appraised value of the home.
When the pandemic hit in 2020, the Federal Reserve (the Fed) quickly dropped interest rates to discourage an economic recession. The Fed recently announced that interest rates will be rising in 2022 as they move to reduce inflation.
The Fed doesn’t set mortgage rates directly, but interest rates respond rapidly to changes in the Fed fund rate. Consumer loans are at the top of the borrowing risk pyramid, but mortgages are the lowest-priced of all consumer loans, because they’re secured by the property.
Fixed-Rate Vs. Adjustable-Rate Mortgages
Fixed interest rates stay the same for the entire length of your mortgage. If you have a 30-year fixed-rate loan with a 4% interest rate, you’ll pay 4% interest until you pay off or refinance your loan. Fixed-rate loans offer a predictable payment each month, which makes budgeting easier.
Adjustable-Rate Mortgage (ARM)
Adjustable rates are interest rates that change based on the market. Most adjustable-rate mortgages begin with a fixed interest “teaser rate” period, which usually lasts 5, 7 or 10 years. During this time, your interest rate remains the same. After your fixed-rate period ends, your interest rate adjusts up or down every 6 months to a year. This means your monthly payment can change based on your interest payment. ARMs typically have 30-year terms.
ARMs are right for some borrowers. If you plan to move or refinance before the end of your fixed-rate period, an adjustable-rate mortgage can give you access to lower interest rates than you’d typically find with a fixed-rate loan.
Your Credit Score, Income And Assets
As we’ve noted, you can’t control current market rates, but you can have some control over how the lender views you as a borrower. Be attentive to your credit score and your DTI, and understand that having fewer red flags on your credit report makes you look like a responsible borrower.
To qualify for the loan, you must meet certain eligibility requirements. Therefore, a person who gets a mortgage will most likely be someone with a stable and reliable income, a debt-to-income ratio of less than 50% and a decent credit score (at least 580 for FHA or VA loans or 620 for conventional loans).
What’s In A Mortgage Payment?
Your mortgage payment is the amount you pay every month toward your mortgage. Each monthly payment has four major parts: principal, interest, taxes and insurance.
Your loan principal is the amount of money you have left to pay on the loan. For example, if you borrow $200,000 to buy a home and you pay off $10,000, your principal is $190,000. Part of your monthly mortgage payment will automatically go toward paying down your principal. You may also have the option to put extra money toward your loan’s principal by making extra payments; this is a great way to reduce the amount you owe and pay less interest on your loan overall.
The interest you pay each month is based on your interest rate and loan principal. The money you pay for interest goes directly to your mortgage provider, who passes it to the investors in your loan. As your loan matures, you pay less in interest as your principal decreases.
Taxes And Insurance
If your loan has an escrow account, your monthly mortgage payment may also include payments for property taxes and homeowners insurance. Your lender will keep the money for those bills in your escrow account. Then, when your taxes or insurance premiums are due, your lender will pay those bills for you.
Almost all home loans charge some type of mortgage insurance unless you are able to make a 20% down payment. Conventional loans have private mortgage insurance (PMI).
FHA loans charge a mortgage insurance premium (MIP), both upfront and on a monthly basis regardless of the size of your down payment. VA loans charge a funding fee that can be rolled into the loan as part of the mortgage. USDA loans charge an upfront and monthly guarantee fee.
You’ll need to purchase private mortgage insurance (PMI) to protect your lender in case you default on your conventional conforming loan. In most cases, you’ll need to pay PMI if your down payment is less than 20%. You can usually request to stop paying PMI when you reach a loan-to-value ratio (LTV) of 80%. That’s a lender’s way of saying that you have 20% home equity.
Typically, PMI costs range from 0.5 – 1% of a home’s purchase price. The cost of PMI can be added to your monthly mortgage payment, covered via a one-time upfront payment at closing or a combination of both. There’s also a lender-paid PMI, in which you pay a slightly higher interest rate on the mortgage instead of paying the monthly fee.
If your mortgage is an FHA loan, you’ll be charged a mortgage insurance premium (MIP) upfront and throughout at least the first 11 years of the mortgage, regardless of the amount of your down payment or whether you’ve already built up 20% home equity. It’s important to note that unless you make a down payment of 10% or more, you’ll pay MIP for the life of the loan.
