How Does a Mortgage Work?

Understanding mortgages

A mortgage is a loan you get from a lender to finance a home purchase. When you take out a mortgage, you promise to repay the money you’ve borrowed at an agreed-upon interest rate.

The home is used as collateral. That means if you break the promise to repay your mortgage, the bank has the right to foreclose on your property. Your loan doesn’t become a mortgage until it’s attached as a lien to your home, meaning your ownership of the home becomes subject to you paying your new loan on time at the terms you agreed to.

Common mortgage terms

You will sign a lot of documents with paragraphs of legal language to obtain a mortgage, including a promissory note, and in many states, a deed of trust. Here are some common terms you’ll need to know if you’re getting a mortgage:

Promissory note. The promissory note, or “note” as it is more commonly labeled, outlines how you will repay the loan, with details including:

• Your interest rate
• Your total loan amount
• The term of the loan (30 years or 15 years are common examples)
• When the loan is considered late
• Your monthly principal and interest payment

Mortgage. Though mortgage is usually used as a catchall term for a home loan, it has a specific meaning. The mortgage gives the lender the right to take ownership of your home and sell it if you don’t make payments at the terms you agreed to on the note.

Deed of Trust. A deed of trust works like a mortgage and is secured against your home. Most mortgages are agreements between two parties — you and the lender. In some states, a third person, called a trustee, may be added to your mortgage through a document called a deed of trust. A deed of trust gives the trustee the authority to take control of your home on behalf of the lender if you stop making payments.

Mortgage closing costs. These are expenses charged by a lender to make or originate your loan.  They typically include origination fees, discount points, fees related to underwriting, processing, document preparation and funding of your loan. However, your total closing costs include appraisal and title fees, title insurance, surveys, recording fees and more. While fees vary widely by the type of mortgage you get and by location, they typically total 2% to 6% of the loan amount. So on a $250,000 mortgage, your closing costs would amount to anywhere from $5,000 to $15,000.

Discount points. Also called “mortgage points,” this is money paid to your lender in exchange for a lower interest rate.

Note rate. This is the actual interest rate you pay each year based on the loan amount you borrow, expressed as a percentage rate. It doesn’t reflect any of the costs or charges for the mortgage, and should not be confused with the annual percentage rate, which we’ll explain next.

Annual percentage rate (APR). The APR is typically higher than your note rate because it reflects the cost of borrowing money, based on the interest, fees and loan term, expressed as a yearly rate. The APR was created to make it easier for consumers to compare loans with different interest rates and costs, and federal law requires it to be disclosed in all advertising. Basically, the higher the difference between your note rate and APR, the more you’re paying in closing costs.

Mortgage insurance. Mortgage insurance protects a lender against losses incurred if they have to foreclose on your home because you can’t make your payments. You’ll pay mortgage insurance on some government-backed loans regardless of down payment, but you can avoid it on conventional loans with a down payment of 20% or more.

How a mortgage works

Every month you make a mortgage payment, it gets split into at least four different buckets that make up principal, interest, taxes and insurance or PITI for short. Here is how each bucket works:

1. Principal. This is the portion of your loan balance that’s paid down with each payment.
2. Interest. This is the interest rate charged monthly by your lender for the mortgage you chose.
3. Taxes. You’ll pay 1/12th of your yearly property tax bill each month based on how much is assessed each year in your neighborhood.
4. Insurance. Lenders require homeowners insurance to cover your home against hazards like fire, theft or accidents. You may have an additional, separate monthly payment for mortgage insurance based on your down payment or loan type.

In the early years of your mortgage, interest makes up a greater part of your overall payment, but as time goes on, you start paying more principal than interest until the loan is paid off.

Your lender will provide an amortization schedule (a table showing the breakdown of each payment). This schedule will show you how your loan balance drops over time, as well as how much principal you’re paying versus interest.

How to qualify for a mortgage

You’ll need to meet minimum mortgage requirements to qualify for a mortgage. Lenders typically consider the following when reviewing your mortgage application:

Your credit score

Your credit score reflects how you’ve managed different credit accounts in your financial history. The higher your credit score, the lower your interest rate and mortgage payment will be. Most lenders require a minimum FICO Score of:

• 620 for a fixed-rate or adjustable-rate conventional mortgage
• 580 for a minimum down payment FHA loan
• 500 for an FHA loan with a higher down payment (at least 10%)

 2023 credit score interest rate update. Fannie Mae and Freddie Mac, government-sponsored enterprises that set guidelines for conventional mortgages, announced changes to mortgage rate pricing that will affect how rates are set after May 1, 2023. Here’s the good news and the bad news:

Your debt-to-income ratio

Your debt-to-income (DTI) ratio is the total of your monthly debt payments divided by your gross monthly income. DTI helps lenders assess your ability to manage your monthly payments and repay the money you’ve borrowed. The Consumer Financial Protection Bureau (CFPB) recommends a DTI ratio of no more than 43%. However, some loan programs (which we’ll cover later) allow DTIs above 50% in certain cases.

