Mortgage definition

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The simple definition of a mortgage is that it's a loan you take from a bank or other financial institution to help you purchase or refinance a home. The loans also are called mortgage loans or home loans.

Basically, they’re a way of getting a home without having to pay all the cash upfront — they make home ownership more accessible for everyone.

Who can get a mortgage?

Lenders will want to check your finances to determine if you qualify for a mortgage loan. They’ll want to see that you’ve had a steady income for the last few years, that you have some money available for a down payment and how your credit report rates.

Basically, they want to ensure that you’ve got a steady source of income — for at least the last two to three years — and that you aren’t a liability or likely to default on your loan based on your personal financial history.

What is the difference between mortgages and other loans?

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Mortgages are secured loans. These kinds of loans cover mortgages, car loans, personal loans and even some credit cards. But the common trait of all secured loans is collateral. It's the "stuff" that you have to put on the line, assuring the lender that even if you fail to repay your loan, they won’t come out empty-handed.

The collateral might be your house or your car. Or you may have to put up your savings. Something valuable it would hurt you to lose. In the case of a mortgage, the collateral is your house.

Mortgages involve multiple inputs on top of the principal and loan — but we’ll get to what that means next.

How does a mortgage work?

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When you take out a mortgage, you agree to repay the loan, with interest, under the condition that if you don’t, your house could be taken away — or, in real estate lingo, foreclosed on.

The amount you borrow for your mortgage loan is known as the principal. With your monthly payment, you are paying off the balance of the principal, as well as the interest that accrues. The interest is what your lender charges you for the loan.

According to the Consumer Financial Protection Bureau, the part of your payment each month that goes toward the principal reduces the amount you owe on the loan and builds your equity. However, the part of the payment that goes toward interest doesn’t reduce your balance or build your equity. So, the equity you build in your home will be much less than the sum of your monthly payments.

When you first take on a mortgage, you’ll be paying more in interest because the principal balance is still high. The more you pay down the balance, the less in interest you’ll have to pay.

Mortgage terminology

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There are a number of terms involved when we talk about mortgages, so let’s go over the most important ones:

Lender

A mortgage lender is a financial institution or bank that offers and underwrites secure loans for the purpose of taking on a mortgage.

Borrower

The borrower is the individual who applies for and receives the funds from a lender for the purpose of buying a home, with the understanding that they pay the funds back over a predetermined time period.

Amortization

This is essentially the timeframe the lender and borrower agree upon that the mortgage loan will be repaid. The typically agreed-upon period is 30 or 15 years.

Down payment

Your down payment is the lump sum you put towards the purchase of a home. Your lender will deduct this sum from the overall purchase price of your home. The more you put down, the less you’ll end up paying in the long run.

Escrow

Being in escrow is a legal concept where a third party holds money in an escrow account on behalf of two other parties (in this case, the borrower and lender) while they’re in the process of completing a transaction.

Interest rate

This is the percentage interest the lender will charge you based on the principal amount of your mortgage loan. There are two kinds of rates: fixed and adjustable.

  • With a fixed-rate mortgage, your interest rate will hold steady for the life of your loan. Fixed-rate mortgages are a good option if your income is stable and you’re planning to stay in your house for the long haul; your monthly payments will remain the same and you won’t have to worry about any surprise rate increases.

  • With an adjustable-rate mortgage, or ARM, you’ll pay a fixed rate for the first part of your loan term, and then your interest rate can go up or down based on the movement of a benchmark, such as the prime rate.

Loan servicer

This is an outside company that some borrowers pay their loan payments through. They handle the day-to-day tasks of managing your loan, including sending you your statement.

What goes into a mortgage or home loan?

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Your monthly mortgage payment covers a variety of costs, including:

Principal

The principal balance on your mortgage is the amount you still have left to pay; it’s the value of your original loan minus your down payment and any monthly payments you’ve made so far.

Each monthly payment you make toward your mortgage reduces your principal and the amount of interest you owe.

