What is a mortgage and how does it work? Home loan basics

Maggie Overholt
The Mortgage Reports editor

Mortgage 101

A mortgage is simply a big loan used to buy a home. Mortgages let you borrow a large amount — often hundreds of thousands of dollars — and pay it back at a low interest rate over a long time.

Mortgages are useful because very few home buyers have enough cash on hand for such a large purchase.

Paying for real estate with a mortgage lets you spread out the cost of your purchase over many years and makes buying a home much more affordable.

If you’re planning to buy a house — or a condo, rental property, or another type of real estate — odds are you’ll need a mortgage.

This is the biggest financial commitment most people ever make, so it’s important to understand how mortgages work before jumping in. Here’s what you’ll need to know.

Check your eligibility for a mortgage today (May 7th, 2021)

In this article (Skip to…)


Mortgage basics

A mortgage loan lets you buy a home now and pay it off over time, rather than having to save up and pay the full sale price upfront.

Most home buyers put some of their own money toward the purchase (this is the ‘down payment’) and cover the rest of the home’s price using a mortgage loan.

Mortgages might seem complicated. But really, you can understand how they work if you know these four simple terms: 

  • Down payment — The amount you pay toward the home purchase out of your own savings
  • Loan amount — The amount you borrow to cover the rest of the purchase price. Your loan amount will be the home’s sale price minus your down payment
  • Loan term — This is the amount of time you have to pay back your mortgage. If you make full payments on time every month, your loan balance will end up at zero during the last month of your loan term
  • Interest rate — Your interest rate or ‘mortgage rate’ is the money it costs you to borrow. For instance, if you borrow $100,000 at 3%, you will pay $3,000 per year in interest. (Well, not exactly because you’re paying down principal throughout the year, but we’ll keep things simple.) This is your mortgage lender’s profit for lending to you. Mortgage rates are expressed as a percent of the borrowed amount, just like auto loan rates or credit card interest rates

There are other details you’ll want to know as you start applying for home loans, but these are the most important mortgage basics.

Your down payment, loan amount, loan term, and interest rate determine how much house you can afford, how big your monthly payments will be, and how much interest you will have paid by the time your home is paid off.  

How a mortgage works

Mortgages come in lots of shapes and sizes. But most home buyers use the same general loan type: a 30-year, fixed-rate mortgage (FRM).

Let’s break down what that means:

  • You have 30 years to pay back what you borrow. You loan amount will be broken down into 360 monthly payments (12 monthly mortgage payments per year x 30 years)
  • Your loan has a fixed interest rate. This means the total interest cost is pre-determined, so you know from the outset exactly how much interest you’ll pay over the life of the loan, and your lender can never increase your rate
  • Your monthly payments are always the same. The monthly payments on a fixed-rate mortgage loan never change. For instance, if you pay $1,000 per month in year 1 of your mortgage, you’ll pay $1,000 per month in year 30

In addition, most home loans are ‘fully amortized.’ That just means your payments are scheduled so that at the end of the loan term, your house will be fully paid off.

There are other loan options, too, like 15-year mortgages and adjustable-rate mortgages. But most home buyers prefer the longer-term 30-year loan for its predictability and affordable payments.

If you’re shopping for mortgages as a first-time home buyer, this is the first loan type you should look at.

You can use a mortgage calculator to estimate how much mortgage you might qualify for based on your current income.

Check your eligibility for a mortgage today (May 7th, 2021)

Do I have to keep my mortgage all 30 years?

One important thing to note is that taking out a 30-year mortgage does not mean you’re committing to living in your home for 30 years.

You don’t have to keep the loan until its end date and pay it off in full. In fact, most homeowners don’t. They either sell the home or refinance their mortgage before its term is up.

  • If you move and sell your home before it’s paid off, part of the proceeds from the home sale will be used to pay off any remaining loan amount due to your mortgage lender
  • If you decide you want a different type of loan or a lower interest rate later on, you can ‘refinance’ your mortgage. This involves replacing your existing mortgage with a new loan that benefits you financially

You don’t need to worry too much about selling or refinancing right now.

Just know that taking out a mortgage doesn’t mean you’re stuck with the same loan for the next three decades.

You can reevaluate your finances at any point down the road, and if your home or your mortgage no longer meet your needs, you’ll be able to move or get a new loan that suits you better.

Do I own my home when I have a mortgage? 

In short, yes, you own your home. But that doesn’t exclude other parties from having some rights to it.

