A mortgage is a loan that funds the purchase of a home or another type of real estate. Mortgages make homeownership more accessible to the average American. With a mortgage loan, you don’t have to pay the full price of real estate out of pocket; instead, you’ll make a monthly payment, with interest, over a number of years (most commonly 30 years).
During that time, the home serves as collateral for the loan. Technically speaking, the mortgage is the document that allows the lender to use your home as collateral on the loan, while the promissory note is the actual loan. However, most people simply use the word “mortgage” for both.
Though a mortgage is a long-term debt, it is one of the best ways to build home equity over time. Below, we’ll review how mortgages work, how to qualify for one, and how to get the lowest rate on your home loan.
How does a mortgage work?
A mortgage works like many other secured loans, such as a car loan. You borrow money upfront for a major purchase, then pay it off over time, with interest. Here’s a high-level breakdown of how mortgages work.
The role of collateral
The home you purchase with a mortgage serves as collateral on the loan. Because of this, there’s less risk for lenders, so they can offer fairly affordable rates compared to other types of loans, such as credit cards and personal loans.
However, if you stop making payments on the mortgage, the lender can foreclose on your property, legally reclaiming the home. That’s why it’s crucial to buy a house that doesn’t overstretch your finances and always prioritize making your monthly mortgage payment.
The mortgage term
The mortgage term refers to the length of the loan. Most traditional mortgages last 30 years, though it’s possible to get shorter loans, such as 10- or 15-year mortgages.
The shorter the mortgage term, the less interest you’ll pay. However, a shorter loan term also means larger monthly payments, since you’re paying off the same loan amount, just with fewer payments.
The amortization process
Amortization refers to how your mortgage balance is paid down over time. While your total payment amount stays the same each month on a fixed-rate mortgage (aside from potential fluctuations to your escrow contributions), how that payment is split between interest and principal changes over the life of the loan.
In the early years of a mortgage, a larger portion of each payment goes toward interest, while only a small amount goes toward the principal balance, or the original amount borrowed. Over time, as the total loan balance shrinks, less interest accrues each month, so more of your payment goes toward paying down the principal. This gradual shift is laid out in an amortization schedule, which shows exactly how each payment is applied over the course of the loan.
How to qualify for a mortgage
When you apply for a mortgage, lenders will review several key factors to determine whether you’re approved to borrow the funds and what interest rate they can offer you. Here’s a high-level look at what you need to qualify for a mortgage:
- Credit score: For most conventional mortgages, you’ll need a credit score of 620 or better. However, credit score requirements are more flexible for Federal Housing Administration (FHA) loans. Borrowers may get approved with a score of at least 580.
- Debt-to-income ratio: Lenders want to ensure your monthly debts aren’t too high compared to your monthly income. To confirm this, they calculate your debt-to-income (DTI) ratio. Many lenders want to see a DTI of 36% or less (meaning your overall monthly debt payments amount to roughly a third of your monthly take-home pay), though some lenders may be willing to work with DTIs as high as 43%.
- Down payment: The gold standard for a down payment is 20% of the home’s purchase price. Putting down less than that amount on a conventional mortgage means you’ll likely have to pay private mortgage insurance (PMI). However, you can get an FHA loan with as little as 3.5% down, and Veterans Affairs (VA) loans are available to eligible borrowers with no down payment.
- Income: Lenders will also verify your income with tax returns, W-2s, pay stubs, and 1099s. It’s easiest to get a mortgage if you have a traditional W-2 job; self-employed individuals may need to get a non-qualified mortgage, which typically comes with higher interest rates.
The mortgage process: From preapproval to closing
A standard mortgage takes about 30 to 45 days to close, once you’ve been approved and accepted the mortgage offer. Here’s what that process looks like.
Mortgage preapproval
Getting preapproved is your first step. While not a legal requirement, a preapproval letter helps your offer stand out because it demonstrates to the seller that a lender has already vetted your finances and is likely to fund your loan.
To get a mortgage preapproval, the lender will perform a credit check and verify some basic information about your income and assets.
