For many people, homeownership is the American dream. But that dream would be out of reach for most of us without a mortgage.
One of the key benefits of a mortgage is that you can purchase a home immediately, instead of having to save for a very long time, potentially for decades.
If you’re thinking about buying a house for the first time, you probably have questions, namely what is a mortgage, and what does it entail?
Don’t sweat it: We’ll unpack everything you need to know about mortgages in plain English, including what they are, how they work, some important terms, and how to go through the application process with confidence.
What Is a Mortgage?
Simply put, a mortgage is a loan that’s used to buy real estate.
They are a great tool if you’re thinking about homeownership, and a very common one. In fact, 80% of homebuyers take out a mortgage to pay for their home.
Here’s how a mortgage works: Let’s say you find your dream home but don’t have enough cash on hand to buy it outright (and let’s face it, most of us don’t). A bank or lender will front you the money, and you agree to repay the loan amount plus interest in monthly installments over time.
The cool part is you get to live in and enjoy your home while you’re paying for it. Keep in mind, though, that your home serves as collateral for the loan, which means the lender can take it from you if you don’t keep up with the payments.
Key Mortgage Terms
The mortgage process has its own unique language.
This brief mortgage glossary will help you get familiar with some common terms you might come across when applying for and taking out a mortgage:
Annual Percentage Rate (APR)
Usually expressed as a percentage, APR is the cost of borrowing money.
In the case of your mortgage, it includes the loan’s interest rate plus lender fees. When you shop for mortgages, you’ll often see two interest rates. The APR is always the larger number because it includes fees.
Amortization
Mortgage amortization is the schedule you follow to pay off the loan over time.
In the early years, most of your monthly mortgage payment goes toward interest, but as your loan balance goes down, more of each payment goes toward paying down the principal or actual loan amount.
Closing Costs
The fees you pay to finalize your mortgage, typically 2-5% of the loan amount. These may include loan charges and fees for appraisals, inspections, and title costs.
Down Payment
The money you pay upfront when buying a home, typically 3-20% of the purchase price. Making a larger down payment typically qualifies you for better loan terms and lower monthly payments.
Escrow
An account managed by your lender that holds funds for property taxes and homeowners insurance. When these bills are due, the payments come out of your escrow account.
Equity
Home equity is the difference between what your home is worth and the amount you owe on your mortgage. Equity, or the amount of your home you own, increases over time as you pay down your mortgage and your home’s value (hopefully) goes up.
Fixed-Rate vs. Adjustable-Rate
A fixed-rate mortgage has the same interest rate throughout the loan term, providing stability and predictable payments.
An adjustable-rate mortgage (ARM) has an interest rate that changes over time based on market rates.
Points
Also called “discount or mortgage points,” points are fees paid to the lender up front in exchange for a lower interest rate on your mortgage.
PITI
PITI stands for Principal, Interest, Taxes, and Insurance. Combined, they represent the monthly cost of owning your home.
Private Mortgage Insurance (PMI)
Insurance that protects the lender if you stop making mortgage payments, typically required when your down payment is less than 20% of the home’s purchase price. Generally, you can stop paying PMI when you reach 20% equity in your home.
Principal
The amount you borrow to purchase your home. Your principal balance decreases as you make mortgage payments over time.
Property Taxes
Taxes charged by local governments based on your home’s value and location.
Typically included in your mortgage payment, property taxes are used to pay for local services such as the fire department, road construction and repairs, libraries, and community development programs.
For a complete list of mortgage terms, check out this comprehensive mortgage glossary.
Steps in the Mortgage Process
The mortgage process can be intimidating, especially for first-time homebuyers. But when you know what to expect, you can tackle homebuying with way more confidence.
Here’s a step-by-step overview, from pre-approval to closing:
1. Pre-Approval
Getting pre-approved is an essential first step in getting a mortgage.
In this step, lenders review financial information such as your income, debt, assets, tax returns, and credit score to determine which loans you may be eligible for, the amount you can borrow, and the interest rates you qualify for.
Your lender usually gives you a pre-approval letter stating how much they’ll lend you. While a pre-approval isn’t a guaranteed loan offer, it will give you a good idea of how much you can afford to spend on a home.
A pre-approval is not the same as a prequalification. Pre-qualifications are fine if you’re curious to see what you can afford someday. On the other hand, pre-approvals are for serious buyers who are ready to begin house hunting or who’ve already found a home.
Pre-approvals dig deeper into your finances and could ding your credit score temporarily, but they show sellers you mean business when it’s time to make an offer.
2. House Shopping and Making an Offer
With pre-approval in hand, you can confidently search for homes within your budget. When you find “the one,” you’ll make an offer with the help of your real estate agent.
Keep in mind that your pre-approval amount represents the maximum you can borrow, not necessarily what you should spend. Consider your other financial goals and make sure the monthly payment fits your budget.
Once the seller accepts your offer, you’ll move on to the mortgage application process.
3. Mortgage Application
Now it’s time to complete a full mortgage application with your lender. Even if you’ve already been pre-approved, consider looking further to make sure you’re getting the best rates and terms, and that you’re working with a lender that fits your needs.
Once you decide on a lender, they’ll let you know what information they need. If you go with the lender that pre-approved you, they may already have some of what they need. Generally, you’ll need to provide a laundry list of information, including:
- Proof of income (pay stubs, W-2s, tax returns for the past 2 years).