When you shop for a home, you might hear a bit of industry lingo you’re not familiar with. We’ve created an easy-to-understand directory of the most common mortgage terms.
Part of each monthly mortgage payment will go toward paying interest to your lender or mortgage investor, while another part goes toward paying down your loan balance (also known as your loan’s principal). Amortization refers to how those payments are broken up over the life of the loan. During the earlier years, a higher portion of your payment goes toward interest. As time goes on, more of your payment goes toward paying down the balance of your loan.
The down payment is the money you pay upfront to purchase a home. In most cases, you have to put money down to get a mortgage.
The size of the down payment you’ll need will vary based on the type of loan you’re getting, but a larger down payment generally means better loan terms and a cheaper monthly payment. For example, conventional loans require as little as 3% down, but you’ll have to pay a monthly PMI fee to compensate for the small down payment. On the other hand, if you put 20% down, you’d likely get a better interest rate, and you wouldn’t have to pay for PMI.
A mortgage calculator can help you see how your down payment amount affects your monthly payments.
Part of owning a home is paying for property taxes and homeowners insurance. To make it easy for you, lenders set up an escrow account to pay these expenses. Your escrow account is managed by your lender and functions kind of like a checking account. No one earns interest on the funds held there, but the account is used to collect money so your lender can send payments for your taxes and insurance on your behalf. To fund your account, escrow payments are added to your monthly mortgage payment.
Not all mortgages come with an escrow account. If your loan doesn’t have one, you have to pay your property taxes and homeowners insurance bills yourself. However, most lenders offer this option because it allows them to make sure the property tax and insurance bills get paid. If your down payment is less than 20%, an escrow account is required. If you make a down payment of 20% or more, you may opt to pay these expenses on your own or pay them as part of your monthly mortgage payment.
Keep in mind that the amount of money you need in your escrow account is dependent on how much your insurance and property taxes are each year. And since these expenses may change year to year, your escrow payment will change, too. That means your monthly mortgage payment may increase or decrease.
An interest rate is a percentage that shows how much you’ll pay your lender each month as a fee for borrowing money. The interest rate you’ll pay is determined both by macroeconomic factors like the current Fed funds rate as well as your personal circumstances, like your credit score, income and assets.
A promissory note is a written document that details the agreed-upon terms for the repayment of the loan being used to purchase a property. In real estate, it’s called a mortgage note. It’s like an IOU that includes all of the guidelines for repayment. These terms include:
- Interest rate type (adjustable or fixed)
- Interest rate percentage
- Amount of time to pay back the loan (loan term)
- Amount borrowed to be paid back in full
Once the loan is paid in full, the promissory note is given back to the borrower. If you fail to uphold the responsibilities outlined in the promissory note (e.g., pay back the money you borrowed), the lender can take ownership of the property.
The loan servicer is the company that’s in charge of providing monthly mortgage statements, processing payments, managing your escrow account and responding to your inquiries.
Your servicer is sometimes the same company that you got the mortgage from, but not always. Lenders may sell the servicing rights of your loan and you may not get to choose who services your loan.
The Bottom Line: There’s A Lot To Learn When You Decide You Want To Own A Home
Becoming a homeowner isn’t easy – and it’s certainly not cheap – but it’s worth the effort. It’s important to take the time to familiarize yourself with what a mortgage is before you plunge into the market. Ready to take the first step in your home buying journey? Get started on your preapproval today! You can also give us a call at (833) 326-6018.
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1 Participation in the Verified Approval program is based on an underwriter’s comprehensive analysis of your credit, income, employment status, assets and debt. If new information materially changes the underwriting decision resulting in a denial of your credit request, if the loan fails to close for a reason outside of Rocket Mortgage’s control, including, but not limited to satisfactory insurance, appraisal and title report/search, or if you no longer want to proceed with the loan, your participation in the program will be discontinued. If your eligibility in the program does not change and your mortgage loan does not close due to a Rocket Mortgage error, you will receive the $1,000. This offer does not apply to new purchase loans submitted to Rocket Mortgage through a mortgage broker. This offer is not valid for self-employed clients. Rocket Mortgage reserves the right to cancel this offer at any time. Acceptance of this offer constitutes the acceptance of these terms and conditions, which are subject to change at the sole discretion of Rocket Mortgage. Additional conditions or exclusions may apply.
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