What is a mortgage loan and how does it work?

A home is the most expensive purchase most people will ever make, so it’s important to understand what goes into taking out a mortgage.

A mortgage is a loan you take out to buy or refinance a house. Since the loan is secured by the home, your lender can foreclose on the property if you’re unable to repay your mortgage. For many borrowers, a mortgage is a crucial part of the homebuying process.

Buying a home can feel overwhelming for first-time home buyers. It helps to understand how mortgages work and what’s included in your payments before applying. 

• What is a mortgage?
• How does a mortgage work?
• What’s included in a mortgage payment?
• Types of mortgages
• Next steps: Apply for mortgage preapproval

What is a mortgage?

A mortgage is a secured loan you take out to buy a home, and the amount you borrow is called the principal. When you take out a mortgage, you agree to repay the loan with interest in monthly installments — typically over 15 or 30 years — until the loan is paid in full. If you stop making payments, your lender has the right to foreclose on the property.

How does a mortgage work?

Banks, credit unions and online lenders are among the places you can shop for a mortgage loan. Most mortgage lenders will require a minimum down payment, though the exact amount needed will vary depending on your lender and loan type.

For example, you’ll typically need to put down at least 3% for a conventional loan. But making a larger down payment can reduce the cost of your loan. It’s also possible to buy a home without an upfront payment. If you qualify, there are certain government-sponsored loans, like VA and USDA loans, that typically don’t require a down payment.

Your down payment will affect how much you need to borrow to cover the purchase price. A smaller down payment means you’ll have to borrow more, which will increase your monthly payments.

Each month, part of your mortgage payments will go toward paying off principal and interest. Because your loan balance is higher at the beginning, you’ll owe more interest. Then, as you start paying off your mortgage, a higher percentage of your mortgage payment will go toward principal.

Once you get close to paying off your mortgage, you’ll owe very little interest, and the majority of your payment will be applied toward principal. This process is called amortization.

Beyond the basic mortgage payment, there are additional housing expenses to consider such as mortgage insurance, property taxes, homeowner’s insurance and homeowner’s association fees (if applicable).

What’s included in a mortgage payment?

There are many different costs that come with taking out a mortgage. Understanding what these costs are can help you come up with a realistic picture of what you can afford. Here are the main costs that come with buying a home:

Principal

The principal is the money you borrowed to buy the home and must repay. For example, let’s say you purchased a $400,000 home and made a 3% down payment of $12,000. That means the principal is $388,000.

Interest

The interest is what your lender charges you for borrowing the money. Putting down 20% could help you secure a lower interest rate — and help you avoid having to pay private mortgage insurance.

Property taxes

Property taxes, which are based on the value of the property, are fees typically charged by your county. Property taxes are usually bundled with your mortgage payment and managed through an escrow account. If your mortgage doesn’t have an escrow account, you’ll have to pay these taxes directly.

Homeowners insurance

Homeowners insurance pays for any damages to your property as the result of a fire or some other kind of unexpected event covered by the policy. If you take out a mortgage, your lender will require you to purchase homeowners insurance. This can also be managed through your escrow account.

Mortgage insurance

If your down payment is less than 20%, your lender will likely require you to purchase mortgage insurance. Mortgage insurance protects your lender if you stop making payments on the loan. There are two main types of mortgage insurance to know about:

• PMI: Private mortgage insurance, or PMI, is usually required for conventional loans if you make a down payment that’s less than 20%. You’ll typically pay for PMI as a monthly premium that’s added to your mortgage payment. However, you could also pay for PMI as a one-time upfront payment at closing.
• MIP: A mortgage insurance premium, or MIP, is usually required if you take out an FHA loan. MIP includes an upfront cost as well as a monthly cost that’s included in your mortgage payment. 

Types of mortgages

When you’re applying for mortgages, you have many options to choose from. Here are some of the different types of mortgages:

• Fixed-rate: If you apply for a fixed-rate loan, your interest rate will stay the same over the life of the loan.
• Adjustable-rate: If you take out an adjustable-rate mortgage, or ARM, you’ll typically receive a lower introductory interest rate than a fixed-rate loan. Once the introductory period is up, your interest rate will change depending on current market conditions.
• Conventional loans: A conventional loan is offered by a private lender and isn’t backed by a government agency. These loans can be conforming or nonconforming, which refers to the size of the loan. Conforming loans have maximum loan amounts that are set by the government. Nonconforming loans include jumbo loans and other loans that don’t meet the criteria for conforming loans.
• FHA loans: FHA loans are backed by the Federal Housing Administration and could be a good option for anyone who doesn’t qualify for a conventional loan. If your credit score is 580 or higher, you can take out a loan with a 3.5% down payment. But if your credit score falls between 500 and 579, you’ll need a 10% down payment. 
• USDA loans: USDA loans are backed by the U.S. Department of Agriculture and help low-income borrowers buy homes in rural areas. To qualify, you can’t earn more than 115% of your area’s median income. You’ll need to check the USDA’s website to ensure that you live in an eligible rural area. 
• VA loans: VA loans are backed by the Department of Veteran Affairs and are designed for veterans and active-duty service members. VA loans don’t come with any minimum credit or down payment requirements, although the lender may have its own.

Next steps: Apply for mortgage preapproval

Now that you understand what a mortgage is and how it works, getting mortgage preapproval could be a good next step. A mortgage preapproval helps you understand how much you may be able to borrow to buy a home. Although it’s not a guaranteed that you’ll be approved for the mortgage, it lets home sellers know that you’ll likely be approved for a certain amount of financing.

During the preapproval process, you can take stock of your credit and determine how much down payment you can afford. When you apply for a mortgage, lenders assess your credit risk by examining your income, debt, credit scores, assets, job history and other factors. Some of the documents you may need to get a home loan approval include pay stubs, W-2s, tax returns and bank statements.

You should also try to set enough money aside in case you face an unexpected home repair or other kind of emergency that could affect your ability to pay your mortgage. Creating an emergency fund that provides enough money to cover your living expenses for three to six months can offer protection against home foreclosure or having to take on more debt.