What You’ll Learn
What a mortgage is and how it works
The steps of the mortgage process
The different types of mortgages and how to compare your options
Relatively few people make an all-cash offer when they buy a home, that’s why getting a mortgage is a necessary part of homeownership. In fact, more than three-quarters of Americans (86%) used a mortgage to finance their home purchase in 2020.
As a first-time homebuyer, you may be surprised to discover just how many mortgage options are available. So, let’s dive into what a mortgage really is, how it works, and the different options available.
Put simply, a mortgage is just like any other loan, such as a car or student loan, where you would borrow money to purchase something when you don’t have all the cash upfront. Mortgages, however, are specific to real estate transactions.
According to the Consumer Financial Protection Bureau, “a mortgage is an agreement between you and a lender that gives the lender the right to take your property if you fail to repay the money you've borrowed plus interest.”
You see, with a mortgage, your home serves as collateral for the loan. When a new mortgage is created, your lender “owns” the majority of your property and issues all the necessary documents in public records to link your name to the mortgage debt. You’ll then begin the process of paying down the mortgage balance for the amount you borrowed.
As time goes by and you pay down your mortgage loan balance, you’ll typically increase your home equity—which is the difference between your home’s value and the amount of money you owe on your mortgage—until the point when your balance is paid in full, and you own the property free and clear.
If you can’t pay your mortgage as agreed, the lender may eventually foreclose on the home. This typically means they’ll sell the property and use the proceeds to pay off the remaining mortgage balance.
How mortgages work
When you take out a mortgage, a lender provides the money you need to pay for a home upfront. In exchange for the loan, you agree to pay the money back—plus interest—in regular installments on a monthly schedule.
How much you’ll be able to borrow will depend on your financial circumstances, such as your current income, assets, and any outstanding debts. Our home affordability calculator can give you a quick estimate of how much you might be able to borrow.
When you take out a mortgage, each installment payment will consist of two main parts, principal and interest, also known as P&I:
- Principal: The amount of money you borrowed to purchase the home.
- Interest: The amount you’ll pay to your lender in exchange for letting you borrow the money.
Your interest rate will be determined by several factors, such as current market and economic conditions, the type of loan you select, your credit score, how much debt you currently have compared to your income, and the amount of your loan.
Your lender may give you the option to view your full schedule of loan payments, known as an amortization schedule. In the early years of your mortgage, your loan payments will typically be allocated more toward interest in the early years and more toward the principal in the later years. This is because your interest rate is based on a percentage of your outstanding loan balance; the larger your balance is, the more you’ll be paying in interest. But as you pay your mortgage and your balance dwindles, the amount that goes toward interest will decrease, because it’s a percentage of a lower amount, and more money will go toward your principal instead. Check out our loan amortization calculator to see how this works.
While you must make at least the minimum monthly mortgage payment to your lender each month, you can also make additional payments at any time. You’ll want to let your lender know your prepayment should be applied to your principal balance, so they’ll know what to do with the extra money when they receive it. Doing so helps to pay off your principal balance sooner, save on loan interest fees, and own your home free and clear earlier than scheduled. On the flip side, if you don’t make your monthly payments on time, you risk possible late fees, loan delinquencies, and potential damage to your credit score.
For many homeowners, the lender also collects money for property taxes and homeowners insurance in what’s known as an escrow account. If your lender manages an escrow account on your behalf, these costs will be added to your monthly mortgage payments. The amount collected each month is typically calculated by taking the full cost of these bills for one year and dividing them over 12 months.
Your lender will take these monies and hold the funds in your escrow account. When the bills are due, they’ll pay them directly to the city and/or county, and your insurance provider on your behalf. Keep in mind that your monthly escrow payment amounts may vary each year depending on whether your property taxes and homeowners insurance premiums change. Your lender will notify you in advance of any changes to your escrow payments. You’ll also be able to review your escrow account payments and balance in your monthly mortgage statements.
Home loan vs. mortgage: Is there a difference?
In real estate, the terms “home loan” and “mortgage” are often used interchangeably. While the two are similar, there is a subtle distinction between them. The term “home loan” simply refers to the exchange of money that takes place when you borrow to buy a property. A “mortgage,” on the other hand, is the actual legally binding document, called the promissory note (aka the note), that comes with buying or refinancing a home. Buyers will typically sign the mortgage document before they receive the funds from their home loan. The promissory note spells out the terms of the loan you are agreeing to and allows the lender to foreclose on the property if you do not pay back the money you owe.
Types of mortgages
Mortgages come in all shapes and sizes, so you can select an option that best suits your needs.
The type of mortgage you choose will affect everything from your interest rate to the amount of time you have to pay back your loan. It will also determine how much you ultimately spend on your mortgage over time.
Here are two popular mortgage options to choose from:
With a fixed-rate mortgage, your principal and interest payment will stay the same for the entire life of the loan because the interest rate is fixed. Many borrowers opt for fixed-rate mortgages because consistent monthly payments can make budgeting easier. You’ll have the certainty of knowing that the P&I of your monthly mortgage payment will never change—even if mortgage rates rise.
Fixed-rate mortgages usually come with repayment terms from 15 years to 30 years. Typically, longer timeframes offer lower monthly payments, but that also means you’ll be paying more interest over time. You’ll want to consider how much you can comfortably afford to pay and balance it with your desire to pay off your loan sooner.
Commonly known as an ARM, an adjustable-rate mortgage offers an introductory interest rate that is fixed for a set period. After the introductory period expires, your interest rate will adjust (and most likely fluctuate) based on the prevailing market rate.