As long as you make your payments, keep the house in good condition, insure it, and pay taxes, no other party can take control of the property.

But if you neglect any of those items, the lender has the right to seize and sell the property. Likewise, if you don’t pay property taxes, your city or county can seize it to pay the taxes.

It may not seem like you ‘own’ the house because of these third-party rights, but just keep in mind that there’s no need to worry about losing any control of the property if you hold up your end of the agreement.

Check your home buying eligibility (May 7th, 2021)

How are mortgages different from other loans?

Mortgages are similar to other loans in that there is a certain amount borrowed, an interest rate paid to the lender, and a set number of years over which the loan must be repaid.

In this regard, a mortgage functions a lot like a car loan or any other ‘installment loan’ that you pay off on a predetermined schedule.

However, there are some key differences that set mortgages apart from other loan types.

  • A mortgage is specifically used to purchase (and sometimes renovate) real estate. The funds you borrow cannot be used for any other purpose — except in the case of some refinance mortgages, which don’t apply unless you have a mortgage already
  • You don’t handle the money yourself. Your mortgage lender will pay the home seller directly, so you don’t actually ‘receive’ the money from your mortgage at any point
  • Mortgages are flexible. You have a lot of control over your down payment amount, loan term, loan program, and other features of the mortgage
  • Mortgages have strict requirements for borrowers. Most mortgages have loan amounts in the hundreds of thousands. Since you’re borrowing so much money, a mortgage lender wants to be extra sure you can pay it back. To make sure you can repay the loan, lenders set minimum requirements for things like your credit score, income, existing debts, and assets

Mortgage requirements are put in place to protect lenders and borrowers.

A mortgage is a ‘secured’ loan, meaning the home you purchase is used as collateral for the money borrowed.

If you can’t repay your mortgage, you could face ‘foreclosure,’ meaning the mortgage lender takes back the home and sells it to recoup the money it lent you.

Lenders scrutinize your personal finances during the mortgage process and ask for lots of documents. But in the end, this benefits you and the lender both, because it helps ensure you’ll get an affordable loan and make a sound investment in your new home.

Why do home buyers use mortgages?

Mortgages make home buying accessible to all types of home buyers. Using a mortgage loan, you can buy a home even if you don’t have a huge savings account, high income, or great credit score.   

Consider that the median home price in the U.S. was around $350,000 at the end of 2020. Most home buyers don’t have $350K lying around that they can hand to a home seller.

Instead, they pay a smaller amount upfront (the down payment) and borrow the rest of the money needed to buy the home.

Some buyers can even get into a new home with $0 out of pocket if they play their cards right.

Mortgage loan benefits

Using a mortgage eliminates the need to come up with hundreds of thousands of dollars in cash. And it lets homeowners pay off their houses in affordable monthly installments.

Here’s an example of how using a mortgage makes home buying more accessible.

  • Home purchase price: $350,000
  • Out-of-pocket down payment: $50,000
  • Loan amount: $300,000
  • Loan term: 30 years
  • Fixed interest rate: 3.5%
  • Monthly payment for loan principal and interest: $1,300
  • Loan balance at the end of year 30: $0
  • Total interest paid by the end of year 30: $185,000

In this case, the home buyer pays only $50,000 upfront on a $350,000 home. And their monthly mortgage payment is around $1,300 — which is comparable to monthly rent payments in many big cities.

And this is just one example. Many home buyers have even smaller loan amounts and lower mortgage payments.

In addition, mortgages are flexible, so you have a lot of control over your loan terms and your monthly costs.

For example, you could choose to save up and make a big down payment. This would lower your monthly housing payments and reduce the amount of interest you pay in the long term.

Or, if you don’t have a lot of savings and but want to buy a home soon, you could make a small down payment. Most home buyers can qualify with just 3% to 3.5% down.

Your loan amount and payments would be a bit bigger in this case, but you can get into your home and start paying it off sooner.

Each home buyer can explore their mortgage options and find a unique loan structure that best fits their needs.

Mortgage loan drawbacks

The obvious downside to using a mortgage loan is that you end up paying a lot of interest to your mortgage lender.

Mortgage rates are much cheaper than other forms of borrowing, like personal loans or credit cards. However, you’re paying interest on a very large loan amount over a long time. So the cost adds up.

But if the alternative is buying a house with cash, a mortgage looks a lot more attractive. 

Saving up hundreds of thousands of dollars in cash just isn’t realistic for most people. So a mortgage becomes the best and only option.