- Employment verification (contact information for current and previous employers).
- Proof of assets (i.e., bank statements, investment account statements)
- Credit history and score.
- Debt information (credit cards, student loans, car loans, etc.).
- Photo ID and Social Security number.
- Proof of residence history.
- Down payment source documentation.
- Gift letters (if using gift money for down payment).
- Property information (for the home you want to buy).
Some lenders might ask for additional information depending on your situation, but these are the basics you should have ready.
Your lender will provide you with a loan estimate within three days of completing your application. This standardized form shows your loan’s estimated interest rate, monthly payment, and closing costs. Review this document carefully to understand the financial commitment you’re making.
4. Loan Processing
If you accept the loan estimate, your lender will begin processing your loan. During this stage, the lender verifies your information and requests the following documents:
- Credit report: A detailed look at your credit history and score.
- Appraisal: An assessment of the property’s value to ensure it’s worth the purchase price.
- Title search: Confirms legal ownership of the property and checks for any claims or liens.
- Employment verification: Confirms your job status and income.
- Asset verification: Validates the funds you have for the down payment and closing costs.
It typically takes a few weeks for the lender to gather all the necessary documentation, so be patient.
5. Underwriting
An underwriter makes the final call on your mortgage approval. They’ll review your application and either approve your loan as is, reject it, or approve it with conditions.
A conditional approval usually means you have to provide additional information before getting final approval on your loan.
6. Closing
Once your mortgage application is approved, the closing is the final step to becoming a homeowner.
You’ll receive a stack of documents requiring your signature, including a closing disclosure, which outlines the final closing costs and whether they’ve changed from the original estimated costs.
At the closing appointment, you’ll:
- Sign all loan documents and legal paperwork.
- Pay your down payment and closing costs.
- Receive the keys to your new home.
Your mortgage becomes active three days after closing. Starting the following month, you’ll begin making mortgage payments to your lender as agreed.
Choose the Right Mortgage For You
Figuring out how to choose the right mortgage for you involves more than just shopping around for the lowest interest rate. Consider these factors when making your decision:
Assess Your Financial Situation
Start by taking an honest look at your finances:
- Credit score: Higher scores typically qualify for better rates. Check your credit report before applying and address any errors it might have.
- Debt-to-income ratio (DTI): Lenders typically prefer a DTI of 50% or lower. You can calculate your DTI by dividing your total monthly debts by your gross monthly income (before taxes and deductions).
- Down payment funds: Determine how much you can comfortably put down. While some loans require as little as 3% down, a larger down payment can mean better terms and lower monthly payments.
- Monthly payment: Be sure to include homeowner’s insurance, property taxes, and potentially private mortgage insurance in your projected mortgage payment.
Your financial situation is unique to you. Make sure you understand the full picture so you can make informed choices and avoid getting in over your head with a mortgage payment you can’t afford.
Compare Lenders and Loan Types
Different loan types serve various needs:
- Fixed-rate mortgage: Offers stable, predictable payments with the same interest rate for the life of the loan. Best for those planning to stay in their home long term.
- Adjustable-rate mortgage (ARM): Starts with a lower rate that can change over time. An ARM may make sense if you plan to move or refinance within a few years.
- Federal loan programs: Government-backed home loans like FHA, VA, or USDA loans offer benefits for qualifying borrowers, including lower down payment requirements and more flexible credit guidelines.
Get quotes from different lenders and compare their offers. Beyond the interest rate, consider:
- Loan terms (15-year vs. 30-year).
- Closing costs and fees.
- Prepayment penalties (fees for paying off the mortgage early).
- Rate lock periods (locks in a guaranteed interest rate for a specific time).
Not all lenders and mortgages are created equal. Your situation may be different, and there may be other factors that you’ll need to think about.
Consider Your Long-Term Plans
Your choice should align with your future goals:
- How long do you plan to stay in the home?
- Are you expecting any significant income changes?
- Do you anticipate any major life events that could impact your finances?
For example, if you expect to move within a few years, an ARM might save you money up front. If long-term stability is more your style, a fixed-rate loan may be a better choice.
Practical Tips for First-Time Homebuyers
As you start your home-buying journey, the first thing you could do is improve your credit, before you apply for a mortgage.
A higher credit score can qualify you for better interest rates, potentially saving you thousands over the life of your loan.
Once you have your eyes set on a house and a mortgage, make sure you save beyond the down payment. You’ll also need money to cover closing costs, moving expenses, and even repairs for your new home.
In fact, financial experts suggest keeping your total housing costs between 25-30% of your gross monthly income.
As a final suggestion, keep in mind that mortgage documents contain important information about your financial obligations. Don’t hesitate to ask questions about terms or fees you don’t understand. A good lender will take time to explain everything clearly.
Taking the First Step Towards Homeownership
Understanding what a mortgage is and how the process works puts you in charge of your homebuying experience.
By familiarizing yourself with key terms, knowing how to choose the right mortgage for you, and being financially prepared, you can approach this significant life milestone with confidence.
Remember that each mortgage payment builds your equity and puts you one step closer to owning your home outright. A mortgage isn’t just a monthly bill; it’s an investment in your future.
Kudzu can help you build the strong financial foundation you need to become a homeowner.
Whether you’re just starting to think about buying a home or you’re already house-hunting and researching lenders, we’re here to support you every step of the way.
Download the Kudzu app and put our personal finance tools to work for you.
