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    Mortgage Basics

    Ashley DonohoeBy 11 Mins Read
    mortgage basics

    Falling mortgage rates might have you thinking of trading in paying the landlord every month for putting your money toward a place that’s completely yours. If you’re like most people, that means you’ll need to borrow money to make this happen. That means taking on a large responsibility for up to a few decades, so it’s not something to go into unprepared.

    From helping friends through the process, I know it can seem confusing when you’re trying to figure out how a mortgage works, what these different programs offer, and just how much money you need to have to get started. Use my mortgage guide to grasp the basics.

    How Does a Mortgage Work?

    Since many people don’t have the money on hand to buy a house, lenders offer mortgages to help with financing these purchases. When a lender approves you for this type of loan, they offer the funds as a lump sum to buy the property. The lender also makes your new place the collateral, which they can take if you don’t repay.

    Your job is to make monthly payments on the borrowed amount and the interest the lender charges. While you’ll most often do over 15 and 30 years, some lenders also offer 20- and 40-year repayment terms. It’s important to know that shorter terms mean less interest than longer terms, but you have to be able to afford a larger payment.

    While parts of each payment normally go toward interest and principal, the proportions usually differ. The early years can be frustrating since more money usually goes toward interest, but eventually more will be going toward the originally borrowed amount. This is because of the amortization that the lender uses. You can check your loan’s amortization schedule or use this calculator to get a better idea of how it works.

    You’ll also probably see other costs in your mortgage payment, like your property taxes and homeowners insurance. Money for those usually goes into an escrow account. You might pay mortgage insurance and homeowners association fees, too.

    What Mortgage Programs Are There?

    You’ll find many types of mortgage programs with different rules, uses, and drawbacks. To keep things simple, I’ll focus on the most common ones to know about:

    • Conventional loans. These are the most familiar mortgages for people with good finances. They give you more flexibility for loan amounts, property types, and appraisals. However, they can be harder to get if you don’t have good credit or owe a lot of existing debt relative to your income. And while down payments start at 3%, anything below 20% down usually means paying up for mortgage insurance. But you can get rid of that once you’ve built up 20% equity.
    • FHA loans. FHA loans are worth considering if you’re worried about your credit score since the minimum starts at 500. They also require just 3.5% to 10% down. Plus, lenders are often more comfortable with higher existing debt. But while the rates can be competitive, you’ll pay for upfront and ongoing mortgage insurance. Also, there are tough property standards to meet.
    • USDA loans. Consider these if you’re open to living in rural places. There are two main types: USDA Direct and USDA Guaranteed. The government either funds or guarantees these loans, which require no down payment and have income rules. USDA Direct loans are for the lowest earners. What’s nice is they have no upfront fees and give you an interest rate subsidy. USDA Guaranteed loans are more widely available and lenient about income but have fees. A friend successfully used the latter to build a house.
    • VA loans. These are more restrictive because you can usually qualify only if you or your spouse is affiliated with the military. Since the VA guarantees the loans, you can usually get nice perks, such as little or no upfront costs, no mortgage insurance, and good interest rates. When I helped my grandfather, he got approved on a fixed income without much hassle. He needed to pay a funding fee, but that was added to the loan itself. Also, the property requirements can be strict.
    • Jumbo loans. Sometimes you need a bigger home loan than what lenders will allow for a “conventional” loan. A jumbo loan can help you there, but you’ll often need to put more money down and have even better financials. Also, fewer lenders offer them. But their rates are usually decent, and you usually won’t need to pay for mortgage insurance.

    What About Mortgage Rates?

    You’ll come across these two types of mortgage rates:

    • Fixed-rate mortgages. These are the most popular for good reason. Many people like the predictability of knowing exactly how much interest they’ll pay over the entire course of the mortgage. Plus, your payment is more predictable over the years. However, if rates go down, you’re stuck with the higher one unless you refinance. So the stability does have a tradeoff.
    • Adjustable-rate mortgages. These are more complicated than fixed-rate mortgages since both your payment and interest rate can change several times over the years, limited by caps. It can be nice initially since you’ll often have a smaller payment and a better rate, but it’s not so great if that rate goes up along with your payment later. That said, it could also go the other way, where your rate drops, but there’s no guarantee in the market. Ultimately, you need to be comfortable with more uncertainty.

    Also, know that many things will affect either rate. For example, the lender and program you pick, how the market is, and what your finances look like. That’s why applying only after you’re prepared is best. 

    What Do I Need to Qualify?