Paying interest isn’t ideal. But for most of us, it’s a necessary tradeoff for being able to buy our own homes and enjoy the personal and financial benefits that come with homeownership.

Types of mortgage loans

There are various mortgage programs available to choose from. Each one offers different benefits and requirements for home buyers.

Here are the four main mortgage loan types, three of which are backed by the federal government:

  • Conventional loansConventional loans are offered by just about every lender, and they have flexible terms and requirements. Conventional mortgages are not backed by the federal government. These loans are typically preferred by borrowers with good credit and moderate or large down payments (5% to 20% down)
  • FHA loansFHA loans are backed by the Federal Housing Administration. This mortgage program is generally meant for home buyers with poor or fair credit and low to moderate income, although those with good credit often choose FHA for its low down payment requirement and other flexibilities
  • VA loans — The VA mortgage program is backed by the Department of Veterans Affairs. These loans make home buying very affordable for veterans and service members. You must have an eligible service history to qualify. But those who do have access to zero-down loans at very low rates
  • USDA loans USDA loans are backed by the U.S. Department of Agriculture. This mortgage program offers affordable loans at zero down for low and moderate-income borrowers in rural areas

FHA, VA, and USDA loans are all insured by the federal government. But they’re offered by private lenders. So you can get them from most banks, credit unions, and mortgage companies.

Within each program, there are also various loan options.

For instance, you can get a 30-year fixed-rate FHA loan or a 15-year fixed-rate FHA loan.

Conventional loans are typically the most flexible, with a wide range of loan terms, loan amounts, and interest rates.

Government-backed loans tend to be a little less flexible, but they have looser requirements intended to help borrowers who might have trouble qualifying for a conventional mortgage.

You can learn more and compare the different types of home loans here.

You’ll also be assigned a loan officer when you apply for a mortgage. This individual will help you compare loan options in more detail and find the right one for your needs.

Find the right type of home loan for you (May 7th, 2021)

How do I qualify for a mortgage?

To qualify for a mortgage, you must meet the minimum standards of whichever loan type you determine is best for needs.

Each loan type is different, with varying qualification standards. But the steps to get mortgage-qualified are similar among the four programs.

First, you will need to meet a minimum credit score requirement.

Specific requirements can vary by lender, but the minimum score required for each program is:

  • FHA loan: 580
  • VA loan: 580-620
  • Conventional loan: 620
  • USDA loan: 640

Next, you will be asked to verify your income using W-2s, pay stubs, and federal income tax returns. Your debts will be verified, too, using a recent copy of your credit report.

If your credit report happens to include errors or omissions, which sometimes happens, you can provide documentation to your lender to correct such mistakes.

Your lender will also want to verify your employment history and your savings.

Lenders typically want to see you’ve been steadily employed with reliable income for at least two years. But there are exceptions to the 2-year rule, so it’s often possible to get a home loan even if you’re in a new job.

How big of a down payment do I need?

When you’re buying a home, the amount of money you bring to closing is known as your down payment.

You can think of your down payment as the part of the home purchase price that you’re not borrowing from the bank.

Many home buyers think they need 20% down to buy a house. But in reality, the minimum down payment required is a lot lower.

  • VA loan: 0% down payment required
  • USDA loan: 0% down payment required
  • Conventional loan: 3% down payment required
  • FHA loan: 3.5% down payment required

Keep in mind these figures are just minimums. You can choose to make a larger down payment if you want.

When you make a larger down payment, your monthly payment is reduced because you’re borrowing less money.

And, if you use a conventional loan — which most home buyers do — larger down payments are linked to lower mortgage rates.

Don’t forget closing costs

The down payment isn’t your only out-of-pocket expense when you buy a house. You also need to pay for closing costs.

Closing costs include all the various fees to set up your mortgage and officially transfer ownership of the home from the seller to you. These are additional charges on top of your down payment.

On average, closing costs come out to about 3% to 5% of the loan amount. So on a $300,000 mortgage, closing costs could easily be $9,000 or more.

This is a hefty amount of money that many first-time home buyers overlook when they’re just starting to think about a mortgage.

You should estimate closing costs for the home you want and include them in your budget, as they’ll have a big impact on the amount of money you need to save.

Check your eligibility for a mortgage today (May 7th, 2021)

Mortgage FAQ

Here are answers to some of the most frequently asked questions about mortgage loans.

What is a mortgage in simple terms?

