For the vast majority of Americans, a mortgage loan is necessary to purchase their first home.
And the truth is that it may take years to save up enough money to afford the down payment alone!
Before you sign on the dotted line (for what’ll likely be the largest purchase of your life), you’re absolutely going to want to have – at a minimum – a basic understanding of what a mortgage is and how it works.
Let’s get started!
What is a mortgage?
In short, a mortgage is an agreement made between a lender — a bank, credit union, or other financial institution — and a borrower — like you. The lender agrees to loan the borrower a sum of money for the purchase of a home (or refinancing a home). In return, the borrower agrees to repay the lender in the time agreed upon, with interest.
A mortgage is a type of secured loan because your home serves as collateral. In other words, if you fail to repay the loan, your lender has the right to seize the home. If you pay back the mortgage, however, the property is yours and yours alone.
What are the different types of mortgage loans?
Although mortgage loans are simple at their core, they can come in many different forms. I’ll break it down below.
Mortgage types, by category
There are a few common types of mortgage loans, but the most prevalent is a conventional loan.
A conventional mortgage is your standard, average-joe loan. It’s not insured by a government agency (we’ll talk about government-backed loans in a moment), so borrowers must follow a stricter set of guidelines to qualify for these loans, such as a credit score of 620.
For borrowers who can’t quite meet the conditions for a conventional loan, another common type of mortgage is government-backed loans like:
- FHA loans (backed by the Federal Housing Administration), USDA loans (backed by the U.S. Department of Agriculture).
- VA loans (backed by the Department of Veterans Affairs).
FHA loans require a credit score of just 580, as opposed to 620; and while conventional loans require a minimum down payment of 3%, USDA and VA loans don’t require a down payment at all.
FHA loans can be an ideal alternative for low-income American families, but USDA loans and VA loans are designed for specific types of borrowers — rural families and military service members, respectively.
Finally, jumbo loans are available for another specific group of borrowers. As the name implies, this mortgage type is available for borrowers who need a larger loan to afford their home. While jumbo loans technically fall under the “conventional” loan category, they are also considered “non-conforming” loans. This is because jumbo loans do not adhere to the lending limit set by the Federal Housing Finance Agency (FHFA).
Mortgage types, by rate
Mortgages also vary by rate. Fixed-rate loans are the more common type in this category, and as one might assume, they offer one, single, unchanging rate. From your first mortgage payment to your last, that rate will stay the same.
However, there are also adjustable-rate loans (ARMs), which provide borrowers with a flexible rate, following a set period where the rate remains constant (typically somewhere around 3 to 10 years). You may start with a lower rate if you opt for an ARM, but you’ll also accept the risk of that rate increasing later on.
Mortgage types, by term
Finally, mortgages can be categorized by term, generally for 15 or 30 years. While 30-year loans are more popular in America, both options have their pros and cons.
For instance, with a 15-year mortgage, you’ll have that bad boy paid off by the time your toddler goes to college. But with a 30-year mortgage, you’ll pay less each month, which means you can save more for your kid’s tuition. However, while your monthly payment may be smaller with a 30-year mortgage, these loans also come with higher interest rates, meaning you’ll pay considerably more in interest over the life of the loan.
For some borrowers, the lower monthly payment available for a 30-year term is more enticing; for others, the money they’d save in interest over a 15-year loan outweighs the short-term perk of monthly savings. Everyone is different; the term that’s right for you depends on your unique priorities and your financial situation.
What are the basic components of a mortgage?
Sadly, a mortgage is not equal to the sales price of your dream home. The reason for this is mortgages are composed of several key factors, all of which influence one another.
First of all, there is interest, which adds thousands of dollars to your principal (or total amount borrowed) over time. You’ll also have to factor in property taxes and homeowners insurance. Depending on the size of your down payment, your loan may require mortgage insurance as well, which protects the lender in case you stop making your monthly payments. Borrowers offering down payments below 20% typically must pay for mortgage insurance.
Once all these numbers are tallied, you’ll discover your monthly mortgage payment. This is the amount you’ll pay your lender every month for the life of your loan. Consequently, make sure you’re aware of every cost that’s factored into your mortgage, so you can determine how the payment will fit into your budget each month.
Who qualifies for a mortgage?
As you may have assumed, every type of mortgage comes with differing qualifications, so a borrower that’s eligible for one type of loan may not qualify for another.
Here are some typical requirements for a few of the more common mortgage types mentioned.
Loan type Minimum credit score Minimum down payment Maximum debt-to-income ratio Caters to...
