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What Is A Mortgage?

Molly Grace5-Minute Read
October 22, 2020

“Mortgage” is one of those very grown-up sounding words that you might not get around to learning the meaning of until you need one.

Though the word can make it seem like a daunting topic, mortgages are actually fairly simple to understand. In the simplest of terms, they’re a type of loan.

What is a mortgage, and how does this loan type work? Let’s go over the basics.

Mortgage: A Definition

A mortgage is a type of loan that is specifically used to purchase a home.

Mortgages allow home buyers to make regular payments against the purchase of their home over a specified period of time (usually 15 or 30 years). In return, lenders charge borrowers interest on their loan and retain the right to foreclose on the home in the event of nonpayment.

Who Gets A Mortgage?

At the start of 2020, the median home sale price in the U.S. was $329,000. Since most people don’t have that kind of money just sitting around in a bank account, they need a loan to be able to afford a home.

In fact, most home buyers use a mortgage to fund their purchase. According to the National Association of REALTORS® (NAR) 2019 Profile of Home Buyers and Sellers, 86% of recent home buyers financed their purchase.

To get a mortgage, you’ll need to be approved for one. Mortgage lenders look for applicants who have good credit, a steady work history, a manageable debt-to-income ratio and sufficient funds for a down payment.

How Does A Mortgage Work?

To get a mortgage, you’ll apply for one at a financial institution that offers them, such as a mortgage lender, bank, credit union or mortgage broker.

The process can seem intimidating, as the lender will go through your entire financial life with a fine-tooth comb to ensure that you have the ability to repay the loan.

When you apply for a mortgage, you’ll be asked to provide documentation that verifies your monthly income. The lender will also check your credit to ensure your credit score meets their standards and they’ll determine how much of a monthly housing payment you can afford in addition to any other debts you’re currently making payments on.

In most cases, borrowers will need to make a down payment on the home to get a mortgage. Most borrowers made a down payment that was equal to 12% of the home’s purchase price, according to the NAR study. The minimum down payment you can make will vary depending on your application and your lender’s guidelines, but it’s possible to get a conventional mortgage with as little as a 3% down payment.

Some borrowers, such as those who qualify for a VA loan, may be able to get a mortgage with 0% down.

Once you’re approved for a mortgage and use it to purchase a home, you’ll make monthly payments to pay back what you owe, plus interest. Your mortgage payments will be made up of what is called PITI: principal, interest, taxes and insurance.

Principal is the amount you initially borrowed that you’re now paying back. The interest rate you’re given when you are approved for the loan will determine how much of your payment is made up of interest. These parts of the payment are paid directly to your mortgage lender.

The taxes and insurance part of your mortgage payment go into a separate account, called an escrow account, that holds the amount you owe in property taxes and homeowners insurance until it’s time to pay these bills. When your taxes or insurance are due, your lender will release the funds in your escrow account to pay these bills on your behalf. This allows you to break up these payments, which might be due in a lump sum just once or twice a year, into more manageable monthly payments.

There are many different types of mortgage loans that vary in how the interest rate is structured, how many years it takes to pay it off and who is responsible for insuring the loan. Here are the most common types of mortgage loans you’ll encounter.

Fixed-Rate Mortgage

The most common type of home loan is the fixed-rate mortgage. As the name suggests, the interest rate attached to these mortgages stays the same – or fixed – throughout their lifetimes. If you qualify for an interest rate of 3.5%, this rate will remain fixed at this level until you either pay off your mortgage, refinance it to another loan or sell your home.

The two most common types of fixed-rate mortgages are the 30-year fixed-rate loan and the 15-year fixed-rate loan. A 30-year fixed-rate loan results in a lower monthly payment because you are repaying your loan over a longer number of years, while a 15-year fixed-rate loan will come with a higher monthly payment, because you must repay it in half the number of years.

The benefit of a 15-year loan, though, is that you’ll pay far less in interest, again because your repayment period is cut in half when compared to a 30-year fixed-rate loan. You can save hundreds of thousands of dollars in interest if you go with a 15-year fixed-rate loan and hold it until maturity versus doing the same with a 30-year mortgage loan. Just make sure you can afford the higher monthly payments that come with a shorter-term loan.

Adjustable-Rate Mortgage

As the name suggests, your interest rate will change over time if you take out an adjustable rate loan. The negative here is that when your loan’s rate adjusts, it might rise significantly higher than what you’d have if you would have just gone with a fixed-rate loan. The benefit? Adjustable rate loans come with a fixed period (typically 5, 7 or 10 years). During this period, your initial interest rate will generally be lower than what you’d get with a traditional fixed-rate loan.

Conventional Vs. Government-Backed Loans

You can also break loans into conventional and government-insured. Conventional mortgage loans are not insured by any government agency. About half of conventional mortgages conform to guidelines established by the quasi-government agencies of Fannie Mae and Freddie Mac.

Other mortgages are insured by one of three government agencies: the Federal Housing Administration, which insures FHA loans; the U.S. Department of Veterans Affairs, which backs VA loans; and the U.S. Department of Agriculture, which insures mortgage loans in rural areas.Not all borrowers will qualify for all government-insured loans. You need to be a veteran or active member of the U.S. military or reserves to qualify for a VA loan. And you must be buying a home in a rural area to apply for a USDA loan.

Choosing The Right Mortgage

Feeling a little more confident in your mortgage knowledge? The most important thing to remember is that, when it comes to mortgages, you want to find the loan type that suits you. Be sure to shop around and explore all your options, both in the type of mortgage you get and who you get it from.

If you’re interested in buying a home, get matched with a Rocket Homes℠ Verified Partner Agent.

Get the right home loan for you.

Molly Grace

Molly Grace is a staff writer focusing on mortgages, personal finance and homeownership. She has a B.A. in journalism from Indiana University. You can follow her on Twitter @themollygrace.