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What is a mortgage?
A mortgage is a loan used to buy a home. You repay the loan, with interest, over a set number of years. The property serves as collateral, meaning if you don't pay, the lender can take the home. Though you are a homeowner while paying the mortgage, it's only once the mortgage is paid off that you own the home "free and clear."
"Mortgage" can also refer to the legal document outlining the loan terms and permitting your lender to seize the home if you don't repay the loan as agreed. In some states, this document is called a deed of trust.
» MORE: How to buy a house
How does a mortgage work?
A mortgage lets you buy a home without paying cash. Mortgages typically require you to pay some money right away — called the down payment — and then repay the rest over time. Each month, you pay back some of what you borrowed, along with interest. Inability to repay the mortgage can lead to foreclosure. Mortgages also last much longer than other types of loans; 30-year mortgages are the most common.
You can get a mortgage from a mortgage lender, which includes banks, credit unions and nonbank lenders like Rocket Mortgage or Guaranteed Rate, which aren't banks but do lend money. When deciding whether to give you a mortgage, a lender reviews every aspect of your finances, including your credit score, debts and employment. Lenders use this information to decide whether they'll lend you money, how much they're willing to lend and what the terms will be. Each lender’s qualifications can vary depending on the kind of home loan you want and other factors.
If you are buying a home with another person, you'll be co-borrowers, and the lender will review both of your finances. A second borrower could help you qualify for a mortgage by increasing your total income or boosting your combined credit score.
» MORE: How to get a mortgage
What a mortgage payment includes
You’ll pay back a mortgage on a monthly basis over a set number of years. Each month, you'll pay some of the amount owed, as well as interest and potentially other costs. Here’s what's included in a mortgage payment.
"Mortgage principal" means two things. It can refer to the original amount you borrowed. It also can refer to the amount you still owe after you have made payments.
For example, if you bought a $200,000 house and made a $20,000 down payment, you’d have originally borrowed $180,000. Each month, a portion of your mortgage payment is applied to your principal, reducing the total amount owed over time.
The interest rate on your mortgage determines how much you’ll pay the lender in exchange for borrowing the money.
Some of each monthly payment goes toward interest. In the first years of the loan, most of each payment covers interest and little goes toward principal; in the final years, most of the payment reduces principal. This process is called amortization.
Your lender may collect a portion of your property tax bill along with your mortgage payment and keep the money in an escrow account until the bill is due, paying it on your behalf at that time.
Homeowners insurance — which can cover damage to your home from fires, storms, accidents and other catastrophes — is usually required by mortgage lenders. They may collect a portion of your premium as part of your mortgage payment and then pay the insurance bill out of your escrow account when it’s due.
When you make a down payment of less than 20%, lenders typically require you to pay for mortgage insurance. Mortgage insurance premiums may be billed in your monthly mortgage statement.
Mortgage insurance protects the lender against the risk that you’ll default on the loan. There are two types: private mortgage insurance, or PMI, for conventional loans, and FHA mortgage insurance, which is required for home loans insured by the Federal Housing Administration. Private mortgage insurance can be canceled once you have enough home equity, but FHA mortgage insurance can last for the life of the loan.
There are two kinds of mortgages.
Fixed-rate mortgage. The interest rate stays the same over time. The vast majority of home loans are fixed-rate mortgages.
Adjustable-rate mortgage, or ARM. The interest rate can change at intervals specified in the loan paperwork. Your monthly payment might increase or decrease as the interest rate changes.
There are several types of loans, which may be either fixed-rate or adjustable. You'll also be able to choose the loan term, or how long you'll have to pay off the mortgage. Again, 30 years is the most common, but you'll probably also see options for 20- and 15-year mortgages.
Conventional loans meet mortgage underwriting standards and conform to limits on loan amounts set by the U.S. government. These mortgages generally require a credit score of 620 or higher and a down payment of at least 3%.
FHA loans are insured by the Federal Housing Administration. Borrowers with credit scores as low as 580 may qualify for an FHA-insured mortgage with a down payment of at least 3.5%.
