What is a Mortgage?
Point of Interest
Buying a home is a significant milestone for most people. Understanding the basics of what a mortgage is and how it works is essential to starting the homebuying process.
The process of buying and then owning a home is a big deal. You spend hours stalking online listings, going to open houses and working with a realtor until you find the perfect place to call home. But once you’ve found your dream home, what’s next? How do you make the purchase happen? For most people, the next step is finding a mortgage.
A mortgage is a loan used for buying a home. A borrower can take out a mortgage from a lender to pay for the purchase of the home and then pay it back with monthly payments over a fixed period of time with interest.
Mortgages are a form of secured loan in which the house itself acts as collateral. This means that the lender could take possession of the home if a borrower doesn’t make monthly payments.
Lenders charge interest on the loan amount, which adds up based on the interest rate and annual percentage rate, or APR. The interest rate determines how much it will cost the borrower to take out the loan. The APR, on the other hand, accounts for interest as well as any other fees or costs associated with the loan, so it’s usually higher than the interest rate itself.
For example, if you take out a $100,000 mortgage to buy a home with a 2.81% interest rate and a 3.000% APR, the total cost of the loan would be $151,777 over a 30-year term.
How to find a mortgage
Mortgages are offered through many banks, credit unions and other lenders. There are many different types of mortgages to fit borrowers’ needs, so it’s best to compare lenders and shop around for the best mortgage rate rather than just checking with your current bank. Mortgage rates are constantly changing, and you may be able to capitalize on government-backed loans or other unique offerings from private lenders.
Most lenders will determine your eligibility for a mortgage and certain interest rates based on your credit score and your debt-to-income ratio. Most lenders also require a down payment, meaning you’ll want to have anywhere from 3% to 20% of the house’s cost saved up. There are some mortgage options that don’t require borrowers to put any money down, such as government-backed VA and USDA loans, but these loans are not available to all borrowers.
Credit score requirements vary by lender and the type of mortgage you’re seeking, but most lenders like to see a credit score of at least 620 as part of their lending requirements. The higher your credit score, the more likely you are to find lower interest rates on mortgages.
However, not having great credit isn’t always a deal-breaker. Many lenders offer mortgages to borrowers with less than perfect credit, but these loans may also come with other costs or fees, such as private mortgage insurance.
Common types of mortgages
There are three main types of mortgages: government-backed, conventional and non-conforming, though each type of mortgage can have several subtypes and term options. In general, though, you’ll be able to choose from these three types of mortgages when searching for a home loan.
Conventional mortgages are a common type of mortgage loans offered by private lenders, and these mortgages include any home loan that isn’t backed by a government organization. Conventional loans often require high credit scores and large down payments to qualify because the lender risks losing money if you default on your mortgage and your home goes into foreclosure.
Conventional loans are offered with fixed- and adjustable-rate options. Fixed-rate mortgages have interest rates that stay the same over the life of the loan, while adjustable-rate mortgages, or ARMs, start with a fixed rate but can fluctuate once per year after a set period of time. For example, a 5/1 ARM will feature a locked-in rate for five years, with the interest rate changing every year after that
Another common type of mortgage loan is a government-backed loan. The federal government makes it easier for homebuyers with less than perfect credit or nontraditional down payments to buy a home by insuring certain types of mortgages for private lenders. If a borrower defaults on this type of loan, the government is responsible for covering the costs to the lender.
The three main types of government-backed loans are FHA loans, VA loans and USDA loans.
- FHA home loans are backed by the Federal Housing Administration and require only 3.5% down in most cases, though the lender requirements will vary based on which lender you speak with. These loans are aimed at assisting first-time or low-income buyers and have a minimum credit score requirement of 580. These loans require mortgage insurance paid over a number of years to reduce the loss to the federal government in case you default.
- USDA home loans are backed by the USDA’s Rural Development program and are meant to provide low-interest mortgages to buyers in eligible rural and suburban areas. Borrowers can qualify for USDA loans with no down payment, though they may have to pay mortgage insurance. Rates can be as low as about 1%, though.
- VA home loans are secured by the Department of Veterans Affairs and have no down payment or mortgage insurance requirement. These types of loans are only available to veterans, active-duty military or military spouses who are deemed eligible by the VA.
You’ll also have the option of a non-conforming mortgage, often called a jumbo loan. These loans don’t abide by the maximum loan guidelines set by the Federal Housing Finance Agency, which means you can take out a jumbo loan if your home purchase price exceeds the guidelines.
Lenders can’t resell jumbo loans to Freddie Mac and Fannie Mae, the governmental agencies that provide a secondary mortgage market for lenders, which makes them more difficult to qualify for. These types of loans require a higher credit score and a larger down payment to qualify. As of 2020, mortgage loans for more than $510,400 are considered non-conforming.
The final word
Mortgages are loans used specifically for home purchases, with the home securing the purchase as collateral in case of default. These types of loans are paid off with monthly payments over a fixed number of years. With so many lenders offering home loans, it’s essential to know what your options are, so do your research before committing to any particular lender.
Finding a mortgage can feel like an intimidating and complicated process, but understanding the key components of a mortgage is a great first step. The more you learn about mortgages, the more prepared you are to make your homeownership dreams a reality, and the better chance you will have to find the best mortgage rates.