Mortgages: what they are, how they work, and how to qualify

Embarking on the homebuying process can be a daunting experience, especially if it’s your first time wading into the real estate market. In addition to finding the right home for your needs, most of us also require financing for such a significant purchase and that’s where a mortgage comes in.

A mortgage is essential for countless home buyers and there’s a lot to know about how they work and the different types of mortgage options available, in order to secure the right financing for your budget and needs.

What is a mortgage?

A mortgage is a loan used to finance the purchase of a home when you don’t have all of the cash necessary upfront. If you’re approved, your lender will extend a loan to cover the difference between the cost of the home minus your down payment.

The home is used as collateral for the loan and the lender has the power to repossess the property if you do not uphold your end of the bargain, which is repaying the loan—with interest—each month. 

How do mortgages work? 

Mortgages are offered by traditional brick-and-mortar banks, credit unions, and many online-only lenders as well.

Obtaining a mortgage begins with an extensive application process that includes a detailed review of your overall financial picture including your income and debts. If you’re ultimately approved for a mortgage, a lender will provide a specific amount of money that can be used to finance a home purchase. 

It’s your responsibility to pay back the loan, with interest, over a defined loan term that can range from 10, to 15 or 20 years. Once you’ve reached the end of the loan term, your payments are complete and the loan is paid in full.

In addition to principal and interest, monthly mortgage payments may also include various other costs. This may include a portion of your annual property tax bill that the lender will collect each month and put into an escrow account in order to pay the taxes on your behalf. In some cases, the cost of private homeowners insurance may also be rolled into your monthly mortgage bill. 

It is important to consider all of these expenses and the total cost of the monthly mortgage payment when evaluating your borrowing options.

How to qualify for a mortgage 

As part of the mortgage application process, lenders conduct a detailed review of your finances including your income, assets, debts, credit profile and down payment. These factors help lenders determine whether you have the financial capability to purchase a home and can reliably make mortgage payments. This review helps lenders determine the interest rate you will be offered for the mortgage. 

“It’s important home buyers understand the factors that will determine their mortgage rate. Most buyers likely understand their credit score will have an impact on their rate, but there are a variety of other factors,” says Brandon Snow, executive director for direct to consumer originations at Ally Bank. “The process to secure a home loan is one of the most comprehensive processes consumers will experience.” 

Factors lenders consider include:

  • Credit score: Your credit score is an important part of your overall financial profile. It plays a significant role in assessing whether your application will be approved and what interest rate you may be offered. In general, higher credit scores indicate that you have a better track record of being a responsible borrower. This in turn helps you qualify for a lower mortgage interest rate. Most lenders use your Fair Isaac Corporation or FICO score when reviewing an application.
  • Income: Lenders like to see a steady and reliable source of income. This helps them establish your ability to make monthly mortgage payments. For salaried and wage-earning employees, this step involves providing not only a few current pay stubs, but also W-2 tax forms for the past few years. For those who are self employed or own their own business other forms of documentation are acceptable such as a 1040 tax form.
  • Debt-to-income ratio: Another key part of your mortgage application in a lender’s eyes is your debt-to-income ratio (DTI), which is the total of your monthly debt payments divided by your gross monthly income. Reviewing this part of your finances helps lenders gauge your ability to manage monthly bills, including a potential mortgage payment.
  • Assets: Your assets are yet another indicator of financial ability to repay a mortgage. These are sometimes referred to as “rainy-day funds” or emergency reserves—meaning they are accounts or financial reserves that could be tapped if need be to make mortgage payments. Lenders typically consider liquid assets such as savings and checking accounts as well as any stock investments you may hold. Lenders may also consider non-liquid assets such as cars or a business you own.

What are the different types of mortgages? 

There are various types of mortgages to choose from, and knowing the differences can help you better select the right one for your needs and budget. In general, mortgages are organized into categories based on the size of the loan offered and whether the loan is part of a government program.

Conventional

The majority of loans are conventional loans. These loans are not backed by a government agency. “Conventional loans are originated, backed and serviced by private mortgage lenders like banks, credit unions and other financial institutions and do not have insurance or guarantees from the US government,” explains Rob Cook, vice president of marketing for Discover Home Loans.

