What is a Mortgage and How Does it Work?

By PropertyClub Team
Jun 16th 2021
Most people understand that a mortgage is a loan used to finance the purchase of a home. But many aren’t familiar with the exact process or the different types of mortgage loans available. 

Buying a home is the single biggest purchase most people make in their lifetime. So, to ensure that you make the most informed decision possible, it’s essential to understand what a mortgage is and how it works. Here is a closer look at the important definitions and terminology.  

hash-markTable of Contents

hash-markMortgage Simple Definition

A mortgage is a type of loan used to finance purchasing or maintaining a piece of real estate. The property itself will be used as collateral for the loan, and the borrower must make regular payments that are used to pay down the principal and the interest owed to the borrower. Once the loan is paid off, the borrower will receive full ownership of the property.

hash-markHow Does a Mortgage Work?

A mortgage is a fairly simple concept if you break it down. A lender agrees to offer a borrower a certain sum of money based on their credit history and income. The borrower will then use that money to purchase a home. The home will be used as collateral to ensure the borrower pays back the loan and can be repossessed if the borrower defaults. 

The borrower will then make monthly payments to the lender. These monthly payments will be divided between paying back the principal of the loan and paying interest to the lender. Once the borrower has paid down the principal entirely, the home will belong to them, free and clear.  

hash-markDifferences Between a Loan and a Mortgage

A mortgage is a type of loan with unique features compared to personal loans and business loans. The relationship is like a rectangle to a square – all mortgages are loans, but not all loans are mortgages. 

The main difference between a mortgage and a simple loan like a credit card or personal loan is that mortgages rely on a process called amortization. 

When you pay a mortgage, you agree to pay the bulk of the interest upfront. With a simple loan, you borrow what you need and pay interest on whatever you cannot repay within a certain time frame. 

So, if you get a mortgage for $100,000, you will be paying interest on the full $100,000 at the same time you pay down the principal. But if you get a loan for $100,000 and only use $25,000, you will only pay interest on that $25,000 if not paid off within the expected time frame. 

hash-markTypes of Mortgages 

Not every mortgage is made equal. There are a variety of different types of mortgage loans available for home shoppers to choose from. Here is a look at the major types of mortgages you should consider.

Fixed-Rate Mortgage

A fixed-rate mortgage is the most common type of mortgage. Fixed-rate mortgages feature an interest rate that is consistent over the life of the loan. Many homeowners prefer these because they offer a consistent monthly payment and will not change with the market.

Adjustable-Rate Mortgage

Adjustable-rate mortgages are another common type of loan that prospective home buyers may consider. With an adjustable-rate mortgage, the interest rate will fluctuate over the life of the loan. These fluctuations typically coincide with changes in the market. Adjustable-rate mortgages offer certain benefits, such as a lower rate at the beginning of the loan. But borrowers should be prepared for any sudden changes that may impact how much they owe their lender each month.

Balloon Mortgage

A balloon mortgage is a loan that starts out with either no or low monthly payments but then increases dramatically toward the end of the loan. These are typically short-term loans that are used for a particular purpose. They can offer some benefits but can be risky for average homeowners. So, anyone considering a balloon mortgage should be aware of the potential downside.

Reverse Mortgage

A reverse mortgage is a loan specifically designed for homeowners aged 62 and older who want to tap into the existing equity on their current homes. Borrowers take out a mortgage that is secured by the equity they’ve built in their current residence and can be disbursed in cash or as a credit line. This type of mortgage can be beneficial to retirees who need a bit more cash flow coming in each month. But borrowers should be aware that the balance must be paid off at the end of the loan.  

FHA Loan

An FHA Loan is a mortgage that is insured by the Federal Housing Administration. This loan program was developed after the Great Depression to encourage homeownership and typically features laxer requirements compared to a conventional mortgage because the government insures the loan. For instance, anyone with a credit score above 580 can get an FHA loan with as little as 3.5% down.

VA loan

A VA loan is a type of loan offered to US military veterans as a benefit of serving in the armed forces. They are backed by the US government and allow veterans and their surviving spouses to purchase homes with a low or no down payment. Other benefits include lower closing costs and assistance to prevent homeowners from defaulting.  

USDA loan

USDA loans are zero down payment loans, specifically for rural homebuyers. They are typically geared toward those who don’t qualify for a traditional mortgage. They are sponsored by the US Department and Agriculture and insured by the government so that eligible applicants can afford to purchase a home, even if they don’t meet the standard requirements of a mortgage.

hash-markHow Do You Get a Mortgage?

The exact process for getting a mortgage will vary depending on the individual lender and the type of loan you get. But here are the general steps you will go through when applying for a mortgage. 

Step 1: Apply for Pre-Approval

The first step for getting a mortgage is applying for pre-approval. This involves approaching a lender and having a conversation about your credit and finances. They will run your credit and check the financial statements you provide them. If everything checks out, they will provide you with a preapproval letter. This letter will verify that they are willing to loan you up to a set amount of money to purchase a home. 

Step 2: Find a Home

Once you’ve been pre-approved, it’s time to start looking for properties. Although nothing is stopping you from looking before approaching a lender, you’ll need to be pre-approved for a loan before you can make an offer. It’s also wise to talk to your lender, mortgage broker, or agent and find out if there are any stipulations on what kind of property you can purchase (for example, you can’t buy an investment property with an FHA loan).

Step 3: Apply for the Loan

Once you’ve found the perfect home, it’s time to officially apply and go through the underwriting process. Even if you’ve been pre-approved, that doesn’t mean you’re guaranteed a loan. The lender will conduct an in-depth investigation into your finances to ensure that the information provided is accurate and nothing has changed since you first applied. They will also want to conduct an appraisal to ensure that you didn’t offer too much. 