Conventional 620 3% (for specific programs) 43% Standard borrowers
FHA 500 (depends on the size of your down payment) 3.5% 50% Low to moderate-income borrowers
USDA 640 (lower scores may qualify, but will be subject to stricter standards) 0% 41% Low-income families in rural areas
VA No established minimum (although lenders may have their own requirements) 0% No established requirement Military service members
Jumbo 700 (depends on the lender) 20% (depends on the lender) 45% (depends on the lender) Borrowers seeking larger loans (higher than $548,250, as of 2021)
To reiterate, while each loan type has its general requirements, the lender is the ultimate authority in many circumstances.
Since lenders evaluate a variety of factors to determine a borrower’s eligibility, they may consider a borrower that doesn’t meet one requirement but exceeds another. For instance, FHA lenders typically require a minimum credit score of 580, but some loan to borrowers with credit scores as low as 500 if those borrowers can afford a down payment of 10% or higher. In the same way, a borrower who applies for a jumbo loan typically needs a down payment of 20% to qualify, but some lenders will consider applicants with down payments as low as 10%.
Who doesn’t qualify for a mortgage?
While lenders may consider borrowers who don’t meet the eligibility requirements stated above, some loans are designed for specific borrowers, which automatically rules out a number of applicants.
VA loans, for example, are available for military service members (and their families) exclusively. In the same way, USDA loans are uniquely designed for rural home buyers, and applicants must visit the USDA site to determine whether or not their home and income level meet the program’s eligibility requirements. Jumbo loans are also for a select group — namely, those borrowing more than the lending limit set by the FHFA.
Although lenders have some wiggle room for requirements like your credit score and debt-to-income ratio, apply for the loan type that most closely meets your personal situation — including your financial history, vocational background (VA loans), and loan size (jumbo loans).
How can you get a mortgage?
If you know you’ll need a mortgage to make your dream of homeownership a reality, there are a few steps you can take today to make your application more attractive to lenders.
Check your credit score
Credit history matters a great deal to lenders. The reason is your credit score is just that, a score.
A lower score indicates to a lender that you may not be the most reliable borrower and may miss payments, or worse. If you have a higher score, however, you’ve earned that number, and lenders know it.
In short, your credit score is a measurement of risk, so lenders know how likely (or unlikely) it is that you’ll follow the terms outlined in your loan and pay back what you owe. Consequently, your score can also impact the terms of your loan. For instance, lenders may offer a lower interest rate to borrowers with higher credit — or dock borrowers they deem high-risk.
Calculate how much house you can afford
Remember the amount you borrow determines your monthly payment, so the question you should be asking isn’t necessarily how much house can you afford; it’s how much can you afford every month?
In many circumstances, borrowers can qualify for a mortgage payment that’s no more than 35% of their gross, pre-tax monthly income. If, however, you sat down to discuss the loan terms with a financial advisor, they might recommend you accept a payment that’s no more than 28%.
The debts you’re already repaying can also impact this recommendation. In fact, according to a study by Coldwell Banker in 2020, first-time homebuyers surveyed said “paying down debt” was the top reason they struggled to afford their home.
To find out how large of a monthly payment your budget can handle, check out MU30’s home affordability calculator below.
Before beginning your house hunt, another important step is to get pre-approved for a loan.
This is basically what it sounds like. A lender reviews your financial history and circumstances to determine just how large of a loan you might qualify for and what interest rate you could receive, but it all happens “pre” home buying.
The pre-approval process gives you extra credibility in the eyes of a seller because you’ve got paperwork from a legitimate source saying you can afford the offer you’re making on their home. Once you’re ready to begin the full-blown mortgage application process, the lender takes a second, more thorough pass over your finances to be sure you’re prepared for the commitment.
If your dentist suggested you undergo a procedure that would cost thousands of dollars out-of-pocket, it would be completely rational in many circumstances for you to request a second opinion first. Why wouldn’t you do the same before agreeing to a decades-long financial agreement?
Not only is it perfectly sensible to consider loan offers from competing institutions, but companies like LendingTree make it simple to do so. With this said, don’t jump at the first lender to say, “yes.” This is a big financial commitment, so make sure you spend time comparing quotes to find the best loan, terms, and rate for you.
Buying a home is no small feat, and for most aspiring homebuyers, the process requires a little more than a hefty check. Unless you have hundreds of thousands of dollars saved, you’ll need a mortgage to claim your dream home.
In exchange for a bank or other financial institution’s mortgage loan, you’ll agree to monthly payments for as much as 30 years, plus tips in the form of interest. Details like your credit score and the size of your down payment impact how much a lender is willing to offer and what they expect from you in return.
So before you accept a mortgage loan, make sure you have a healthy understanding of all it entails.