What Is A Mortgage? Loan Basics For Beginners

For many, owning a home is part of the American dream. For most homeowners in America, getting a mortgage is just one of the steps to getting there.

If you’re contemplating homeownership and wondering how to get started, you’ve come to the right place. Here, we’ll cover all the mortgage basics, including loan types, mortgage lingo, the home buying process and more.

Before we dive in, let’s talk about some mortgage basics. First, what does the word “mortgage” even mean?

 

A mortgage, also referred to as a mortgage loan, is an agreement between you (the borrower) and a mortgage lender to buy or refinance a home with money provided by the lender. This agreement gives lenders the legal rights to repossess a property if you fail to meet the terms of your mortgage, most commonly by not repaying the money you’ve borrowed plus interest.

Who Gets A Mortgage?

Most people who buy a home use a mortgage. A mortgage is a necessity if you can’t pay the full cost of a home out of pocket.

 

There are some cases where it makes sense to have a mortgage on your home even though you have the money to pay it off. For example, investors sometimes mortgage properties to free up funds for other investments and to take advantage of tax deductions.

What’s The Difference Between A Loan And A Mortgage?

The term “loan” can be used to describe any financial transaction where one party receives a lump sum and agrees to pay the money back.

 

A mortgage is a type of loan that’s used to finance property. Mortgages are “secured” loans. With a secured loan, the borrower promises collateral to the lender in the event that they stop making payments. In the case of a mortgage, the collateral is the home. If you stop making payments on your mortgage, your lender can take possession of your home, in a process known as foreclosure.

When you get a mortgage, your lender gives you a set amount of money to buy the home. You agree to pay back your loan – with interest – over a period of several years. The lender’s rights to the home continue until the mortgage is fully paid off. Fully amortized loans have a set payment schedule so that the loan is paid off at the end of your term.

 

The difference between a mortgage and other loans is that if you fail to repay the loan, your lender can sell your home to recoup its losses. Contrast that to what happens if you fail to make credit card payments: You don’t have to return the things you bought with the credit card, though you may have to pay late fees to bring your account current in addition to dealing with negative impacts on your credit score.

The mortgage loan process is straightforward if you have a regular job, adequate income and a good credit score.

 

There are several steps you’ll need to take to become a homeowner, so here’s a rundown of what you need to do.

1. Get Preapproved Or Be Ready To Show Proof Of Funds

You’ll need a preapproval to be taken seriously – by real estate agents and sellers – in today’s real estate market.

 

Preapproval

 

It’s a good idea to get an initial approval from your mortgage lender before you start looking for homes. Getting preapproved upfront can tell you exactly how much you’ll qualify for, so you don’t waste time shopping for homes outside your budget. In some very hot seller’s markets around the U.S., you may not be able to get a real estate agent to meet with you before you have a preapproval letter in hand.

 

There’s a difference between prequalification and preapproval. Prequalification involves sharing verbal or written estimates of your income and assets with your lender, who may or may not check your credit.

 

You can use our home affordability calculator to get a sense of what you can afford as you begin thinking about buying a home, but the numbers you use aren’t verified, so it won’t carry much weight with sellers or real estate agents.

 

Mortgage preapproval, on the other hand, means that the lender has verified your financial information and issued a preapproval letter to show sellers and agents that you have essentially been approved, pending only a determination of the house’s value and condition.

 

Rocket Mortgage^® offers Verified Approval, which confirms your income, assets and credit upfront, giving you the strength and confidence that you’ll qualify for the home you want to buy.

 

When you’re ready to make an offer, you’ll attach your preapproval letter to your offer so that the seller can be sure you’ll be able to get a mortgage.

All-Cash Purchases

In many real estate markets, sellers have the luxury of choosing a buyer from among several all-cash offers. That means that sellers avoid the uncertainty of waiting for the buyer’s mortgage to be approved.

 

In those situations, buyers should attach a proof of funds letter with their offer so that the seller is certain that the buyer has the money they need at the ready to complete the transaction.

2. Shop For Your Home And Make An Offer

Connect with a real estate agent to start seeing homes in your area. Your real estate agent will be able to schedule viewings and find open houses for you to attend during the house hunting process. You can also view homes online using a multiple listing service (MLS).

 

Your (buyer’s) agent will likely be your eyes and ears to get the best property. Real estate professionals can help you find the right home, negotiate the price and handle all the paperwork and details.

3. Get Final Approval

Once your offer has been accepted, there’s a bit more work to be done to finalize the sale and financing.

