A mortgage isn’t just a loan—it’s the key that makes homeownership possible for millions of Americans. Whether you’re buying your first home or refinancing an existing one, the mortgage you choose can shape your finances for decades.
But not all mortgages are the same. From interest rates to loan terms, knowing how they work can help you avoid surprises, save money, and make confident decisions about your future home.
What is a mortgage?
A mortgage is a loan used to buy a home or other real estate. You borrow money from a lender, agree to pay it back with interest, and the home serves as collateral until the loan is fully repaid.
If you stop making payments, the lender can take back the property through foreclosure. That’s why paying on time is so important—your house is literally on the line.
How the Mortgage Process Works
Getting a mortgage starts with applying through a lender, such as a bank or credit union. You’ll share details about your income, credit history, debts, and the home you want to buy.
If approved, the lender offers a loan with specific terms, including interest rate, length, and payment amount. Once you accept and sign the agreement, the lender sends the money to the seller, and you start making monthly payments until the loan is paid off.
Refinancing Your Mortgage
While mortgages are primarily used to buy homes, many homeowners refinance their existing loan to lower their rate, adjust the repayment term, or tap into home equity.
There are two main types of refinancing:
- Cash-out refinance: You borrow more than your current balance and take the difference as cash. This can help pay off debt, fund renovations, or cover other major expenses.
- Rate-and-term refinance: You replace your mortgage with a new one—often to reduce your interest rate or change the loan term.
Keep in mind, lenders typically limit how much cash you can take out. In most cases, you’re capped at 2% of the loan amount or $2,000, whichever is less.
Fixed vs. Adjustable Rates
There are two ways mortgage interest can be structured—fixed or adjustable.
- Fixed-rate mortgage: Your interest rate stays the same for the entire loan. That means predictable monthly payments, which can be easier to budget for.
- Adjustable-rate mortgage (ARM): The interest rate starts off fixed for a set time, then adjusts annually based on market conditions. ARMs come with caps so your rate can’t jump too high or drop too low.
What Goes Into a Mortgage Payment
Your mortgage payment includes:
- Principal: The part of your payment that reduces your loan balance.
- Interest: What the lender charges you for borrowing the money.
Many borrowers also roll property taxes and homeowners insurance into their mortgage through an escrow account. This simplifies your monthly bills, but it can increase your total payment.
When You’ll Pay Private Mortgage Insurance
Private mortgage insurance (PMI) is usually required if your down payment is less than 20%. It protects the lender—not you—in case you default on the loan.
PMI adds to your monthly payment, but you can ask to remove it once you reach 20% equity in your home.
Conventional Mortgage vs. FHA Mortgage
There are different types of mortgages. A conventional mortgage and an FHA mortgage are two common programs that many borrowers find themselves using.
Conventional Loans
Conventional mortgages generally have stricter qualifying guidelines, such as a higher credit score and lower loan to value (LTV). An FHA mortgage is insured by the government and is typically more flexible with its credit score requirements.
FHA Loans
FHA loans, backed by the Federal Housing Administration, also allow you to borrow more money to purchase your home. Typically, conventional loan programs will only allow you to borrow up to 80% of your home’s purchase price. This means for a purchase, you’ll need to come up with a 20% down payment on your own.
With an FHA loan, you can borrow up to 97% of the value of the home. While it may allow you to save on your down payment, it will cost you more each month. Loans with an LTV above 80% are required to carry private mortgage insurance (PMI). PMI is the monthly premium that you will pay as part of your monthly payment to ensure your loan against default.
Is taking out a mortgage ever a bad idea?
If the subprime housing crisis of the mid-aughts taught us anything, it’s that you never want to overextend yourself. That is especially important when considering how much you can afford to pay each month towards your mortgage payment. The requirements for loan approval vary among mortgage lenders.
However, the rule of thumb is that you don’t want to spend more than 28% of your monthly income on your housing expenses. Even if your mortgage lender approves you for an amount that is higher than that, consider borrowing less. You can always apply any leftover money at the end of the month towards lowering your principal balance.