Most mortgage payment schedules start with a larger portion of your monthly payment going toward interest. As you near the end of the loan term, this distribution will shift — and the bulk of your payment will go toward your principal.

Your payments stay the same, but the mix of interest and principal changes — through a process called amortization.

Interest

The interest rate on your mortgage is the annual cost of borrowing the money, expressed as a percentage of your loan.

There are two main options: a fixed rate mortgage or an adjustable rate mortgage.

“An ARM is an attractive program for someone who is planning on living in their home for less than 10 years,” says Alan Rosenbaum, founder and CEO of GuardHill Financial, a mortgage banking and brokerage firm in New York. “It comes with a lower rate than a fixed-rate mortgage and is locked in for a stable period of five to 10 years before it can adjust up or down.”

According to Rosenbaum, “an ARM with an interest-only option is ideal for homeowners whose income fluctuates, since they have the option of how much principal they want to pay each month.”

Taxes and insurance

In addition to your mortgage payment, your lender might collect property taxes and keep the money in an escrow account until your property tax bill is due, then pay it on your behalf.

But it's possible you may have to pay your property taxes on your own, so you should get this issue nailed down with your lender — so you won’t miss a payment.

Some lenders may require you to pay for home insurance, which covers damage to your house caused by weather, accidents and natural disasters.

As with property taxes, your lender might collect your homeowners insurance premiums as part of your mortgage payments and keep the funds in an escrow account until it's time to pay your bill. It's a good idea to confirm this with your financial institution, just to make sure.

Private mortgage insurance

Mortgage insurance protects lenders against the risk of borrowers defaulting on their loans.

Most mortgage lenders will require you to buy private mortgage insurance, or PMI, if your down payment is less than 20% of your home’s purchase price, or if you’re refinancing and your equity is less than 20% of your home’s value.

If you’re paying PMI and your equity reaches 20% of your home’s purchase price, your lender may be willing to cancel your PMI.

For loans backed by the Federal Housing Administration, or FHA, you can make a down payment of as little as 3.5%, but you must pay a mortgage insurance premium, or MIP. You make a MIP payment upfront, at closing, and then pay annual premiums spread across your monthly mortgage payments.

If your down payment on an FHA loan is less than 10% of your home’s purchase price, you’ll be required to pay your MIP for the entire term of your loan. If you put more than 10% down, you’ll pay MIP for only 11 years.

Fees

In addition to your down payment, you’ll also pay a number of fees when securing your mortgage, including lender and origination fees, third-party closing costs and taxes and government fees.

Before you close, there will also be appraisal and home inspection costs. On your loan, if you’re working with a mortgage broker, you will pay a fee to them as well as your legal representative.

Once you close, you’ll pay property taxes and title fees. With the exception of your lawyer, who typically charges based on hourly services, each of these fees will reflect a specific percentage of the overall sale price.

Types of mortgage loans

Most mortgages are made up of the same core elements — principal, interest, monthly payments, and so on — but different types of home loans have their own unique conditions you should know about.

While there are a number of different types of loans, the three main types of mortgages are conventional, Federal Housing Administration (FHA) and Veterans Affairs (VA).

Conventional mortgages

These are the most common mortgages taken out by U.S. homebuyers and homeowners.

The requirements for getting a conventional mortgage are stricter than for a government-sponsored loan, such as an FHA mortgage.

Conventional mortgages are typically available only to people with good credit. The minimum credit score to qualify for a conventional loan is typically around 620.

These mortgages require private mortgage insurance if the down payment amount is less than 20% of the home’s purchase price.

There are two main types of conventional loans: conforming and nonconforming.

Conforming mortgages

These follow specific dollar-amount limits set by Fannie Mae and Freddie Mac, two government-sponsored agencies that buy mortgages from lenders and sell them as investments while guaranteeing the underlying loans.

The limits for single-unit homes in 2021 are:

  • $548,250 for most states.

  • $822,375 in high-cost areas, plus Alaska, Hawaii, Guam and the U.S. Virgin Islands.

Nonconforming mortgages

Also known as jumbo loans, these go beyond the limits listed above.

