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Bankrate.com's Mortgage 101 Guide

Mortgage Basics

Learn everything you’ll need to know to qualify and apply for a mortgage. Whether you’re buying your first home -- or your tenth one -- the process is the same. Here’s an overview of mortgages and what each step in the lending process entails so there are no surprises.

What is a mortgage?

A mortgage is a loan from a financial institution that enables a borrower to purchase a house without putting up all the cash. A mortgage is secured by the home itself, so if you default on the loan, the bank can sell the home and recoup the money it provided. Mortgage payments are usually monthly and consist of four components: principal, interest, property taxes and homeowners insurance.

Before getting a mortgage, you agree to certain terms and conditions, such as how long you have to repay the mortgage (known as the loan term), and how much you’ll pay at closing, representing your equity in the property (known as the down payment). The down payment is a percentage of the home’s cost, and certain loan types have minimum down payment requirements.

Interest rate vs. APR

It’s easy to confuse a mortgage interest rate and APR, but they’re quite different. The interest rate is the cost of borrowing money for the principal loan amount. It can be variable or fixed, but it’s always expressed as a percentage. An APR (annual percentage rate) is a broader measure of the cost of a mortgage because it includes the interest rate plus other costs such as broker fees, discount points and other lender fees, expressed as a percentage. It’s often higher than your interest rate. Learn more.

Mortgage repayment

Borrowers repay the bank for their mortgage at regular intervals, usually monthly. The payments go toward the total amount of money borrowed, which is called the principal, and the interest, although the latter may be tax-deductible. The process of paying off a mortgage is called amortization.

Mortgages are considered secured loans, which means they’re backed by an asset — the house — should you default, or fail to repay the loan. When you default, the lender can take back the house in a process called foreclosure. For this reason, some lenders require certain borrowers to take out some kind of insurance, such homeowners’ insurance, which covers material damage to the property, or mortgage insurance, which protects the lender in case the borrower defaults.

Different types of mortgages

As a borrower, you have a lot of options when choosing a mortgage. Here’s a look at the most common types of home loans.

Fixed-rate mortgages are the most common type of mortgage. The interest rate remains the same for the life of the loan. With a fixed-rate mortgage, your monthly payment won't change (outside of property taxes, insurance premiums or homeowner's association fees).

Adjustable-rate mortgages, or ARMs, have monthly payments that can move as interest rates change. Most ARMs have an initial fixed-rate period during which the borrower's rate doesn't change, followed by a longer period during which the rate may change at preset intervals. Generally, interest rates are lower to start than with fixed-rate mortgages, but they can rise, and you won't be able to predict future monthly payments.

Conventional mortgages are home loans that are not insured by the federal government. There are two types of conventional loans: conforming and non-conforming loans.

A conforming loan simply means the loan amount falls within maximum limits set by Fannie Mae, Ginnie Mae or Freddie Mac, government agencies that back most U.S. mortgages. Loans that don’t meet these guidelines are considered non-conforming loans. Jumbo loans are the most common type of non-conforming loan. Generally, lenders require you to pay private mortgage insurance on many conventional loans when you put down less than 20 percent of the home’s purchase price.

Jumbo mortgages are conventional loans that have non-conforming loan limits. This means the home prices exceed federal loan limits. For 2019, the maximum conforming loan limit for single-family homes in most of the U.S. is $484,350, according to the Federal Housing Finance Agency. In certain high-cost areas, the price ceiling is $726,525. Jumbo loans are more common in higher-cost areas and generally require more in-depth documentation to qualify.

Government-insured loans are backed by three agencies: the Federal Housing Administration (FHA loans), the U.S. Department of Agriculture (USDA loans) and the U.S. Department of Veterans Affairs (VA loans). The U.S. government isn’t a mortgage lender, but it sets the basic guidelines for each loan type offered through private lenders.

FHA loans help make home ownership possible for borrowers who don’t have a large down payment saved up and don’t have pristine credit. Borrowers need a minimum FICO score of 580 to get FHA’s maximum 3.5 percent financing. However, a credit score of 500 is accepted with at least 10 percent down. FHA loans require two mortgage insurance premiums: one is paid upfront, and the other is paid annually for the life of the loan if you put less than 10 percent down. This can increase the overall cost of your mortgage.

