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How Does a Mortgage Work?

Updated Apr 25, 2023   |   10 mins read

A mortgage is a loan to purchase property, often a house or condo. When you take out a mortgage, you borrow money from a lender, such as a bank or a credit union, to pay for the property. In exchange, you agree to pay back the loan with interest over a set period, often 15 to 30 years.

Buying a home is one of the largest purchases you’ll make. It can be exciting, but getting a mortgage can feel like navigating a complicated maze. By understanding how mortgages work, you can make an informed decision about your future.

In this guide:

When is a mortgage needed?

You might need a mortgage when you want to buy a property, such as a house or a condo, but you don’t have the full amount of cash to pay for it upfront. 

By taking out a mortgage, you can spread out the cost of the property over several years and make monthly payments instead. 

Am I eligible for a mortgage?

Eligibility requirements vary by lender, but you must often meet these minimums to get a mortgage: 

  • A good credit score (typical minimum of 620)
  • A stable income and employment history
  • A low debt-to-income ratio (often no more than 43%, although certain lenders have price-based thresholds)
  • A sufficient down payment (often 3% to 20% of the home’s purchase price)
  • A satisfactory financial history, including no recent bankruptcies or foreclosures

Who offers mortgages?

You might consider several types of lenders for a mortgage. 

  • Banks: Banks are perhaps the most well-known type of mortgage lender. They offer a variety of mortgage products, including fixed-rate, adjustable-rate, and jumbo mortgages. Many banks require good credit scores and steady incomes to qualify for a mortgage.
  • Credit unions: Credit unions are nonprofit financial institutions that offer many of the same mortgage products as banks. They often offer lower interest rates and fees than traditional banks, but membership requirements may apply.
  • Online lenders: Online mortgage lenders have become popular in recent years thanks to their convenience and streamlined application processes. They offer a range of mortgage products and can appeal to those who prefer to do everything online.
  • Government-backed lenders: The U.S. government offers several mortgage programs through the Federal Housing Administration (FHA), the U.S. Department of Agriculture (USDA), and the U.S. Department of Veterans Affairs (VA).

What types of mortgages are there?

Borrowers have several types of mortgages available, including fixed-rate mortgages, adjustable-rate mortgages, FHA loans, VA loans, jumbo loans, and interest-only mortgages. 

Each type has unique eligibility requirements. Comparing your options or chatting with a lending specialist can help you choose the best mortgage loan for your financial situation.

Who is involved with the mortgage lending process?

The mortgage lending process involves several parties, each with a unique role.

  • Lender: This is the institution that provides mortgage funds. It’s also responsible for assessing the borrower’s eligibility, setting loan terms, and disbursing funds.
  • Borrower: This is the individual or individuals applying for the mortgage. They’re responsible for providing necessary documentation, meeting the eligibility requirements, and making regular payments on the loan.
  • Real estate agent: In many cases, this person helps the borrower find a suitable property, negotiate the purchase price, and navigate the closing process.
  • Appraiser: This person or company is responsible for evaluating the property’s value to ensure it’s worth the borrowed amount.
  • Title company: This company conducts a search on the property to ensure no outstanding liens or other issues exist to affect the sale. It also handles the closing process, including the transfer of ownership and disbursement of funds.

How to get a mortgage

Getting a mortgage involves several steps, including: 

  1. Determine your budget.
  2. Research lenders.
  3. Get preapproved.
  4. Submit a formal application.

Understanding your financial situation and credit history, as well as the types of mortgages and rates available, can help you make an informed decision. 

For a more in-depth look at the mortgage process, check out our article on how to get a mortgage.

How do down payments work?

A down payment is the first payment you make toward purchasing a home. It’s often a percentage of the home’s sale price, and you pay it upfront at the time of purchase. 

The exact amount of your down payment depends on the type of mortgage you apply for, but it often ranges from 3% to 20% of the home’s value. The average down payment in 2022 was 13%, according to the National Association of Realtors Research Group

Down payments aren’t always required, but they’re often recommended. A down payment can help reduce the debt you take on and improve your approval chances. It can also lower your monthly payments and help you avoid the need for private mortgage insurance (PMI). 

What is earnest money?

When a buyer is interested in a home, they may put down “earnest money” to prove they’re committed to the purchase. Earnest money is a percentage of the home’s sale price, often 1% to 3%.