Without the blessings of Fannie Mae and Freddie Mac, conforming loans are considered higher risk and often come with higher interest rates and require larger down payments, usually 20% of the purchase price or more.

FHA loans

FHA loans are guaranteed by the Federal Housing Administration and are designed to benefit first-time homebuyers and those with lower or middle incomes.

The guidelines for FHA loans are less strict than for conventional loans: They require a lower minimum credit score to qualify — usually around 580.

The minimum down payment for an FHA loan is 3.5% of the loan amount. But again, any down payment under 10% of the purchase price will require you to pay a mortgage insurance premium (MIP) for the entire life of the loan, which can get pricey depending on the length of your term.

USDA loans

USDA loans are mortgages for rural and suburban homeowners that are guaranteed by the United States Department of Agriculture and require no down payment and no private mortgage insurance.

You’ll have to pay an upfront guarantee fee of 1% of the loan amount and an annual fee of 0.35%, but these costs are generally more affordable than paying for mortgage insurance.

There are income limits to qualify, so you won’t be able to take out a USDA loan if your household earns too much.

The 2021 income limits in most parts of the U.S. are $90,350 for one- to four-member households and $119,200 for five- to eight-member households, but the thresholds may be higher if you live in a county with a steeper-than-average cost of living.

VA loans

VA loans are guaranteed by Department of Veterans Affairs and are available to active service members, veterans and some surviving military spouses.

VA loans offer major benefits. They require no down payment or mortgage insurance, but borrowers do pay an upfront funding fee.

The fee typically ranges from 1.25% to 3.6% of the total amount of the loan, depending on your down payment amount and whether it's your first VA loan.

Second mortgage.

A second mortgage, also known as a home equity line of credit (HELOC), is a loan on a home that already has a primary mortgage.

It allows you to tap the equity, or value, you've built up in your home to cover expenses such as home improvements or your kid's college tuition.

If you can’t make your mortgage payments, your lender will be able to foreclose on your home and sell it to recoup the company's losses.

A second mortgage must be paid off after your first mortgage, so if you stop making payments your second lender won’t be paid until your primary lender has been fully reimbursed.

How to get a mortgage

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Get approved

To get approved for a mortgage loan, you can file an online application.

Shop around for a low rate

After you’ve started the application process, you will have to request a loan estimate from three or more lenders. You’ll need to provide them with:

  • Your name.
  • Your income.
  • Your Social Security number (so the lender can check your credit).
  • The address of the home you plan to purchase or refinance.
  • An estimate of the home's value.
  • The loan amount you want to borrow.

Get final approval

When you’ve picked the right loan with the right borrower for you, you’ll have to contact them to let them know you’re ready to proceed. They’ll ask you to provide them with proof of your income, assets, and employment and work as they process your loan application. It’s important to note that loan estimates will expire, so be sure to request them when you’re ready to move on a loan.

Close

Your final step will be to sign your closing documents. You’ll want to be sure to double-check everything here because once you sign, you’re responsible for the mortgage loan.

After you’re done submitting your documents and addressing anything with your lender, you’ll have to:

  • Schedule a home inspection.
  • Sign up for homeowner’s insurance.
  • Get title insurance and other closing services.
  • Review any new documents.
  • Save and file all documents.

How to lower your interest rate and pay smaller amounts

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Now that you’re up to speed on the basics of mortgages, you may be wondering how to get one at the lowest mortgage rate possible. A lower interest rate will ensure your monthly mortgage payment is lower, too.

The key to landing a low rate is to make yourself as appealing as possible to a lender.

Boost your credit score. When you have a higher credit score, you'll be seen as less risky — and will be rewarded with a better interest rate.

Credit scores are determined by information in your credit reports, including your payment history, the balance-to-limit ratios on your credit cards, the length of your credit history, and your current amount of debt.

The easiest way to increase your credit score is to pay your bills on time and keep your credit card balances low.

If you’re not sure about the current status of your credit score, get a free score online to find out.