The difference between pre-qualification vs. preapproval
You can also obtain a pre-qualification letter to get a basic understanding of what kind of loan you may get, but these don’t carry the same weight when you make an offer on a home. That’s because a pre-qualification doesn’t include actual verification of your income, assets, and credit history; instead, it’s based on data you report to the lender.
Mortgage application and underwriting
Once you make an offer on a home and it’s accepted, you’ll submit a formal mortgage application and the lender will begin the underwriting process. This is when a specialist reviews your financial and credit history to confirm the details in your tax forms, bank statements, and pay stubs. The underwriter also evaluates the home itself to ensure it serves as sufficient collateral for the loan amount.
Home inspection
At this time, you can arrange for a home inspection. This professional assessment identifies potential safety issues or costly repairs, such as foundation cracks or outdated wiring, before you finalize the sale. It ensures you aren't inheriting major problems that could compromise your investment or your budget.
Appraisal and title search
Next, the lender orders an appraisal to confirm the house is worth the purchase price. They also perform a title search to make sure the property is free of liens — legal claims or debts held by others — meaning the seller has the right to transfer the home to you.
You’ll see the fees for both the appraisal and title search listed in your closing costs.
Closing the loan
Closing day involves meeting with your real estate agent, the seller’s agent, and the mortgage company. You’ll sign a significant amount of paperwork, including the promissory note — the legal document where you agree to repay the loan. Expect to pay the down payment and closing costs at this time, which typically range from 2% to 5% of the total purchase price.
Once the paperwork is finalized and the funds are transferred, you’ll receive the keys — the home is officially yours.
Common types of mortgage loans
While a “mortgage” is a blanket term for home loans, there are several subcategories. Here are the main types of mortgages to know.
Conventional loans
Conventional loan is a catch-all term for any kind of mortgage that isn’t backed by the federal government. Conventional loans are either conforming or non-conforming.
A conforming conventional loan is one that doesn’t exceed $832,750 in most counties (the number differs in areas with a higher cost of living). A conforming jumbo loan is then any loan larger than that, up to the county limit.
Then there are non-conforming mortgages, which include even larger jumbo loans and government-backed loans.
Government-backed loans
The federal government backs specific mortgage loans to make homeownership more accessible, even if you have lower income or less-than-ideal credit. There are three key types of government-backed mortgages:
- FHA loans are backed by the Federal Housing Administration and are ideal for first-time homebuyers, buyers who can’t afford a large down payment (only 3.5% is required), and buyers with a lower credit score (580 is acceptable).
- VA loans are backed by the Department of Veterans of Affairs and are available to active-duty service members, veterans, and surviving spouses. VA loans notably don’t require a down payment or private mortgage insurance.
- USDA loans are backed by the Department of Agriculture and are designed to encourage home purchases in more rural areas. Like VA loans, USDA loans don’t require a down payment.
Fixed-rate vs. adjustable-rate mortgages (ARMs)
More than 90% of mortgages are fixed-rate, according to the Federal Reserve Bank of St. Louis, and for good reason. Fixed-rate mortgages, as the name implies, come with a locked-in interest rate for the life of the loan. This keeps payments predictable throughout the loan term.
Alternatively, some buyers choose adjustable-rate mortgages (ARMs). These loans often start with lower introductory interest rates than fixed-rate options. After a set number of years, the lender reviews and adjusts the rate — usually once or twice annually — to match current economic benchmarks. Because this rate can fluctuate significantly over time, your future monthly payments remain unpredictable.
Adjustable-rate mortgages have many different structures, but here are some of the most common:
- 5/1 ARM: Fixed rate for 5 years, then adjusted once each year
- 5/6 ARM: Fixed rate for 5 years, then adjusted twice each year (once every six months)
- 7/1 ARM: Fixed rate for 7 years, then adjusted once each year
- 7/6 ARM: Fixed rate for 7 years, then adjusted twice each year (once every six months)
- 10/1 ARM: Fixed rate for 10 years, then adjusted once each year
- 10/6 ARM: Fixed rate for 10 years, then adjusted twice each year (once every six months)
The anatomy of a mortgage payment: Understanding PITI
Your monthly loan payment consists of four core components: principal, interest, taxes, and insurance, commonly referred to as PITI.