VA loans provide flexible, low-interest mortgages for members of the U.S. military (active duty and veterans) and their families. VA loans do not require a down payment or PMI, and closing costs are generally capped and may be paid by the seller. A funding fee is charged on VA loans as a percentage of the loan amount to help offset the program’s cost to taxpayers. This fee, as well as other closing costs, can be rolled into most VA loans or paid upfront at closing.

USDA loans help moderate- to low-income borrowers buy homes in rural areas. You must purchase a home in a USDA-eligible area and meet certain income limits to qualify. Some USDA loans do not require a down payment for eligible borrowers with low incomes.

Understanding mortgage rates

Mortgage rates can and often do change daily (sometimes, even multiple times a day). Mortgage rates go up or down based on economic events, yields on the 10-year Treasury, or things like Fed meetings and policy changes. Your interest rate can also change after you receive a quote, so when you get a good rate, be sure to lock it in and receive written confirmation from your lender.

How to get a mortgage

Unless you can buy your home with cash, you (and most other homebuyers) will borrow money from a lender to purchase your home. Getting approved for a mortgage relies on: your credit score and history, down payment amount, your income and job status, your assets and liabilities (or debts), and the type of property you buy.

Things to consider before getting a mortgage

Before you get a mortgage, here are some steps to take to put you in the best position possible to buy a home.

1. Strengthen your credit

Your credit score and credit history show lenders how well you manage your debts and pay your bills. The lower your credit score, the harder time you’ll have qualifying for a mortgage. You’ll also pay more in interest and might not be able to borrow as much money as you need. Take a look at your credit score to see where you stand – you should aim for the mid 700s. If your score is lacking, go to AnnualCreditReport.com to order three credit reports for free, and check for errors. Contact the rating agency immediately if you spot any.

Other good ideas: Pay off a revolving balance, and limit your credit card usage to just 20 percent of your available credit. Also, don’t apply for a new card before you apply for a mortgage or close existing credit lines that you’ve had for a long time.

2. Reduce your debt

A key metric lenders consider is your debt-to-income ratio, or DTI. To get this figure, which is expressed as a percentage, a lender divides your monthly debts (including the mortgage payment) by your monthly gross income. Generally, most conventional lenders prefer to see a DTI ratio below 43 percent, although a DTI ratio of up to 50 percent is allowed in some cases.

3. Know how much you can afford.

A homebuyer typically puts down 10 percent of the home price, and opts for a standard 30-year, fixed-rate mortgage. But that’s not true for everyone. With some conventional loans, you can put down as little as 3 percent and some government-insured loans require no money down. However, putting more money down and opting for a shorter loan term can save you hundreds of thousands in interest.

One good rule of thumb: Look for a home that requires you to borrow no more than 2.5 times what you make in a year. Use Bankrate’s affordability calculator to get a more detailed estimate. Another strategy: buy a less-expensive home that you can pay off faster and will be comfortable for your budget. Keep in mind that lenders look at the debts that appear on your credit report when determining how much you can afford, but your monthly budget has other items -- groceries, utility, daycare, education, retirement saving, etc. -- you’ll need to factor in to figure out what monthly payment you’re comfortable with.

4. Build your savings

In addition to monthly mortgage principal and interest payments, you’ll also owe property taxes, homeowner’s insurance and private mortgage insurance if your down payment is less than 20 percent. Then there’s closing costs, which run around 3 percent of the sales price. You’ll likely spend around 3 percent of the home price on upkeep and repairs annually, in addition to roughly $2,000 in maintenance costs. You want to have at least three to six months’ of living expenses in savings even after you buy a home. Avoid draining your savings by either buying a less-expensive home or getting help with down payment and closing costs.

Choosing the right mortgage

Narrowing your loan choices can be difficult. Here’s a list of pros and cons of each of the options mentioned earlier to help you decide.

