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Published: Oct 11, 2023 14 min read

A mortgage is a loan used to finance the purchase of a home or other real estate. Unlike credit cards or personal loans, mortgages are secured against the property being purchased. This means that if the borrower fails to pay back the loan, the lender or financial institution may repossess the property.

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How do mortgages work?

A home is perhaps the most expensive purchase most people will ever make, and not everyone will be able to afford it upfront. In fact, over 80% of homeowners in the United States have a mortgage.

Mortgage loans allow borrowers to purchase a new home or refinance an existing mortgage. These financial agreements use the property as collateral, so if you fail to repay your mortgage, the lender can repossess the home.

There are different types of mortgages available, so eligibility requirements, loan limits and even the kinds of properties eligible for financing will depend on the type of loan it is. Lenders may also impose their own requirements for eligibility.

In general, most lenders require prospective borrowers to have a debt-to-income (DTI) ratio of less than 50%, a credit score of at least 580 for FHA loans or 620 for conventional loans and a stable source of income.

Parties involved in a mortgage

Borrower

If you’re reading this, that means the borrower would most likely be yourself! The borrower is the individual seeking to take a loan out with a lender to purchase a home.

Lender

The lender is not an individual like a borrower. Typically, it would be either a bank or a financial company. This body is the participant that provides the financing for the home that the borrower will pay back with interest. The lender, being the financier of the mortgage, will approve or deny a home loan application, and can pre-approve a loan with added conditions.

Title company

Title companies are tasked with verifying that the seller has the full legal right to sell their property. It ensures that nobody but the seller is listed on the home’s title, and also checks to make sure there are no liens or other claims of ownership over the property. If the title company finds any encumbrances against the property, it will also see that those claims are closed before the house is sold.

Additionally, title companies can offer title insurance. This ensures that if anything comes up that the company didn’t find, you are still protected.

Appraiser

The appraiser’s job is to take a thorough look at the home before the transaction. They will assess the fair market value of the home to ensure that the buyer and the lender are paying a fair price for the piece of property. The appraiser will also help to determine property taxes on the home — an important piece of information to know prior to buying.

Insurance provider

Mortgage insurance is an insurance policy meant to protect the lender, typically when a buyer purchases a home with a down payment smaller than 20%. The buyer pays the premium on the policy, and if the borrower defaults on their mortgage payment, the lender receives the payout. The insurance provider is the company that writes out the mortgage insurance policy. Check out our guide on mortgage insurance to understand the different types of policies offered.

Escrow agent

The escrow agent’s job is to be a neutral third-party which mediates the transaction until completed. The escrow agent is trusted to hold onto the funds and assets of the sale before all of the parties involved in the transaction have fulfilled their obligations and the sale is closed on.

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Types of mortgages

The following is a list of the different types of mortgage loans and some of the most relevant details about each one.

Conventional loans

Conventional loans are those that are not secured by the federal government.

Conventional mortgages are the most popular among homeowners. According to data mining company ICE Mortgage Technology, conventional loans made up 81% of all mortgage applications in April 2021.

These loans can be either conforming or non-conforming.

Conforming loans

Conforming loans are conventional loans that meet the loan purchase standards of government-sponsored enterprises Fannie Mae and Freddie Mac. One of these standards is meeting the loan limits set each year by the Federal Housing Finance Agency (FHFA).

In 2023, the maximum conforming loan limit for one-unit properties in most U.S. counties is $726,200. That limit can go as high as $1,089,300 in more expensive housing markets.

Non-conforming loans

Non-conforming loans are those that don't meet the purchase requirements set by Freddie Mac and Fannie Mae.

There are two types of non-conforming loans: jumbo loans and government-backed loans.

Jumbo loans are used to finance expensive properties that exceed FHFA borrowing limits.

For 2023, loans that exceed $726,200 are considered jumbo in most areas. The limit goes up to $1,089,300 in certain high-cost markets, yet actual limits vary by state and county.

Lenders typically charge higher interest rates on jumbo loans and have stricter qualification requirements.

Government-backed loans

Government-backed mortgages are those that are insured by the federal government through one of three agencies:

  • FHA Loans: backed by the Federal Housing Administration, these loans are designed to assist low to moderate-income homebuyers in urban areas. FHA loans are popular among first-time homebuyers and can be used to purchase either single-family or multi-family primary residences.
  • USDA loans: backed by the U.S. Department of Agriculture, these loans are designed to assist low-income homebuyers in rural or suburban areas. USDA loans are intended for the purchase, renovation, or construction of single-family primary residences.
  • VA loans: backed by the Department of Veterans Affairs, these loans are designed to assist qualified members of the military, veterans and eligible spouses. To qualify, the borrower must meet specific service requirements and have a Certificate of Eligibility (COE).

Government-backed loans tend to have better interest rates and can provide forbearance in the event of financial hardship.

Standards for government-backed loans are also less strict than those for conventional loans. If you cannot meet the credit score and down payment requirements of a conventional loan, you may be able to get a government-backed mortgage.

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Current mortgage rates

Mortgage rates fluctuate… a lot. The rate you will get from your lender is informed by factors like the home’s value, your credit score, and the Federal Funds Rate, which is the interest rate (determined by the Federal Reserve) at which banks can borrow money. Check out our page on current mortgage rates to stay the most up-to-date on where average rates stand.