 

At this point, your lender will verify all the details of the mortgage – including your income, employment and assets – if those details weren’t verified upfront. They’ll also need to verify the property details. This typically involves getting an appraisal to confirm the home’s value and you getting an inspection to evaluate the condition of the home. Your lender will also hire a title company to check the title of the home and make sure there are no issues that would prevent the sale or cause problems later.

4. Close On Your Loan

Once your loan is fully approved, you’ll meet with your lender and real estate professional to close your loan and take ownership of the home. At closing, you’ll pay your down payment and closing costs and sign your mortgage papers.

There are up to three parties involved in every mortgage transaction – a lender, a borrower and possibly a co-signer.

Lender

A lender is a financial institution that loans you money to buy a home. Your lender might be a bank or credit union, or it might be an online mortgage company like Rocket Mortgage.

 

When you apply for a mortgage, your lender will review your information to make sure you meet their standards. Every lender has their own standards for who they’ll loan money to. Lenders must be careful to only choose qualified clients who are likely to repay their loans. To do this, lenders look at your full financial profile – including your credit score, income, assets and debt – to determine whether you’ll be able to make your loan payments.

Borrower

The borrower is the individual seeking the loan to buy a home. You may be able to apply as the only borrower on a loan, or you may apply with a co-borrower. Adding more borrowers with income to your loan may allow you to qualify for a more expensive home.

Co-Signer

Sometimes, because of a negative credit history or no credit history, a lender may ask a prospective borrower to find a co-signer for the mortgage. This is also synonymous with a co-borrower. A co-signer isn’t merely vouching for your character. They are entering into a legally binding contract that will hold them responsible for paying for the mortgage with or without any rights of ownership, should the borrower default on the loan.

There are many types of home loans. Each comes with different requirements, interest rates and benefits. If you’re just beginning the home buying process, you may be surprised to learn there are two main categories of mortgages: conforming loans and non-conforming loans. Non-conforming loans include government-backed mortgages, jumbo and non-prime mortgages.

 

Here are some of the most common types you might hear about when you’re applying for a mortgage.

The phrase “conventional loan” refers to any loan that’s not backed or guaranteed by the federal government. Conventional loans are often also conforming loans. The term “conventional” means that a private lender is willing to make the loan without government support, and “conforming” means that the mortgage meets a set of requirements defined by Fannie Mae and Freddie Mac – two government-sponsored enterprises that buy loans to keep mortgage lenders liquid, so they can continue making loans.

 

Conventional loans are a popular choice for buyers. You can get a conventional loan with a down payment of as little as 3% of the purchase price of the home. If you put down less than 20% for a conventional loan, you’ll usually be required to pay a monthly fee called private mortgage insurance, which protects your lender in case you default on your loan. This adds to your monthly costs but allows you to get into a new home sooner.

Conforming mortgages are subject to lending limits. In 2023, the conforming loan limit in most of the U.S. is $715,000, while in areas of the country with high-cost housing, the limit is as high as $1,073,000. If you want to buy a house that costs more than that and you need financing, you’ll have to apply for a jumbo loan.

 

Because jumbo mortgages exceed the conforming loan limits and are offered by private lenders without government incentives, they’re considered conventional non-conforming loans. Traditionally, a jumbo loan required at least a 20% down payment, and tons of paperwork to get approved.

 

Rocket Mortgage offers the Jumbo Smart loan. With a Jumbo Smart loan, you can borrow up to $2.5 million. To qualify, you’ll need a down payment of 10.01% for a loan amount up to $2 million. (or 15% if you’re buying a multifamily home.) Beyond $2 million, you’ll need a down payment of 25%. You’ll need a qualifying credit score of at least 680 and a debt-to-income ratio no higher than 45%.

 

One money-saving feature here is that Rocket Mortgage does not require private mortgage insurance on Jumbo Smart loans. Insurance is typically anywhere between 0.1% – 2% of the loan amount annually. On a $1 million loan, this alone could save you anywhere between $83.34 – $1,666.67 per month.

Interest rates are the charges for the mortgage you’re seeking. Mortgage rates are determined by analyzing a wide variety of factors, most of which have nothing to do with either the lender or the borrower.