Step 4: Close on the Sale and Begin Making Payments

If everything checks out, all that’s left to do is close on the sale. An attorney will draft the contracts and transfer the title over to you. After the contract closes, you will begin making payments on the following first of the month.

hash-markWho Are the Parties Involved in a Mortgage?

Multiple parties will be involved in the process of getting a mortgage. Here is a look at the primary responsibilities of each party involved.

Lender

The lender is the one who will be supplying the capital for the home purchase. This is typically a direct or retail lender such as a bank, credit union, or online mortgage provider. They will agree to supply the borrower with the money to buy a home in exchange for monthly mortgage payments. They will also conduct an underwriting process to ensure the borrower meets the necessary financial criteria.  

Borrower

The borrower is the prospective homeowner or real estate investor. This could be a single individual or multiple people, such as a married couple. The borrower will agree to put up their future home as collateral in the transaction and make monthly payments toward the interest and principal until the loan is satisfied.

Co-Signer

If the borrower does not meet the necessary financial requirements, the lender may request that they get a co-signer. This could be due to a negative or lack of credit history or financial shortcomings. A co-signer is legally responsible for making sure the loan is paid along with the borrower. So, if the borrower defaults, the co-signer is responsible for the debt and may also face financial and legal repercussions if it is not paid.   

hash-markWhat’s in a Mortgage Payment?

When you make a monthly mortgage payment, it does not all go toward paying down the loan. It is split between the principal, interest, and additional fees such as taxes and insurance. Here is a breakdown of what goes into a mortgage payment.

Principal

The principal is the remaining balance that you owe on the home. So if you purchased a home for $200,000 with 20% down ($40,000), you would start your mortgage payments with a principal balance of $160,000. As you whittle away at the principal, the faster you’ll be able to pay it down, thanks to a process called amortization.  

Interest

The interest refers to the amount of money you owe the bank for borrowing the cash. Interest is calculated as a percentage of the remaining principal. At the beginning of the loan, the majority of your monthly payment will go toward the interest. But over time, this ratio will reverse as the principal decreases (unless you have an adjustable rate or miss payments).  

Taxes and Insurance

Taxes and insurance are also often included in your monthly mortgage payment. Homeownership comes with a lot of responsibilities beyond just paying back the bank. You will now have to start paying property tax, which is often included in your monthly bill. Plus, you will likely get a homeowner’s insurance policy to protect the home in the event of a catastrophe, which may be included in your mortgage payments as well.

Mortgage Insurance

Many homeowners choose to take out a mortgage insurance policy if they cannot afford the full 20% downpayment. This is different from homeowner’s insurance and protects the lender if you default on the loan. The cost of PMI is typically factored into your monthly mortgage payment.  

hash-markKey Mortgage Terminology

Amortization

Amortization is an accounting strategy that lowers the value of a loan periodically over time. In the case of a mortgage, the borrower pays back the loan in periodic installments, which slowly decreases the principal over time. As the principal decreases, the amount of interest required with each payment also slowly decreases until the loan is entirely paid off.

APR

Annual Percentage Rate (or APR) refers to the rate of interest charged to a borrower per year. So, an APR of 3.5% on a 30-year fixed-rate loan of $100,000 means you will be paying about $3500 in interest per year (which is about $105,000 over the life of the loan).

Conforming

If a mortgage is conforming, that means it meets the guidelines established by the government-sponsored entities Fannie Mae and Freddy Mac. The GSEs bundle mortgages in a group and sell them to other investors on the secondary mortgage market. For a mortgage to be purchased by the GSE, it must meet certain guidelines. Loans that meet these guidelines are known as conforming. 

Down Payment

The down payment refers to the initial sum of money the borrower is required to provide the lender to secure the mortgage, which will go toward paying the principal. Most lenders recommend that the borrower put down at least 20% at the time of signing. However, many will accept less if you are willing to pay private mortgage insurance. There are also government programs that allow borrowers to secure a loan with little or no down payment.

Escrow

Escrow is a contractual arrangement where a third party agrees to hold a sum of money on behalf of two parties engaged in a transaction until an agreed-upon condition is met. In real estate, escrow refers to the account in which the funds are held until the sale of a home is closed.

Mortgage Servicer

A mortgage servicer refers to a company that collects your monthly loan payments. This may or may not be the same company that issued the loan, which is called a mortgage lender. But, it’s not uncommon for lenders to outsource the payment processing aspect of the transaction to a separate company, known as a mortgage servicer.  

Non-Conforming

Non-conforming means that the loan does not meet the guidelines created by the GSEs. Mortgages that feature lower credit and income requirements than the standard conventional loan, such as government-backed FHA, VA, and USDA loans, are considered non-conforming. Or loans larger than what is typical for the average home (also known as jumbo loans) are also considered non-conforming.

Private Mortgage Insurance

Private mortgage insurance is a policy that protects the lender if a borrower defaults. PMI is often required if the borrower cannot make the full 20% down payment on a conventional mortgage. That way, if the borrower does default, the lender can collect from the insurance provider to make up for the loss. 

Promissory Note

A promissory note is a legal document that contains a written promise between two parties that a debt will be repaid by one to the other at a specified date. This document will state the amount of the debt, any interest owed on the loan, and any penalties for late payment. Borrowers will be required to sign a promissory note with the lender when getting a mortgage, to ensure that the debt is paid back.

Underwriting

Underwriting is a process in which a financial expert analyzes your financial profile and assesses the amount of risk a lender would be taking in issuing you a loan. This process determines whether or not you will be approved for a loan and what interest rate the lender is willing to offer given your level of risk.