 2023 DTI ratio interest rate update. After Aug. 1, 2023, you may pay more for a DTI ratio over 40% on a conventional mortgage, due to changes announced by Fannie Mae and Freddie Mac.

Your down payment

A down payment is how much money you pay upfront to buy a home. Not all loan programs require a down payment, but the more you put down, the lower your mortgage payment will usually be. Lenders typically ask for two months of bank statements to show where your funds are coming from. You’ll need to document down payment funds from a gift, 401(k) loan or down payment assistance program.

 2023 down payment interest rate update. A higher down payment always leads to a lower monthly payment because you’re borrowing less, but it may not lead to lower conventional mortgage rate after Fannie Mae and Freddie Mac changes take effect. Here are some highlights worth knowing:

• You may pay a higher rate for a down payment between 5% and 20% and credit scores between 680 and 779. However, your rate may be slightly lower if you make less than a 5% down payment in this credit score range.
• You may get a better rate with a down payment between 3% and 25% and credit scores of 620 to 679 when the new changes kick in.

Your rainy-day reserves

Essentially, mortgage reserves are assets you can easily convert to cash to make your mortgage payments if you were to hit a rough financial patch. They can make the difference between mortgage approval and denial, especially if you have low credit scores or a high DTI ratio.

Examples of accounts you can use to meet a mortgage reserve requirement include:

• Money in checking and savings accounts
• Investments in stocks, bonds, mutual funds, CDs, money market funds and trust accounts
• Vested retirement account assets
• The cash value of life insurance policies

Your property type

Though you might not realize it, your property has to qualify for the mortgage you’re applying for. The lender is providing you with money that is secured by your home, and they want to make sure the property is acceptable in case you default and they have to resell it.

Different property types come with different requirements and, in some cases, extra costs.

Single-family home. This is the most common home type and is a one-unit home built on a lot you own. Lenders typically offer the most competitive rates on a single-family residence.

Condominium. More common in cities and urban areas, a condominium gives you ownership of what’s inside the walls of your unit, but you share the outer walls and areas with other residents. You pay monthly dues to an association for repairs and maintenance of the “common areas,” and the lender reviews the association’s money-management history. Rates are slightly higher, due to the risk a neighbor or the association’s actions could damage or make your unit hard to sell.

Multifamily home. One way to buy a home and earn income at the same time is to purchase a two- to four-unit property, live in one of the units and rent the others out to tenants for extra income. The added risk a tenant could bail or damage the property generally means you’ll pay a higher interest rate and make a larger down payment for a multifamily home.

 2023 multifamily interest rate update. You may get a lower rate quote on a multifamily home, as conventional charges are reduced for purchase or refinance loans on two- to four-unit homes. The changes officially take effect on May 1, 2023.

Manufactured home. Also called mobile homes, these are structures built in a factory and then permanently attached to land that you own. Although building standards have improved significantly, lenders charge slightly higher mortgage rates to borrowers looking to refinance or buy a manufactured home, due to the risk that they may not fare well in extreme weather conditions.

Your occupancy plans

Occupancy is a lender term referring to how you’ll “occupy” the home. There are three standard types of occupancy: Owner, second home and non-owner.

• Owner occupancy. This is a home you’ll live in as your primary residence. Mortgage lenders offer the best rates for a home you live in full time.
• Second homes. A second home may be a vacation home on the beach, a cabin in the mountains or a house you own in another state close to family. Guidelines are stricter for second homes, and they usually come with higher down payment requirements and more expensive interest rates.
• Non-owner occupancy. This is the occupancy you’ll choose if you plan to rent the home out to someone and earn income. Investment property mortgage rates are higher for rental homes, and you’ll need higher credit scores, higher down payments and more cash reserves to qualify.

  2023 investment property interest rate update. Fannie Mae is reducing charges for investment property financing, which is good news if you want to refinance or buy a rental home. Conventional loans are much cheaper than other investment property loans like hard money or non-qualified mortgage loans.