A mortgage is a big loan used to buy a home. Like other types of loans, you pay a mortgage back over time with interest. But mortgages are different from other loans for three main reasons: the money must be used to purchase real estate, you can pay it back over up to 30 years, and interest rates are very low.   

What’s an example of a mortgage?

Here’s a basic example of how a mortgage works: Imagine you want to buy a home that costs $300,000. You pay $25,000 from your own savings, and cover the rest of the purchase price ($275,000) using money borrowed from a lender. The $275K you borrow is your mortgage loan — you’ll pay it off over time by making monthly payments to your mortgage lender. This lets you buy the home right away and pay it off gradually, rather than having to pay $300,000 in cash upfront.

Is a mortgage the same as a home loan?

Yes. ‘Home loan’ is just another term for a mortgage loan.

Where can I get a mortgage?

Most financial institutions offer mortgages. You can get one from a big bank, local credit union, or a specialized mortgage lender that only does home loans. There are also ‘mortgage brokers’ that act as a middleman to help you find and compare lenders. You should compare a few different lenders and choose one that offers a combination of low rates, low fees, and good service.

Can you buy a house without a mortgage?

Yes! If you have enough money saved up to buy a house with cash, you don’t have to use a mortgage. You can pay the seller directly and own the house outright. However, most home buyers don’t have enough cash saved up to do so — or they want to use their cash for other purposes.

How much income do I need for a mortgage?

There’s no ‘minimum income’ needed for a mortgage. Lenders just want to know you’ll be able to afford the monthly payments on your new home — so you have to shop in the right price range. With a higher income, you’ll qualify for a bigger mortgage and can buy a more expensive house. With a lower income, you can still get a mortgage, you’ll just have a smaller home buying budget. 

What credit score do I need for a mortgage?

The minimum credit score to qualify for a mortgage varies based on the type of loan you apply for. FHA loans have the lowest minimum credit score, at 580. But you can qualify for most other types of home loans with a score of 620 or above.

How much down payment is required to buy a house?

You don’t need 20% down to buy a house, despite common beliefs. In fact, most home buyers can qualify for a conventional loan with just 3% down, or an FHA loan with 3.5% down. Home buyers who are eligible for a VA loan or USDA loan might even qualify for a zero-down-payment mortgage. Explore your loan options to find the down payment amount that best meets your needs. 

Should I put 20% down on a house?

A 20% down payment is not required, and most buyers don’t put that much down. However, there are certain benefits if you chose to make a large down payment. You loan amount will be smaller and your interest rate will likely be lower, meaning you can save money on interest in the long run. And, you can probably avoid an extra monthly cost called ‘private mortgage insurance’ (PMI), which is charged on most loans with less than 20% down. Consider the pros and cons of both a small and large down payment before making your decision.

What will my interest rate be?

Mortgage interest rates are low across the board right now, well below 4% for most borrowers. But rates can vary a lot from person to person. Your specific interest rate will depend on your credit score, down payment, loan amount, loan type, and other factors. In general, the stronger your personal finances are, the lower your rate will be.

What’s the monthly payment on a mortgage?

The average mortgage payment is around $1,300-$1,500 per month. However, your own monthly payments will depend on your loan amount and interest rate. Also keep in mind that your mortgage payment includes more than just loan principal and interest due to the lender. Most home buyers also pay property taxes and homeowners insurance as part of their monthly mortgage payment, which will substantially increase the amount due each month.

Is the book ‘Mortgages For Dummies’ a good resource for beginners?

No. The latest edition was published in 2008 when home loans were drastically different. You probably wouldn’t read an outdated book about social media or current events, and the same applies here. Mortgage rules change frequently, so books have a relatively short shelf life. The best resources for current information are reputable websites that update their articles frequently.

Do you qualify for a mortgage right now?

Online mortgage calculators can help you determine whether you might qualify for a mortgage. They can also help you estimate your home buying budget.

But, when you’re ready to get serious about home buying, you’ll need to get a mortgage pre-approval from a lender.

The pre-approval process involves filling out a loan application and letting a lender look at your credit and finances. The lender can then verify your mortgage eligibility and let you know how much you’re able to borrow.

Most home sellers and real estate agents won’t accept an offer if the borrower hasn’t been pre-approved, so this step is essential.

Luckily, getting pre-approved is generally free and can be done online pretty quickly.

If you’re ready to take the next step toward buying a home, you can start your pre-approval using the link below or by contacting a mortgage lender directly.

Verify your new rate (May 7th, 2021)

How To Buy A Home : Infographic from The Mortgage Reports