 

The interest rate is determined by two factors: current market rates and the level of risk the lender takes to lend you money. You can’t control current market rates, but you can have some control over how the lender views you as a borrower. The higher your credit score and the fewer red flags you have on your credit report, the more you’ll look like a responsible borrower. In the same sense, the lower your debt-to-income ratio (DTI), the more money you’ll have available to make your mortgage payment. These all show the lender that you are less of a risk, which will benefit you by allowing you to qualify for a lower interest rate.

 

If you’re shopping around – Freddie Mac’s research shows that soliciting even one additional offer can save borrowers $1,500 on average – you’ll want to get the best rate possible for your mortgage. But lenders sometimes offer very low rates but charge high fees. To meaningfully compare mortgage offers, you’ll need to look at a loan’s annual percentage rate (APR).

 

The amount of money you can borrow will depend on what you can reasonably afford and, most importantly, the fair market value of the home, determined through an appraisal. This is important because the lender cannot lend an amount higher than the appraised value of the home.

Economic Conditions

When the pandemic hit in 2020, the Federal Reserve (the Fed) quickly dropped interest rates to discourage an economic recession. The Fed has since hiked the federal funds interest rate throughout 2022 in an effort to combat inflation.

 

The Fed doesn’t set mortgage rates directly, but interest rates respond rapidly to changes in the Fed fund rate. Consumer loans are at the top of the borrowing risk pyramid, but mortgages are the lowest-priced of all consumer loans, because they’re secured by the property.

Your Credit Score, Income And Assets

As we’ve noted, you can’t control current market rates, but you can have some control over how the lender views you as a borrower. Be attentive to your credit score and your DTI and understand that having fewer red flags on your credit report allows you to qualify for the lowest possible rates.

 

To qualify for the loan, you must meet certain eligibility requirements. Therefore, a person who gets a mortgage will most likely be someone with a stable and reliable income, a debt-to-income ratio of less than 50% and a decent credit score (at least 580 for FHA or VA loans or 620 for conventional loans).

Fixed-Rate Vs. Adjustable-Rate Mortgages

Mortgages are structured in endless iterations, but they’re almost all either fixed-rate or adjustable-rate mortgages.

Fixed-Rate Mortgage

Fixed interest rates stay the same for the entire length of your mortgage. If you have a 30-year fixed-rate loan with a 6% interest rate, you’ll pay 6% interest until you pay off or refinance your loan. Fixed-rate loans offer a predictable payment each month, which makes budgeting easier.

Adjustable-Rate Mortgage (ARM)

Adjustable rates are interest rates that change based on the market. Most adjustable-rate mortgages begin with a fixed interest “initial rate” period, which usually lasts 5, 7 or 10 years. This is different from a “teaser rate” you may see advertised for other loans, so make sure you understand the difference when getting a mortgage. During this time, your interest rate remains the same. After your fixed-rate period ends, your interest rate adjusts up or down every 6 months to a year. This means your monthly payment can change based on your interest payment. ARMs typically have 30-year terms.

 

ARMs are right for some borrowers. If you plan to move or refinance before the end of your fixed-rate period or have a very expensive mortgage, an adjustable-rate mortgage can give you access to lower interest rates than you’d typically find with a fixed-rate loan.

Your mortgage payment is the amount you pay every month toward your mortgage. Each monthly payment has four major parts: principal, interest, taxes and insurance.

Principal

Your loan principal is the amount of money you have left to pay on the loan. For example, if you borrow $200,000 to buy a home and you pay off $10,000, your principal is $190,000. Part of your monthly mortgage payment will automatically go toward paying down your principal. You may also have the option to put extra money toward your loan’s principal by making extra payments; this is a great way to reduce the amount you owe and pay less interest on your loan overall.

Interest

The interest you pay each month is based on your interest rate and loan principal. The money you pay for interest goes directly to your mortgage provider, who passes it to the investors in your loan. As your loan matures, you pay less in interest as your principal decreases.

Taxes And Insurance

If your loan has an escrow account, your monthly mortgage payment may also include payments for property taxes and homeowners insurance. Your lender will keep the money for those bills in your escrow account. Then, when your taxes or insurance premiums are due, your lender will pay those bills for you.

Mortgage Insurance

Almost all home loans charge some type of mortgage insurance unless you are able to make a 20% down payment. Conventional loans have private mortgage insurance (PMI).

 

FHA loans charge a mortgage insurance premium (MIP), both upfront and on a monthly basis regardless of the size of your down payment. VA loans charge a funding fee that can be rolled into the loan as part of the mortgage. USDA loans charge an upfront and monthly guarantee fee.