- Principal: This is the actual loan balance — the original amount borrowed — that you’re paying down.
- Interest: This is the ongoing cost of borrowing money from your lender.
- Taxes: Instead of paying a large property tax bill twice a year, you contribute monthly to an escrow account — a holding account managed by your lender to pay these bills on your behalf.
- Insurance: Most homeowners also use their escrow account to pay for homeowners insurance. Depending on your loan type and equity, you might also pay for private mortgage insurance this way.
How escrow accounts work
Until you’ve paid off your home loan, home insurance payments and property tax funds are typically held in a lender-managed escrow fund. The lender will distribute those funds to the insurer and government as needed throughout the year.
Because home insurance costs and property tax amounts change over time, your lender will perform an annual escrow analysis to determine if you’re paying too much or not enough into escrow. Then, the lender will adjust your monthly mortgage payment accordingly.
How to shop for the best mortgage rate
Your house is most likely the biggest purchase you’ll ever make, so you should take your time with every decision — and that goes beyond searching for your dream home. It also means doing your due diligence to find the best mortgage rate available.
Compare multiple lenders
Often, your real estate agent will recommend a lender when you’re ready to get your preapproval letter. While you can certainly go with this lender, you do not have to. In fact, experts recommend comparing quotes from several lenders to see where you’ll get the best rate.
Ideally, try to get quotes from at least three to five lenders, including a nice mix of banks, credit unions, and online financial institutions.
Shop within a specific window
Because mortgage preapprovals require a hard credit inquiry, you don’t want to regularly apply for preapprovals. After all, a hard credit check can reduce your credit score by up to 5 points, impact your credit score for a year, and stay on your credit report for two years.
However, if you’ve already applied for preapproval with one lender, you can get preapprovals from other lenders within a tight window (14 to 45 days, according to FICO), without any additional impact on your score. This makes it easier to rate-shop without substantially affecting your credit.
Analyze the loan estimate
Once you make an offer on your home, you can apply to one or more of the mortgage lenders you’ve been considering. At this stage, you are only legally required to provide six key pieces of information, according to the Consumer Financial Protection Bureau:
- Your name
- Your income
- Your Social Security number
- The property address
- An estimate of the property value
- The desired loan amount
While you’re not required to submit any financial information at this time, doing so can help the lender give you a more accurate offer. Within three days, the lender will provide a standard loan estimate, which is a three-page form that includes the estimated interest rate, monthly payment, and closing costs for the mortgage.
If you get multiple loan estimates, the most important number to compare is the annual percentage rate (APR). The APR represents the total cost of the loan, including the interest rate, fees, and some closing costs.
Don’t be afraid to negotiate
Some lenders may have rate-match or rate-beat guarantees, so getting multiple loan estimates can work in your favor. Even if a lender doesn’t advertise this, it’s worth showing your preferred lender a lower rate you were offered elsewhere to see if they will match or beat it.
How to lower your mortgage rate
Mortgage rates are ultimately determined by macroeconomic factors outside your control, such as the 10-year Treasury yield, the federal funds rate, inflation, and financial markets. However, lenders still have a little wiggle room, and there are a few things you can do to get the lowest mortgage rate possible.
Boost your credit score
While you only need a credit score of 580 to qualify for an FHA loan, the best rates go to borrowers with higher credit scores — specifically those with very good (740–799) or exceptional (800+) FICO Scores.
You can’t improve your credit score overnight, but there are things you can do now if you plan to buy a house in the next six months to a year, including:
- Make on-time payments for rent, utilities, insurance, credit cards, student loans, car loans, personal loans, and any other debts
- Reduce your credit utilization by swiping your credit card less and paying down any outstanding balances
- Dispute errors you notice on your credit report
- Avoid opening up new credit cards or getting other types of loans in the lead-up to your mortgage application
Make a larger down payment
Putting more money down on your home is also likely to yield a better rate. The more you pay out of pocket, the lower your loan-to-value (LTV) ratio is. A lower LTV reduces your risk profile. When you pose less risk, the lender can offer you a lower rate.