Fixed-rate mortgages vs. adjustable-rate mortgages

Once you’ve chosen your mortgage term and type, you'll have to determine whether you want a loan with an adjustable or a fixed interest rate. This is the most important step when it comes to establishing your budget and payment plan.

Interest rate

Main advantage

Who it's for

Fixed-rate mortgage

Remains the same throughout the life of your loan.

Protection from market conditions so monthly payments remain the same.
Homebuyers planning to stay in the home long term.
Adjustable-rate mortgage
Changes according to market conditions, so payments can go up over time.
Usually begin with much lower monthly payments.
Homebuyers planning to move out of the home before the fixed-rate period is up.

Fixed-rate mortgages

Fixed-rate mortgages maintain the same interest rate for the life of the loan, regardless of market conditions.

Since that makes for predictable monthly payments, conventional fixed-rate loans are among the most common mortgages.

Loan terms for fixed-rate mortgages can range from 10 to 30 years.

Most fixed-rate loans are also amortized. Amortization is a repayment schedule where the monthly loan payment applies first to the interest and anything left over goes to pay off the principal loan balance.

As interest is paid off over time, a larger portion of each monthly payment starts going toward the principal balance.

That means borrowers with fixed-rate mortgages will pay more toward their interest during the first few years of their mortgage.

Adjustable-rate mortgages

As the name suggests, adjustable-rate mortgages feature interest rates that adjust at predetermined intervals after an initial fixed-rate period.

Mortgage lenders express the frequency at which ARM rates reset following a particular structure — 5/1, 7/1, or 10/1. The first number represents how long the rate will remain fixed and the second represents how often the rate will adjust.

So a 5/1 ARM mortgage, for example, will feature a fixed rate for the first five years, after which it will adjust annually based on an index.

Starting rates for ARMs are typically lower than those for fixed-rate mortgages but can increase over time, making your monthly mortgage payments unaffordable. However, some adjustable-rate mortgages have a cap on how high interest rates can go.

With an ARM, the amount of principal and interest you pay with each monthly installment will shift. Each time the principal and interest adjust, the loan is re-amortized to be paid off at the end of the term.

What is mortgage refinancing?

When you refinance your mortgage, you are essentially taking out a new loan to pay off your existing loan. That new mortgage can have a different interest rate and loan term, and can be secured through a mortgage refinance company different from your original mortgage lender.

Most homeowners choose to refinance to get a lower mortgage rate, which helps them lower their monthly payments.

Others might choose to refinance to get a shorter loan term (to pay off their loan sooner and save money on interest) or to get a longer term (to lower their monthly payment).

Whether or not it makes sense to refinance your mortgage will depend on something called the break-even point. Simply put, you break even on a mortgage when your savings are greater than the cost of refinancing.

To know your break-even point, add up the closing costs on your new loan — like origination, appraisal and credit report fees — and divide them by your new monthly savings.

You can also use our mortgage refinance calculator to find out how much you could save.

How to apply for a mortgage

Pre-qualification or pre-approval

Before the formal mortgage process, homebuyers can receive mortgage pre-approval. This gives the homebuyers some idea of the loan amount they can get. To get pre-approved or pre-qualified, the borrower will go to their lender with some basic information, which the lender can use to estimate the size of a potential mortgage. Keep in mind that this step is much more informal than later steps in the process. Lenders won’t actually verify any information provided, and they won’t monitor credit reports in the pre-approval process.

Mortgage application

When the borrower finds a home they’d like to buy, they will then submit a formal mortgage application to their lender. This application builds heavily on the same criteria submitted in the pre-approval process, with lenders considering the borrower’s credit history and employment record, as well as information about the property being purchased.

Mortgage processing

Mortgage processing simply refers to the period of time between the application submission and the actual mortgage approval process. For the borrower, this period is mostly a waiting game, but it’s also important because it’s when they will get their interest rate locked in. The borrower will need to provide documents like pay stubs and tax returns for lender consideration.

Mortgage approval

During processing, the lender will verify all of the information on the borrower’s application. Once the lender authenticates the borrower’s income, debt and other finances, as well as details about the home itself, it will approve the home loan. Around this point, the borrower will provide the agreed-upon down payment amount and all parties will settle on the closing costs.

Closing

Closing is simply the process of officially closing the home sale and transferring the title to the borrower. A closing meeting mostly consists of signing the necessary documents to facilitate the transfer of homeownership. Then, the borrower will receive the keys to their new home.

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Summary of Money's guide to mortgages

  • The most popular loan in America is a 30-year fixed-rate mortgage, which features predictable monthly payments.
  • Lenders also offer fixed-rate loans with 15-year terms and a few even offer custom terms.
  • Adjustable-rate mortgages are an alternative to fixed-rate loans. Monthly payments on ARMs can fluctuate based on the market.
  • FHA, USDA and VA loans are issued by lenders and backed by the federal government. These loans could be an alternative if you don't qualify for a conventional loan.
  • Your credit and debt-to-income ratio are important factors in determining your eligibility for loans.
  • Before you start shopping for a mortgage, work on your credit, pay down your debt, have your documents in order and run some numbers to know what to expect.
  • Finally, shop for rates with different lenders or brokers to ensure you're getting the lowest possible rate.
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