Fixed-rate mortgages
Pros

• Rates and payments remain constant, despite what happens to interest rates.
• Stability makes budgeting easier. People can manage their money with more certainty because their housing payments don’t change.
• Simple to understand

Cons

• Interest payments tend to be higher for longer-term, fixed-rate loans (i.e. 30-year vs. 15-year mortgages).
• To get a lower rate, borrowers have to refinance the loan -- and pay closing costs again, as well as get an appraisal and be approved for a new mortgage.

Who should get one? A fixed-rate mortgage is ideal if you plan to stay in your home many years and want predictable, stable payments at the same interest rate for the life of the loan.

Adjustable-rate mortgages
Pros

• Feature lower rates and payments early in the loan term.
• Allow borrowers to qualify for more house because their payments are lower. Because lenders can use the lower payment when qualifying borrowers, people can buy larger homes than they otherwise could buy.
• Help borrowers save and invest more money with a lower payment, at least early in the loan.

Cons

• Rates and payments can rise significantly over the life of the loan, especially in a rising-rate environment.
• Shock of higher rates -- and payments -- when the loan resets can be hard to manage in a tight budget.  
• ARMs are difficult to understand. Lenders have much more flexibility when determining margins, caps, adjustment indexes and other things, so unsophisticated borrowers can easily get confused or trapped by shady mortgage companies.

Who should get one? An ARM is ideal if you don’t plan to stay in your home for more than a few years. When rates are relatively higher, ARMs make sense because their lower initial rates allow borrowers to still reap the benefits of homeownership.

Conventional mortgages
Pros

• Can be used for a primary home, second home or investment property.
• Overall borrowing costs tend to be lower than other types of mortgages, even if interest rates are slightly higher.
• You can ask your lender to cancel PMI once you’ve gained 20 percent equity.
• You can pay as little as 3 percent down for loans backed by Fannie Mae or Freddie Mac.

Cons

• Minimum FICO score of 620 or higher is required.
• You must have a debt-to-income ratio of 45 to 50 percent.
• Likely must pay PMI if your down payment is less than 20 percent of the sales price.
• Significant documentation required to verify income, assets, down payment and employment.

Who should get one? Conventional loans are ideal for borrowers with strong credit, a stable income and employment history, and a down payment of at least 3 percent.

Government-insured loans
Pros

• Help you finance a home when you don’t qualify for a conventional loan.
• Credit requirements are more relaxed.
• Don’t require a large down payment.
• Open to repeat and first-time buyers.

Cons

• Expect to pay mandatory mortgage insurance premiums that cannot be canceled on some loans.
• Higher overall borrowing costs.
• Expect to provide more documentation, depending on the loan type, to prove eligibility.

Who should get one? Government-insured loans are ideal if you have low cash savings, less-than-stellar credit and can’t qualify for a conventional loan. VA loans tend to offer the best terms and most flexibility compared to other loan types for military borrowers.

Jumbo mortgages
Pros

• You can borrow more money to buy a home in an expensive area.
• Interest rates tend to be competitive with other conventional loans.

Cons

• Down payment of at least 10 to 20 percent is needed.
• A FICO score of 700 or higher typically is required, although some lenders will accept a minimum score of 660.
• You cannot have a debt-to-income ratio above 45 percent.
• Must show you have significant assets (10 percent of the loan amount) in cash or savings accounts.

Who should get one? Jumbo loans make sense for more affluent buyers purchasing a high-end home. Jumbo borrowers should have good to excellent credit, high incomes and a substantial down payment.

How to find the right lender

Settling on the first lender you talk to may not be the best idea. To find the best mortgage lender, shop around. Talk to big banks, credit unions, online lenders and local independents to ensure you’re getting the best deal on rates, fees and terms. Another option: working with a mortgage broker. A broker isn’t a lender but does the legwork for you by evaluating your mortgage application and then gathering quotes from multiple lenders who closely match your needs. Compare the loan offers a broker gets against those you find on your own. Look at differences in rates, fees, points, mortgage insurance and down payments — and compare your bottom-line costs.

