How Do Mortgages Work?

If you’re looking to buy or sell a home, understanding current mortgage rates and how mortgages work is important. We’ll break it down for you here.

Fixed mortgages. Conventional loans. FHA programs. Down payments and closing costs. These are just some of the mortgage terms you’ll encounter when buying or selling a house, and it can be downright confusing to understand which concepts are even relevant to you—much less what it all means. How do mortgages work and what do you need to know before you apply for one? Find out in our guide below.

In This Piece

What is a mortgage?
How do you qualify for a mortgage?
What are mortgage rates and why does it matter?
What are mortgage terms?
What other factors impact your mortgage payments?
How do payments on a mortgage work?
Shopping for a mortgage

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What Is a Mortgage?

A mortgage is a loan for purchasing property and the legal agreement behind that loan. While the legal arrangement of each mortgage differs, there are some common basics:

• The lender agrees to provide the money to purchase the home.
• The borrower agrees to pay the money back in a set period of time, plus interest.
• The lender legally owns the home until the money is paid back.
• If the borrower defaults (doesn’t pay as agreed) the lender can force a sale of the property to recoup its losses.
• Once the borrower makes all agreed payments and completes the terms of the mortgage, ownership in the home is transferred to the borrower and they own the property outright.

How Do You Qualify for a Mortgage?

A mortgage is the biggest type of debt most people take on personally. Because of the risk involved for the lender, mortgages come with more hoops to jump through than smaller loans like auto loans or credit cards. While each situation differs, you typically have to prove the following to be able to get mortgage approval:

• Creditworthiness: Lenders will look at your credit score and credit history to determine your creditworthiness, which lenders view as your “riskiness”—the likelihood that you will pay your loan back on time and in full or not.
• Ability to pay: You’ll need to demonstrate that you are in a position to make the monthly mortgage payments without major hardship. Lenders look at factors such as your current income, how much debt you already have, and how much money you’re trying to borrow.
• Home worth: You typically can’t borrow more than a property is worth because that’s a terrible investment for a lender. But some mortgages and lenders only provide loans up to a certain percentage of the home’s value. You’ll be expected to pay the rest upfront as your down payment.

Do you need a down payment?

Depending on factors including your credit, the value of the home, and what type of mortgage loan you’re applying for, you may need a down payment. Traditionally, it’s been expected for buyers to have at least 20% of the purchase price as a down payment, but that’s not necessarily true anymore. Loans guaranteed by government programs, such as USDA or FHA loans, require smaller down payments. And even conventional loans may not require as much of a down payment.

However, if you don’t make a down payment of at least 20%, you will have to pay private mortgage insurance. This helps protect the lender if you default on the loan. Usually, PMI goes away once you pay the principal of your loan down to 80% of the value of the home.

What credit is required for a mortgage?

While you can potentially get approved for a mortgage with a score in the poor credit category, the terms may not be in your favor. Government-backed program such as FHA home loans tend to have more lax credit requirements, but in general you want a score of 620 or higher to get approved for conventional loans. And the higher your score, the better the terms might be—and that makes your home potentially less expensive in the long run.

Want to know how close you are to a good credit score for getting a mortgage? Sign up for ExtraCredit and get a look at 28 of your FICO® Scores before you start shopping and applying for mortgages. You can also get prequalified for a mortgage to have a better understanding of what type of home purchasing power you have.

What Are Mortgage Rates and Why Do They Matter?

Mortgage rates refer to the interest you pay on the loan. This is how the lender makes money, but it’s important to you because it’s one of the biggest factors in how much your house ends up costing over time. The better your credit and financial situation, the better your chances at getting good interest rates. Another term for these rates is mortgage APR.

Want to understand how big of a difference a small change in interest rate can make? Throw some different numbers in our mortgage calculator to see what you might end up paying on the same loan amount at different rates.

What Are Mortgage Terms?

Another factor in what you’ll pay monthly and over the life of your mortgage is the term. That’s how long you’re going to take to pay off the mortgage, as well as how the interest will be factored.

One of the most common options is a 30-year fixed rate mortgage. That means your payments are split up over 30 years of monthly payments and that the interest rate is fixed. It won’t change unless you refinance your mortgage.

Other common terms include 15-year fixed rate mortgages and 15- or 30-year adjustable rate mortgages. With an adjustable rate mortgage, the interest on your loan varies over time. This may be beneficial if you expect interest rates to drop in the near future.

What Other Factors Impact Your Mortgage Payment?

Many things make up your monthly mortgage payment. In addition to interest and principal, you may also pay taxes, homeowner’s insurance, and mortgage insurance as part of your monthly payment.

• Taxes. You may be able to pay property taxes as part of your mortgage payment. The money is placed into an escrow account and remains there until the tax bill for the property comes due. The lender will pay the property tax at that time out of the escrow fund.
• Homeowner’s insurance. Homeowner’s insurance is insurance that covers damage to your home from fire, accidents, and other covered incidents. Some lenders require this insurance be included in your monthly mortgage payment. This would also be held in the escrow fund.
• Mortgage insurance. Some types of mortgages require you to pay private mortgage insurance if you don’t make a 20% down payment on your loan and until your loan-to-value ratio is lowered. PMI backs the mortgage loan to protect the lender from the risk of the borrower defaulting on the loan.

How Do Payments on a Mortgage Work?

Basically, your mortgage payments work a lot like your car payments or other credit  payments. You have a due date every month that you must make your payment by. You can pay more than you owe to get ahead on your loan in many cases, and you can break your monthly payment into multiple payments if you need—as long as the total amount is in before the due date.

If you don’t make your mortgage payments on time, you could be charged a late payment penalty. The mortgage lender may also report the late payment to the credit bureaus, which can hurt your credit score. In many cases, you do have a short grace period to allow for mailed payments or small errors, so make sure you read your mortgage agreement carefully.

If you ever think you can’t pay your mortgage, don’t hide from the problem or ignore it. Contact your lender immediately, as it may be able to offer options such as mortgage assistance or restructuring.

Defaulting on your mortgage—which means not paying it as agreed—can result in foreclosure or other negative action. This is a huge negative impact to your credit and can result in you losing your home. If you find yourself in this situation, consult with a professional immediately.

Shopping for a Mortgage

You want to find the best deal when you’re ready to shop for a mortgage. But remember to apply for all mortgages you’re interested in within a short period—such as two weeks. That way these all get lumped together as one hard inquiry on your credit report, which is a smaller impact to your credit than a bunch of inquiries would be.

If you’re ready to start shopping for a mortgage, start by researching current mortgage rates.

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