Within this mortgage category there are two types of loans—conforming and non-conforming loans. Conforming loans have a maximum loan amount that is established by the government. In most places, the conforming loan limit for 2022 is $647,200 in most places though in high-cost areas the limit is as high as $970,800. 

Loans above the conforming loan borrowing limits are referred to as non-conforming or jumbo loans. “A jumbo loan can exceed the conforming loan limit and typically they have higher interest rates, so homebuyers should be aware of the conforming limit as it will impact their financing cost,” explains Cook.

Generally, the loan limit in this category is as high as $1 million to $2 million, according to the Consumer Financial Protection Bureau (CFPB). In order to qualify for this type of loan, applicants typically need a significant down payment and high credit score.

Government insured mortgage loans 

Government-insured (which are sometimes also referred to as government backed mortgages) are another option for prospective home buyers. These mortgages are often aimed at borrowers who may not qualify for conventional mortgages and typically include lower down payment requirements.

“Government-insured mortgage loans fall into three categories, FHA, USDA, and VA. The loans are insured by the Federal Housing Administration, Department of Veterans Affairs, and Department of Agriculture in order to help Americans become homeowners,” says Ernest Jones Jr., board president for the National Association of Mortgage Brokers.

FHA loans

These loans are provided by private lenders but regulated and insured by the FHA. (The FHA does not lend money directly.) There are several notable benefits associated with FHA mortgages, which are designed to make home ownership more accessible. 

“FHA loans…are available to consumers who may not have excellent credit or a large down payment,” says Snow, of Ally Bank. “Only a 3.5% down payment is required for FHAs, making them a great option for first-time homebuyers.”

VA loans 

Loans offered by the VA are aimed at helping active service members, veterans, and their families buy homes. Similar to FHA loans, the VA does not lend money itself but establishes guidelines for the loan program and guarantees the loans. VA loans are generally available through private banks and mortgage lenders. 

Because the loans are guaranteed by the VA, lenders are able to offer more favorable loan terms. The benefits typically include no down payment, minimized closing costs, low interest rates and no requirement that borrowers obtain private mortgage insurance.

USDA loans

USDA loans are aimed at low- to moderate-income borrowers and specifically those who live in rural and suburban parts of the country. Like the other government-backed mortgages, the loans are provided by lenders and guaranteed by the government agency.

These loans are more affordable than conventional mortgages in many ways including offering zero down payment options. However, USDA mortgages do require that borrowers obtain and pay for mortgage insurance. 

What is the difference between fixed-rate and adjustable-rate mortgages?

The interest rate options available with various mortgages is another significant part of the decision making process when selecting the best financing for your budget. There are two types of interest rate structures available—fixed-rate mortgages and adjustable rate mortgages. Each option has benefits and drawbacks.

  • Fixed-rate. As the name implies, a fixed-rate mortgage means your interest rate remains the same for the entire mortgage term. The interest rate is set when you obtain the mortgage and stays the same until the loan is paid off unless you refinance your mortgage at a later date. “As a tradeoff for the security of kObtaining a mortgage is a critical part of home buying for many people. Here’s what they are, how to secure an interest rate, and how they work.nowing your monthly payment will never increase, the interest rate will be slightly higher than the rate on an adjustable-rate mortgage,” says Cook. 
  • Adjustable rate. In contrast to fixed-rate mortgages, the interest on an adjustable rate may go up or down over time. These loans are often appealing to buyers because they typically start with a lower introductory interest rate than fixed mortgages do. However, the rate eventually increases, sometimes after several months or after a few years. This means your monthly mortgage payment will also go up.

    “The interest rate adjusts periodically after the initial term expires, which is anywhere from 1 to 10 years, depending on movements in market interest rates,” says Cook. “This means your monthly mortgage payment could increase or decrease in the future, based on the annual adjustments to the interest rate on the loan.”  

The takeaway

A mortgage is a critically important part of the homebuying process. Researching the various financing options and selecting a loan that works for your financial goals and budget can make a big difference in your ability to keep up with mortgage payments over the long term. 

As you embark upon the home shopping process, it’s a good idea to meet with a mortgage professional to find out what type of mortgage you may qualify for, as this can help guide your home shopping. 

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