    Whether you qualify depends on the mortgage you’re trying to get. I recommend focusing on these main factors:

    • Credit. A 500 credit score might get you an FHA loan. However, other mortgages likely require a minimum somewhere in the 600s. But since your credit score also affects the interest cost, I recommend applying with a higher score to potentially save a lot of money over time.
    • Debt-to-income ratio. Ideally, your housing costs won’t use up more than 28% of your monthly income. Also, it’s ideal if your debt payments don’t exceed 36% of your earnings. That’s not to say you’ll be denied with higher ratios, but you might get a worse rate or a lower loan amount than you’d like. Also, managing your mortgage payment might be harder.
    • Income stability. You can use many types of income to get a mortgage, but the key is stability. Lenders especially like to see that you’ve received income from the same source for at least two years. For the self-employed, some lenders will accept one year of stable income if you’ve worked in that same field as a W-2 employee beforehand.
    • Down payment. Minimums can run from 0% to 20%. Many people save each month for years for a sizable down payment, but down payment assistance programs or gift funds from family can also help. I encourage a larger down payment to lower the loan amount and possibly get a better interest rate. And for conventional loans, providing 20% can save you mortgage insurance.
    • Closing costs. Expect to have another 2% to 6% of the mortgage amount saved for closing costs. You can sometimes just have them added to the loan, but remember that’s more to borrow and more interest. Sellers and government programs can also help.
    • Cash reserves. Lenders might ask for up to 12 months of money in savings accounts or other accessible places.

    Am I Ready for a Mortgage?

    Before jumping into a mortgage, I recommend checking whether you can afford the payment and upfront costs. Besides looking at your savings, use a mortgage affordability calculator to run the numbers and see how much you can afford, considering your income and other debts. You can consider the 28% guideline. Also, keep room in your budget for unexpected expenses.

    Then you should check if you meet the requirements for the mortgage program you’re interested in. Talking to a lender early on is helpful. I’ve found that they can look at your documents and credit and recommend what’s likely right for you. This is also a good way to see if you need to work on some area of your finances before you officially apply.

    If all checks out and you proceed, carefully think through what’s right for your finances. Besides a reasonable target home price, consider what you’re willing to put down, whether you want the rate to be fixed or adjustable, and how long you need to repay the mortgage. Don’t forget all the possible fees either, like mortgage insurance and charges sneaked into closing costs.

    Maybe you learn you’re not ready for this commitment. For some people, renting makes more sense. Besides the lower upfront costs, there’s more flexibility if you’re not ready to settle down. You can check out Freddie Mac’s rent vs. buy calculator and go from there.

    How Do I Get a Mortgage?

    First, I recommend researching mortgage lenders online. See what programs they offer, what their rates look like, what they require, etc. From there, narrow down your options to a few and get prequalified. This is a mostly simple process where you share some information so the lender can estimate your loan amount and other details.

    When you’re ready to start shopping for houses, being preapproved can help you stand out. You’ll need to show documents, such as your tax returns, W-2 forms, and bank statements. The lender will also probably pull your credit. You’ll get a preapproval letter to show sellers.

    After a seller accepts your offer, things move along more intensely. You’ll need to finalize your mortgage decision, submit more paperwork, and sign forms. Then you have to follow several other steps, such as getting a home inspection, working with title companies, and finding homeowners insurance. That also means fixing any application issues that come up and doing a final walkthrough.

    If all goes well, you’ll proceed to the exciting part, mortgage closing day. You’ll meet with others involved in the purchase, sign papers, pay upfront costs, and get the keys to your new place. You’ll officially become a homeowner and mortgage borrower and need to start making payments by your due date.

    Frequently Asked Questions

    Can you get a mortgage without paying money upfront?

    Maybe. Avoiding the down payment may be possible with VA or USDA loans or down payment assistance programs. For closing costs, ask the lender about rolling those into the loan, or see if the seller will help pay for them.

    Can I apply for a mortgage with someone else?

    Yes, and it can be worth considering if your finances alone aren’t good enough or you want to buy the home with someone else. You could use a co-signer who won’t own the home but is responsible if you don’t pay. A co-borrower, on the other hand, would own the place and share responsibility for the loan.

    Should I pay off my mortgage early?

    It depends on your situation. It can be a good way to save on interest and free up your budget, so I recommend it mainly if you have a lot of cash and want peace of mind. But investing could be a better alternative if your mortgage rate is low and you’re in no rush to become debt-free.

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    Sources:

    https://myhome.freddiemac.com/resources/calculators/rent-vs-buy

    Ashley Donohoe is a personal finance educator with over 15 years of writing and editing experience. Whether she’s covering complicated tax laws or investment strategies, Ashley is skilled at breaking down complex topics with practical examples. Ashley holds multiple financial education certifications, including the Certified Financial Literacy Professional℠ (CFLP®) and Certified Financial Education Instructor (CFEI®) from the National Financial Educators Council. She also earned the Financial Planning & Wealth Management Professional℠ (FPWMP®) credential She’s an IRS Annual Filing Season Participant and holds the Uniform Tax Certification. Her work has appeared on major websites, such as The Independent, CNN Underscored, MarketWatch, FinanceBuzz, Car and Driver, GoBankingRates, and Money.com. Ashley’s holds a B.S. in Multidisciplinary Studies and a B.S. in Accounting and Data analysis from Liberty University, and an M.B.A. from Western Governors University.

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