While similar to a down payment, the earnest money is a separate deposit made early in the homebuying process. It’s held in an escrow account until the sale is finalized. 

  • If the sale goes through, the earnest money is often rolled into the buyer’s down payment or closing costs. 
  • If the sale falls through due to a contingency in the agreement (such as a failed inspection or inability to secure financing), the earnest money may be refunded.

Earnest money isn’t always required, but it can improve your chances of getting approved for a home. 

What happens if you’re denied a mortgage?

If you’re denied a mortgage, you still have options. 

  1. You can try to find another lender willing to approve your application. 
  2. You can improve your credit score, reduce your debt-to-income ratio, or save for a larger down payment, which can increase your future approval chances.

Around 8% of mortgage applications were denied in 2021, according to data collected from the Home Mortgage Disclosure Act (HMDA). Reasons for denial can include poor credit scores, high debt-to-income ratios, insufficient income, or insufficient funds for a down payment. 

However, being denied a mortgage is not the end of the road for borrowers. By improving your financial situation and working with a knowledgeable lender, you may still be able to achieve your dream of homeownership.

How does mortgage repayment work?

Mortgage repayment often involves making monthly payments over a 15- or 30-year period until you repay your loan. 

The specifics of how mortgage repayment works can vary depending on the type of mortgage and loan terms. 

How mortgage interest works

Mortgage interest is extra money you pay your lender for letting you borrow money to buy a home. Often expressed as an annual percentage rate (APR), it’s calculated based on several factors, including the borrower’s credit score, the loan amount, the length of the loan, and current market conditions.

Your outstanding loan balance is used to calculate your interest payment. For example, if you take out a 30-year fixed-rate mortgage for $300,000 with an interest rate of 4%, your monthly mortgage payment would be $1,432. The interest portion of your first payment is calculated as follows:

  • Outstanding balance of loan = $300,000
  • Monthly interest rate = 4% / 12 months = 0.333%
  • Interest portion of monthly payment = $300,000 x 0.333% = $1,000

In this example, the remaining $432 of your monthly payment would go toward your principal balance. Over time, the interest portion of your payment decreases while the portion going toward the principal increases until you pay the loan in full.

Do I need private mortgage insurance?

Whether you need private mortgage insurance (PMI) depends on the size of your down payment and mortgage type. If you put down less than 20% of the home’s purchase price, your lender will likely require you to pay for PMI to protect itself in case you default on the loan. 

However, once you’ve paid down the loan enough to have 20% equity in the home, you can often cancel PMI.

Do I have to pay taxes on a mortgage?

As a borrower, you may need to pay property taxes on your home. Taxes and homeowners insurance are often rolled into monthly mortgage payments via an escrow account. Local governments assess property taxes based on the value of your home and the surrounding area. 

You may be able to deduct a portion of your mortgage interest payments and property taxes on your federal income taxes if you itemize your deductions. The amount of mortgage interest you can deduct depends on several factors, including the amount of the loan, the interest rate, and your tax filing status. 

Consult a tax professional if you have questions about tax deductions related to your mortgage.

What fees do I have to pay on a mortgage?

You may be required to pay several fees when you get a mortgage. 

  • Origination fee: The lender charges this fee to cover the cost of processing your loan application. It’s often a percentage of the loan amount, ranging from 0.5% to 1.0%.
  • Appraisal fee: This fee covers the cost of having a professional appraiser evaluate the property’s value. It can range from $300 to $400 for a single-family home.
  • Title search and insurance: These fees cover the cost of ensuring the property has a clear title. The cost often ranges from $450 to $600.
  • Inspection fee: This fee covers the cost of a professional inspector evaluating the property’s condition. It can range from $300 to $400.
  • Prepaid interest: This is the interest you pay upfront at closing to cover the period between the closing date and the date of your first mortgage payment.
  • Closing costs: These are fees associated with closing the mortgage, such as attorney fees, document preparation fees, and recording fees. They can range from 2% to 5% of the loan amount.

What are the best mortgage lenders?

Many lenders offer mortgages, but not all suit your needs.

To make your search easier, we’ve compiled a list of the best mortgage lenders. Our list considers factors such as customer satisfaction, loan options, and rates to help you find the right lender.