ARMs tend to have slightly lower introductory interest rates than the interest rates of a fixed-rate mortgage, however, when your interest rate adjusts, your payment may change dramatically. While this type of mortgage may offer lower initial payments, there is less certainty about what you’ll be expected to pay over time. If you’re planning to keep the property for only a few years—before the adjustable portion of the mortgage kicks in—then an ARM could potentially save you money on interest payments.
You will typically see an ARM expressed as a fraction, such as 5/1, 7/1, or 10/1 ARM. Here’s what those numbers mean:
- First number: The ARM’s introductory fixed-rate period in years.
- Second number: How often your ARM’s interest rate may change after the fixed period ends (expressed in months or years).
So, for example, a 5/1 ARM would have a fixed rate for the first five years. After that, the interest rate would adjust once per year according to market conditions for the rest of your loan term, which is typically 30 years. There’s usually a limit to how high or low your rates can go—these limits are called rate caps. You may see rate caps for your first rate change and future changes, along with a lifetime cap. You’ll want to confirm all these numbers with your lender to ensure that you’re comfortable with the possibility of payment increases in the future.
Choosing between an adjustable- and fixed-rate mortgage comes down to a few factors, such as how long you plan to live in the home, the current interest rate environment, and your comfort level. Learn more about how to determine which option may be right for you here.
How to get a mortgage and the mortgage process
Lenders want to be sure you can afford your monthly mortgage payments, along with your other bills, so there’s a bit of leg work to be completed before you’ll be approved. Here are the basic steps of getting a mortgage:
During the early stages of your home search, it’s a good idea to get pre-approved for a mortgage. A pre-approval is an official letter from a lender that states the amount you’ll likely be approved to borrow based on your specific financial information.
A pre-approval can be beneficial for several reasons: First, by answering some questions about your financial situation and running a soft credit check (which doesn’t impact your credit score), a lender can tell you how much they’d be prepared to lend you for your new home and match you with the best mortgage options available to you. Second, a pre-approval letter shows sellers that you are serious about buying a home, which can increase the likelihood that your offer will be accepted. This is especially important in competitive real estate markets.
At Better Mortgage, our online pre-approval takes as little as 3 minutes. Our technology will instantly match you with a range of mortgage options based on the information you provided, and you’ll get a free, no-commitment pre-approval letter that gives you an estimate of how much you can borrow for your future home.
2. Mortgage application
Once your offer on a home has been accepted, it’s time to select your mortgage type and length, lock an interest rate, and complete your formal mortgage application. You’ll also receive a list of the required documents you’ll need to provide so your lender can verify your income, assets, and debts to finalize what loan they can offer you.
After you’ve submitted your application, everything will be sent to a mortgage underwriter for review. Your underwriter will take an in-depth look at your overall financial picture and your supporting documentation. It's their job to approve or deny your loan application based on a set of established risk factors.
If all of your information checks out, and you meet the requirements of the loan, you’ll receive what’s known as “conditional loan approval.” Conditional approval means that you’ll be approved for the loan once any outstanding conditions are met. These conditions may vary depending on your financial situation or the real estate transaction itself but can include stipulations like a home inspection, home appraisal, and other contingencies that must be met before the transaction is complete.
If your loan application is denied, it’s not necessarily the end of the road; here’s what you can do.
4. Clear to close issued
When you receive a “clear to close” from your lender, it signals that your loan application is officially approved, and you have the green light to close on your mortgage. You’ll receive a closing disclosure from your lender and you’ll have 3 business days to compare this to your loan estimate to see if there are any discrepancies.
On the day you sign the loan documents, known in many states as closing day, you will sign all the paperwork for your mortgage and the real estate transaction. In most states, the funds for your loan will be released to the rightful parties, you’ll officially become a homeowner, and you’ll get the keys to your new home on the same day. In Alaska, Arizona, California, Hawaii, Idaho, Nevada, New Mexico, Oregon, and Washington there are typically 3 business days between the day you sign the loan documents and the day you get the keys. Here’s what to expect when you close.
How to compare mortgage loans
You might be tempted to get a mortgage with the first lender that pops up on a Google search, but it’s just as important to shop around for the right mortgage lender, as it is to shop for the perfect home.
Here’s how to compare mortgage options:
Get multiple quotes
There are a number of lenders that provide mortgage loans. For instance, you can go with a big bank, local lender, or direct lender for your loan. Each lender may have unique pros and cons, offer different interest rates, and charge a range of fees.
Contacting different lenders to inquire about their loan options or submitting an application doesn’t lock you in, so feel free to consider several lenders before you commit.
Compare apples to apples
When gathering quotes, you want to ensure you’re giving each lender the same information and evaluating the same type of loan options. Doing so will ensure that you can make an accurate apples-to-apples comparison of each lenders’ rates, fees, and loan structures.
After you submit a loan application with a lender, they must send you a loan estimate within three business days. This document will provide a clear breakdown of the details and costs associated with your potential loan, which will help you accurately compare each offer. Once you’re pre-approved with Better Mortgage we can give you a loan estimate in seconds.
Keep in mind, while some costs for a mortgage may be unavoidable (e.g., third-party fees for your credit report, home inspection, and appraisal), others are totally unnecessary. Luckily, with Better Mortgage, you’ll never pay lender fees for your application, loan origination, underwriter fees, or loan officer commissions.
See what your mortgage could look like
In as little as 3 minutes you can see how much you’re likely to be approved for, view your mortgage options, and apply for a loan any time, any place through our 100% online application process. Our streamlined technology makes it less expensive for us to build the loan, so we can pass the dollar savings on to you—savings to the tune of $8,200* on average for new homebuyers over the life of the loan. Get pre-approved and we’ll match you with a loan consultant to talk through your options.