VA loans are guaranteed by the Department of Veterans Affairs and do not require a down payment. VA loans are available to qualified U.S. veterans, active-duty military personnel and some surviving spouses.
USDA loans don’t require a down payment and are available to homebuyers who meet income requirements in designated rural and suburban areas. They are guaranteed by the U.S. Department of Agriculture.
Jumbo loans are mortgages that exceed the government's limits on loan amounts. The limits vary by county, and they’re higher where housing is more expensive.
Mortgage terminology to know
There's a lot of vocab to learn when you're looking for a home loan. To make things even trickier, in many cases these are specialized uses of everyday words. Here are some terms you might come across.
APR. APR is short for annual percentage rate. This number represents the total cost of borrowing money to buy a home because it combines your interest rate with fees, points and other lender charges. Looking at the APR different lenders offer gives you another way to compare costs.
Appraisal. After you have applied for a mortgage, the lender has an appraiser compare the details of the home you want to buy with similar properties that have recently sold in your area. This tells the lender the property's value, which is important because it won't let you borrow more than the home is worth.
Closing. Closing has two different but related meanings when it comes to buying a home. It can refer to the time between applying for a mortgage and actually signing the paperwork and receiving the keys, or it can refer to that last day when the loan "closes."
Loan Estimate. The Loan Estimate is a document that you'll get when you are preapproved for a mortgage. It shows all the costs related to getting a home loan, including rates and fees. The Loan Estimate also shows which costs are set in stone and which you can shop around for. All lenders have to use the same format, which makes Loan Estimates easy to compare.
Mortgage broker. A mortgage broker is an independent agent who can help you with the home loan process. Based on your needs, they'll present you with loan options and help you work with the lender that you choose. You don't have to work with a mortgage broker. With the amount of information readily available online, it's easier to do research and compare loans than it used to be.
Mortgage originator. A mortgage originator is the lender that initially provides your home loan. You'll work with the mortgage originator from your initial application through closing day.
Mortgage servicer. A mortgage servicer is the company that handles your mortgage once you own the home. You send the servicer your monthly payment, it manages your escrow account and you'll call it with any questions about your home loan. In some cases, your mortgage originator will also service the mortgage, but most of the time, originators resell mortgages to servicers.
Second mortgage. A second mortgage is another loan on a home that already has a first, or primary, mortgage. Also called "junior liens," second mortgages are a way to access the equity in your home as spendable funds without selling or refinancing. Home equity loans and home equity lines of credit are two types of second mortgages.
Points. Sometimes called mortgage points or discount points, points are optional fees that you can pay when buying a home in order to reduce your interest rate. One point usually costs 1% of the total amount you're borrowing, and for each point you buy, the lender reduces your interest rate by 0.25 percentage point. When you're comparing interest rates, check whether points are included — sometimes lenders will add points to their sample rate calculations to make their interest rates appear lower.
Preapproval. A mortgage preapproval is a letter from a lender stating how much they might be willing to lend you to buy a home. A preapproval doesn't mean that you'll definitely get the loan, but because it's based on the lender verifying some of your financial information — including doing a credit check — a preapproval shows real estate agents and home sellers that you're a legit buyer.
Prequalification. A mortgage prequalification is a more informal way to estimate how much you might be able to borrow to buy a home. You provide a lender with basic information like your income and credit score range, and they'll tell you what kinds of loans you could be able to get. Since the lender doesn't independently verify any of your financial info, a prequalification doesn't carry as much weight as a preapproval.
Title. The title represents the home's ownership history. If a home has a "clear title," that means that the current owner has the right to sell the property and no one else can make a claim to it. Title issues can crop up if there are judgments against the property owner (for example, unpaid taxes). Getting a title search is part of the closing process.
Underwriting. Underwriting is the process lenders use to make sure that borrowers are qualified. It happens after you apply for a mortgage, and it can last for weeks. During this time, an underwriter will look closely at your finances, plus examine the house's appraisal and the title search, to make a final determination as to whether to give you a mortgage. Once the underwriter gives the go-ahead, you'll get the Closing Disclosure (a finalized version of the Loan Estimate) and be able to schedule the closing.
» MORE FOR CANADIAN READERS: How does a mortgage work?