What is a Mortgage?
For most people, buying a home means borrowing a large amount of money. That loan is called a mortgage.
If you have never had a mortgage before, the terminology can make the process feel much more complicated than it needs to be. Principal, interest, escrow, APR, fixed rate, adjustable rate, preapproval... suddenly buying a house comes with its own vocabulary.
A mortgage is simply a loan used to buy a home. You borrow money from a lender, agree to repay it over a set period of time, and the home serves as collateral for the loan.
Understanding the basics before you start shopping can help you understand what you are actually agreeing to.
How a Mortgage Works
Let's say you want to buy a $250,000 home and have $25,000 for a down payment.
Your mortgage would be approximately:
Home price: $250,000
Down payment: $25,000
Mortgage: $225,000
The $225,000 is the amount you are borrowing. You then repay the lender over the term of the mortgage, usually through monthly payments.
Your mortgage payment generally includes two major pieces:
Principal: The amount going toward paying back the money you borrowed.
Interest: The cost of borrowing the money.
Your monthly payment may also include money collected for property taxes and homeowners insurance. When these expenses are placed into an escrow account, your lender collects part of the expected annual cost each month and pays the bills when they come due.
Some borrowers also have mortgage insurance, particularly when using certain loans with a smaller down payment.
This is why two homes with the same purchase price can have different monthly payments. The interest rate, down payment, taxes, insurance, mortgage insurance, and loan terms can all affect the amount you actually pay.
Your Interest Rate and Loan Term Matter
Your interest rate determines how much you pay the lender for borrowing the money.
For example, imagine borrowing $225,000 with a fixed interest rate. Over a 30-year mortgage, you make payments for a much longer period than you would with a 15-year mortgage. The 30-year loan generally has a lower monthly payment, while the 15-year loan generally requires a higher monthly payment but pays the loan off faster.
A longer loan term can mean paying substantially more interest over the life of the mortgage.
The interest rate matters too. Even a relatively small difference in rates can change both your monthly payment and the total amount of interest you pay.
That is why looking only at the purchase price of the house does not tell you what the house will actually cost you.
Fixed-Rate Mortgages
With a fixed-rate mortgage, the interest rate stays the same throughout the loan term.
That makes the principal-and-interest portion of your payment predictable and can make long-term budgeting easier.
Adjustable-Rate Mortgages
An adjustable-rate mortgage, or ARM, can have an interest rate that changes after an initial period.
For example, an ARM might begin with a fixed rate for several years and then adjust according to the terms of the loan.
An ARM can have an attractive initial rate, but you need to understand when the rate can change, how much it can change, and how that could affect your payment.
What Lenders Look At
When you apply for a mortgage, the lender wants to determine whether you can reasonably repay the loan.
Your income is one part of the picture. The lender may verify your employment, pay, tax information, and other sources of income.
Your credit history matters too. Lenders can review how you have handled credit and debt, including your payment history and outstanding balances.
Your existing debts are another important consideration.
One measurement lenders may use is your debt-to-income ratio, or DTI. It compares your monthly debt payments with your gross monthly income.
For example:
Gross monthly income: $5,000
Monthly debt payments: $1,500
Debt To Income: 30%
Mortgage underwriting involves more than one number, and different loan programs have different requirements. Your credit, income, assets, debts, down payment, property, and the type of loan can all affect the application.
Prequalification, Preapproval, and Shopping for a Mortgage
Before spending hours looking at houses, it helps to understand what you may actually be able to finance.
Prequalification is generally an initial estimate based on information you provide to a lender. It can give you an idea of your potential borrowing range.
Preapproval generally involves a more detailed review of your financial information. A lender may review documents such as income information, assets, debts, and credit as part of the process.
A preapproval can help you understand your potential price range and can make your offer more credible to a seller. It still is not a guarantee that your mortgage will ultimately be approved. The property and your financial circumstances still have to satisfy the lender's requirements before closing.
You also do not have to use the first lender you talk to.
Different lenders can offer different interest rates, fees, loan programs, and terms. Comparing loan estimates can help you see what you are actually paying for the mortgage rather than choosing based only on the advertised interest rate.
Figure Out What You Can Actually Afford
This is where your personal budget becomes more important than the maximum amount a lender says you can borrow.
Imagine a lender approves you for a $300,000 mortgage. Your budget might tell you that a $250,000 home makes much more sense.
Why?
Because the mortgage payment is not your only expense.
You still need to pay for utilities, groceries, transportation, healthcare, savings, debt payments, maintenance, and everything else in your life. Homeownership also brings expenses such as property taxes, homeowners' insurance, repairs, and maintenance.
A broken air conditioner does not care whether it happens three months after you buy the house. Neither does a leaking water heater.
Before deciding how much house you can afford, look at the complete monthly cost of owning it.
A mortgage that technically fits the lender's requirements can still leave your personal budget stretched too thin.
Final Thoughts
A mortgage is a long-term loan, and the amount you borrow is only part of the story. Your interest rate, loan term, down payment, taxes, insurance, mortgage insurance, and other costs all affect what you will actually pay.
Before buying, learn the terms of the loan, compare your options, and build your budget around what you can comfortably manage rather than simply the largest loan you can qualify for.
Understanding the mortgage before you sign it puts you in a much better position to understand the commitment you are making.
Up Next: Your mortgage does not necessarily have to come entirely from your own savings. The next article looks at First-Time Homebuyer Programs, including down payment assistance, low-down-payment loans, and programs that may help eligible buyers with the upfront costs of purchasing a home.
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