Lower your debt-to-income ratio

Your debt-to-income ratio compares your monthly debt payments to your monthly gross income, and keeping it down can be a great way to get a better rate on your mortgage. A lower ratio demonstrates to your lender that you have enough money to comfortably make your mortgage payments every month.

The ideal ratio is 36% or less, which signals that you’re managing debt well and have money left over after paying your monthly bills.

If your ratio is higher than 50%, that means you're stuck spending a substantial portion of your monthly income on debt — not a good look if you’re applying for a mortgage.

The two primary ways to lower your debt-to-income ratio are to increase your income — maybe by taking on a part-time job or asking your boss for a raise — and to pay off your debt.

If you can get your debt fully paid off, maybe with the help of a debt consolidation loan, your ratio will drop down to 0% — which is a level that any lender will find very appealing.

Make a larger down payment

Another strategy for scoring a low mortgage rate is to make a larger down payment when you buy a home.

If you’re planning to take out a conventional loan, aim for a down payment of 20% or more of the purchase price so you can avoid that pesky private mortgage insurance.

If you qualify for an FHA loan, try to make a down payment of at least 10% of the price of your home to avoid getting locked into a mortgage insurance premium for your entire mortgage term.

Although paying a larger down payment will put more of a strain on your bank account when you first purchase your home, the long-term savings on interest and insurance premiums will be worth it.

Frequently Asked Questions

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How do mortgage lenders make money?

Mortgage lenders make their money mostly through fees. Upfront, they will charge you an origination fee that is a percentage of the total loan. There will also be some processing, application, underwriting, loan lock and closing fees that they will charge you.

Is it better to go to a bank or mortgage broker?

The main difference between these two is that a bank represents only its institution’s offerings, while a broker will server as an intermediary between multiple lenders and is paid a referral fee by those lenders. A broker will have a larger network and help you compare rates, fees and features. You may get a lower rate, however, brokers can also ding you with fees after closing.

How much should I save up before buying a house?

That depends on what kind of house you’re looking to buy. A good rule of thumb is to plan to have a 20% down payment on your home. While you’re planning and saving, it might be helpful to look at the kinds of homes in the neighborhood you’re hoping to buy in and see what price they’re selling for -- this will give you a better idea of how much you should have ready.

If most of the homes you’re finding have purchase prices that would make it difficult for you to put even 5% down, you may want to look at smaller houses or different neighborhoods. Or you may even want to hold off on buying a home until you have more money saved up.

What happens if I don’t have a down payment for a house?

The USDA mortgage for rural and suburban homeowners require no down payment and no private mortgage insurance. However, there are upfront fees and these loans are limited to households below a certain annual income.

What is a debt-to-income ratio tool?

Your debt-to-income ratio is used by lenders to determine whether they believe you can manage additional debt. They use a tool that compares the money you earn to the debt you're already carrying.

A lower DTI ratio shows a mortgage lender you have sufficient income to handle your current debt payments — and add a home loan to the mix. Generally, with a lower percentage, you can expect to be approved faster and at better interest rates for any loans, lines of credit or credit cards.

What goes into my monthly mortgage payment?

When you take out a loan to buy a home, what you’ll owe your mortgage lender goes beyond the amount you borrow (that is, your loan principal).

In fact, for the first few years of your loan term, you’ll mostly be paying interest — which is why it’s so important to lock in a great interest rate. Additionally, your payment may include your property taxes, private mortgage insurance premiums and homeowners insurance.

What is the best loan to buy a house?

It all depends on your credit score, how your personal finances stack up, and how much of a down payment you plan to make.

There are a lot of options to consider when it comes to taking out a mortgage. If you’re still feeling a bit lost, don’t worry — there are mortgage experts online who can help you figure out which type of mortgage loan is best for you.

About the Author

Sigrid Forberg

Sigrid Forberg

Staff Writer

Sigrid is a staff writer with MoneyWise. Before joining the team, she worked for a B2B publication in the hardware and home improvement industry and ran an internal employee magazine for the federal government. As a graduate of the Carleton University Journalism program, she takes pride in telling informative, engaging and compelling stories.

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