Documents lenders look for when you get a mortgage

When you apply for a mortgage, lenders need some documentation about your finances to help determine whether you qualify for a loan (and if so, for how much). You’ll likely need to provide:

• Proof of income, including the previous year’s W-2 and federal tax return, as well as your most recent pay stub.
• Documentation on additional earnings, like alimony, child support or employment stock options.
• A list of all debts, including credit cards, student loans, auto loans, alimony and child support, along with balances and monthly payments.
• An inventory of your assets, including bank statements, investment records, retirement accounts, real estate and auto titles.
• Bankruptcy discharge papers, if you have had a bankruptcy within the last several years

In some cases, you may also have to sign an IRS Form 4506-T, which allows the lender to get a transcript of your tax return from the IRS.

How the mortgage application process works

A typical mortgage application includes several parts: pre-approval, home appraisal and approval. Although timing varies depending on your lender and your individual situation, it takes about 30 days on average, or 45 to 60 days during busier months, and longer if you have a complex application.

You can find out current rates in Bankrate’s national rate tables, which are free to use and can be tailored to your region and terms with a few keystrokes. Rates for home equity loans and home equity lines of credit are here. If you’re thinking about a cash-out refinance of your mortgage, see Bankrate’s FAQs on this here. You can skip right to the mortgage refi rates on rate tool by clicking Refinance in the left-hand corner of the page.

Mortgage preapproval The first step in the process to a mortgage preapproval. Getting preapproved includes completing a mortgage application and providing documentation on your finances so that your lender can check your background and credit score. You’ll receive a conditional commitment for the loan amount you’re likely to get approved for, and you’ll have an idea of what your interest rate will be. You may be able to lock in your interest rate at this stage. You’ll also receive a loan estimate, a document lenders are required to provide that outlines your loan terms, interest rate and estimated fees and closing costs.

Preapproval sometimes gets confused with a mortgage prequalification. A prequalification is a general idea of the loan amount you’d qualify for based on information about your credit and income you provide to a lender. The difference, however, is the lender doesn’t verify your income, credit or employment in a prequalification; it’s just to get a ballpark idea of how much house you can afford and holds no weight with sellers when making offers.

Home inspection After you find a home you like and get your offer accepted by the seller, it’s a good idea to get a home inspection. Lenders don’t require this step, but it’s strongly recommended so you know the home’s true condition and can negotiate repairs or credits with the seller if major issues are found.

Property appraisal Your lender will order a professional property appraisal to determine the home’s market value. If the appraisal is lower than what you agreed to pay, you have three options: ask the seller to lower the price, make up the difference yourself, or request a new appraisal.

Underwriting and loan approval If you meet all loan requirements, the lender will officially approve your mortgage after it goes through underwriting to ensure you meet all the borrowing requirements for the specific loan you chose. The lender also performs a title search to make sure there are no issues with ownership claims and the property can be transferred from the seller to you (the buyer).

Before -- and during -- your home purchase, avoid opening new lines of credit, closing credit cards, taking out new loans, or making large purchases -- all of which can impact your credit score and debt-to-income ratio. It’s also a good idea to hold off switching jobs and making any large deposits into your bank account; both can delay or derail your loan approval.

Closing After you’ve jumped through all of these hoops and received the green light from your lender, it’s time close. A real estate closing is where you sign legal paperwork and pay closing costs to finalize the transaction. You’ll receive a closing disclosure three days before your closing date. Some of the fees might change a bit from the initial loan estimate but there shouldn’t be any big surprises. Check the closing disclosure for any errors, and ask for clarification on anything you don’t understand. Just before closing you’ll do a final walk-through of the home to check its condition.

At closing, you’ll sign a lot of paperwork either by hand or electronically. You’ll sign legal documents that fall into two categories: the agreement between you and your lender regarding the terms and conditions of the mortgage, and the agreement between you and the seller transferring ownership of the property. Be sure to read all documents carefully before signing them, and do not sign forms with blank lines or spaces. You’ll pay closing costs and items that have to be paid upfront, such as property taxes, hazard insurance, private mortgage insurance and special assessments. Once you’re done, the house keys are yours along with a new title: homeowner. Congrats!

Next steps

Check Bankrate’s rate tables that are specific to your area and the type of house and loan you want.