Mortgage Terminology
Part of simplifying the mortgage process is understanding the terminology. It can be overwhelming when your loan agent throws around terms like DTI and APR when you are unfamiliar with them. We’ve broken down some commonly used mortgage terms that you’ll need to know to get through your first mortgage application.
Prequalification or Preapproval
This is your first step when considering purchasing a home. You’ll speak with a loan agent or mortgage broker and review all of your debts and income. They will use this information to estimate how much you can expect to be approved for.
Just keep in mind that this isn’t a guarantee, but only an estimate of what you can afford. But it’s enough to get you and your realtor started on finding properties in your price range.
Annual Percentage Rate (APR)
It’s a little different from the interest rate, which determines how much your monthly payment will be. This number includes what your rate would be if all costs were rolled into the loan. It allows you to compare the cost of your mortgage across different lenders who may charge different fees and points.
It helps you make an apples-to-apples comparison with the points and fees other lenders charge for the same product. This way you can see who has the best deal without having to go line by line through the fees.
Credit Score
Your credit scores represent your creditworthiness as a borrower. They are based on your credit reports issued by the three main credit reporting agencies, Equifax, Experian, and TransUnion.
Credit scores range from 350 to 850. The five factors that determine your credit score are:
- Payment history: This is the most important factor in determining your credit score. Lenders want to see that you have a history of making timely monthly payments on your debts.
- Credit utilization: This is the amount of credit you are using compared to the amount of credit that is available to you. High credit utilization, or using a large percentage of your available credit, can lower your score.
- Credit history length: A longer credit history indicates that you have a track record of managing credit responsibly over time.
- Credit mix: Having various credit accounts, such as credit cards, mortgages, and car loans, can improve your credit score.
- New credit: Applying for new credit accounts can temporarily lower your credit score, as it may indicate that you are taking on more debt.
Debt to Income Ratio (DTI)
This is the percentage of your income that goes towards paying your monthly obligations. The thing to remember with this number is that the income is based on your gross earnings. The debts they use are those that report to the credit agencies. So, things like your cell phone bill or car insurance aren’t included. This is why that 28% rule of thumb is so important to remember.
Loan-to-Value (LTV)
This is what your mortgage lender means when they talk about much you can borrow verse what your down payment is. If your loan-to-value is 80% that means you have borrowed 80% of the home’s value. You’ll need to come up with the remaining 20% out of pocket. For a refinance, the loan-to-value refers to the equity you have built up in your property.
If your home is worth $100,000, and you only owe $40,000 on your mortgage, you have $60,000 in equity. That means with a conventional loan, you could borrow up to 80% of the value of your home. In this example, you could get $40,000 cashback (excluding fees and costs associated with the refinance).
Down Payment
The down payment on a house is a payment made by the buyer at the time of purchase, usually in the form of cash. It’s typically a percentage of the purchase price of the property and can vary in size, ranging from 3% to 20% or more.
The size of the required down payment on a property is typically influenced by the type of mortgage being used and the borrower’s financial situation. Down payments may also be affected by the type of property being purchased, such as whether it is a primary residence or an investment property.
Closing
This is where you sign the mortgage documents. Whether you’re refinancing or purchasing your home, you will need to sign legal documents securing your property against the loan. These documents will include a promissory note and a deed stating how the property title is held.
Closing Costs
Closing costs are the expenses that buyers and sellers are subject to pay at closing to complete a real estate transaction. These costs may include loan origination fees, discount points, appraisal fees, title insurance, title searches, credit report fees, surveys, property taxes, and deed recording fees.
If you’re ready to talk to someone about buying a home, check out our recommended list of lenders.
Final Thoughts
Getting a mortgage is one of the biggest financial decisions you’ll make, but it doesn’t have to be confusing. Whether you’re buying your first home or refinancing, knowing how mortgages work can help you borrow smarter and avoid costly mistakes.
From fixed vs. adjustable rates to down payments and PMI, every piece of the puzzle affects your monthly payment and long-term costs. The more prepared you are, the more confident you’ll feel when it’s time to sign on the dotted line.
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