 

PMI

 

You’ll need to purchase private mortgage insurance (PMI) to protect your lender in case you default on your conventional conforming loan. In most cases, you’ll need to pay PMI if your down payment is less than 20%. You can usually request to stop paying PMI when you reach a loan-to-value ratio (LTV) of 80%. That’s a lender’s way of saying that you have 20% home equity.

 

Typically, PMI costs range from 0.1% – 2% of a home’s purchase price. The cost of PMI can be added to your monthly mortgage payment, covered via a one-time upfront payment at closing or a combination of both. There’s also a lender-paid PMI, in which you pay a slightly higher interest rate on the mortgage instead of paying the monthly fee.

 

MIP

 

If your mortgage is an FHA loan, you’ll be charged a mortgage insurance premium (MIP) upfront and throughout at least the first 11 years of the mortgage, regardless of the amount of your down payment or whether you’ve already built up 20% home equity. It’s important to note that unless you make a down payment of 10% or more, you’ll pay MIP for the life of the loan.

When you shop for a home, you might hear a bit of industry lingo you’re not familiar with. We’ve created an easy-to-understand directory of the most common mortgage terms.

Amortization

Part of each monthly mortgage payment will go toward paying interest to your lender or mortgage investor, while another part goes toward paying down your loan balance (also known as your loan’s principal). Amortization refers to how those payments are broken up over the life of the loan. During the earlier years, a higher portion of your payment goes toward interest. As time goes on, more of your payment goes toward paying down the balance of your loan.

Down Payment

The down payment is the money you pay upfront to purchase a home. In most cases, you have to put money down to get a mortgage.

 

The size of the down payment you’ll need will vary based on the type of loan you’re getting, but a larger down payment generally means better loan terms and a cheaper monthly payment. For example, conventional loans require as little as 3% down, but you’ll have to pay a monthly PMI fee to compensate for the small down payment. On the other hand, if you put 20% down, you’d likely get a better interest rate, and you wouldn’t have to pay for PMI.

 

A mortgage calculator can help you see how your down payment amount affects your monthly payments.

Escrow

Part of owning a home is paying for property taxes and homeowners insurance. To make it easy for you, lenders set up an escrow account to pay these expenses. Your escrow account is managed by your lender and functions kind of like a checking account. No one earns interest on the funds held there, but the account is used to collect money so your lender can send payments for your taxes and insurance on your behalf. To fund your account, escrow payments are added to your monthly mortgage payment.

 

Not all mortgages come with an escrow account. If your loan doesn’t have one, you have to pay your property taxes and homeowners insurance bills yourself. However, most lenders offer this option because it allows them to make sure the property tax and insurance bills get paid. If your down payment is less than 20%, an escrow account is required. If you make a down payment of 20% or more, you may opt to pay these expenses on your own or pay them as part of your monthly mortgage payment.

 

Keep in mind that the amount of money you need in your escrow account is dependent on how much your insurance and property taxes are each year. Since these expenses may change year to year, your escrow payment will change, too. That means your monthly mortgage payment may increase or decrease.

Interest Rate

An interest rate is a percentage that shows how much you’ll pay your lender each month as a fee for borrowing money. The interest rate you’ll pay is determined both by macroeconomic factors like the current Fed funds rate as well as your personal circumstances, like your credit score, income and assets.

Mortgage Note

A promissory note is a written document that details the agreed-upon terms for the repayment of the loan being used to purchase a property. In real estate, it’s called a mortgage note. It’s like an IOU that includes all of the guidelines for repayment. These terms include:

• Interest rate type (adjustable or fixed)
• Interest rate percentage
• Amount of time to pay back the loan (loan term)
• Amount borrowed to be paid back in full

Once the loan is paid in full, the promissory note is given back to the borrower. If you fail to uphold the responsibilities outlined in the promissory note (for example, pay back the money you borrowed), the lender can take ownership of the property.

Loan Servicer

The loan servicer is the company that’s in charge of providing monthly mortgage statements, processing payments, managing your escrow account and responding to your inquiries.

 

Your servicer is sometimes the same company that you got the mortgage from, but not always. Lenders may sell the servicing rights of your loan and you may not get to choose who services your loan.

Becoming a homeowner isn’t easy – and it’s certainly not cheap – but it’s worth the effort. It’s important to take the time to familiarize yourself with what a mortgage is before you plunge into the market. Ready to take the first step in your home buying journey? Get started on your mortgage approval today! You can also give us a call at (833) 326-6018.