Pay for discount points
Even with an excellent credit score and a large down payment, you can only improve your mortgage rate by so much. But you may be able to decrease it significantly if you purchase discount points, also called mortgage points.
Many lenders allow you to purchase these at closing to reduce your rate. Generally, to reduce the rate by 0.25%, you must pay 1% of the total loan balance. So, if you want to reduce your rate by a full 1%, that would mean paying an extra 4% at closing.
If you intend to stay in the house for a long time, this can pay off down the road. To find out how long it will take you to recoup the upfront cost by way of reduced monthly payments from the lower rate, you can use this break-even calculation.
Break-even calculation how-to
Divide the total cost of discount points by monthly savings. The result is the number of months it will take to earn back what you spent upfront. Any savings enjoyed after that are truly yours.
For instance, assume:
- $400,000 loan
- 6% rate
- $2,398 monthly payment (excluding taxes and insurance)
To reduce the rate to 5%, you’d spend an additional $16,000 at closing (0.04 x $400,000). Your new monthly payment becomes $2,147. That’s a monthly savings of $251.
$16,000 / $251 = 63.75 months
In this example, it takes almost 64 months (or 5 years, 4 months) of payments to earn back what you spent upfront.
Consider a shorter loan term
Most borrowers go with a 30-year fixed-rate mortgage, but lenders offer lower rates on shorter-term loans, such as 15 years. You can save a lot of money by opting for a shorter-term loan — both because the rate is lower and because it means 15 fewer years of paying interest.
The caveat: a shorter-term loan means significantly higher monthly payments. Don’t choose a payment that will be tough on your budget. This can spread you thin and put you at risk of defaulting on the loan.
Use a float-down option
Mortgage rates fluctuate daily. If you think rates may drop further after you lock in your mortgage rate, you may be able to get a float-down option. This feature allows you to take advantage of a lower rate if market rates fall between when you locked in the rate and when you actually close on the house.
Lenders usually charge a fee for float-downs, and rates may need to drop by a specified amount (like at least 0.25%) for them to take effect. Always read the fine print before agreeing to the float-down option.
Frequently asked questions
What is the difference between interest rate and APR?
The interest rate on a mortgage is just that: the actual interest charged on the loan. Unlike some other types of loans, mortgages have simple interest, meaning it doesn’t compound monthly or annually. Rather, the amount of interest you pay is predetermined at closing.
Though people conflate interest rate and APR, they are not the same thing. The annual percentage rate (APR) on a mortgage is more nuanced. The APR represents the total cost of the loan, including interest and some closing costs and fees like origination fees, broker fees, and underwriting fees. APR gives you a better picture of how expensive a mortgage is, and it will always be higher than the interest rate.
How long is a preapproval letter valid?
A mortgage preapproval letter is generally good for 60 to 90 days, giving you two to three months for a seller to accept your offer to buy a home. However, some lenders may only issue 30-day preapproval letters.
The best way to determine how long the preapproval letter is good for is to check the letter itself, which should specify its expiration date. You can always ask the lender how long their preapprovals are good for before they pull your credit to issue the letter. This may be especially crucial if you’re worried you might need more time to find the right house.
What is private mortgage insurance (PMI)?
Private mortgage insurance (PMI) is an extra monthly cost that’s typically required if you put down less than 20% on a conventional mortgage. Because a smaller down payment increases the risk to the lender, the PMI acts as a safeguard in case you default on the loan.
It’s worth noting: PMI protects the lender, not you — but you’re still the one who has to pay for it. The good news is PMI isn’t permanent. Once you build enough equity in your home and reach a loan-to-value ratio of 80% or less, you can usually request to have PMI removed, which will reduce your monthly loan payment.
Can I pay off my mortgage early?
Yes, you can pay off your mortgage early — and it might be a great idea, if you’re able. For many homeowners, the most feasible way to do so is to pay extra toward the principal each month. Alternatively, you could make one additional mortgage payment each year.
This can be great, especially if you have a mortgage with a high interest rate. However, if you secured a low-rate mortgage, your money may be better spent on investments with earnings that outpace your mortgage interest rate. It can help to consult a financial expert for advice on the best strategy for your situation.
