What is a mortgage?

A mortgage is a loan extended to you by a lender for buying a home. You have many years to pay back the mortgage, but it will accrue interest during that time.

Zack Sigel

Zack Sigel

Published October 3, 2018

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  • A mortgage is a home loan, meaning a mortgage lender will extend you money that you need to pay back.

  • The most common mortgages are 15-year and 30-year fixed rate mortgages.

  • Your mortgage payment covers the principal and interest portions of your monthly mortgage balance.

  • A mortgage may be a lifetime commitment, but for most Americans it's the only way to buy a house.

A mortgage is a loan extended to you by a lender for the purpose of buying a home. Typically, you have many years to pay back the mortgage, but it will accrue interest during that time. If you stop repaying your mortgage, the lender may repossess the house.

Because purchasing a house costs a lot of money, for most people a mortgage is the only way to become a homeowner. However, owning a home is one of the most important ways to build personal wealth. Once your mortgage is paid off, you’ll likely own an asset that has appreciated in value considerably.

Mortgage payments are usually made monthly, according to an amortization schedule that calculates your total monthly payment based on the remaining principal and interest you owe. Every time you make a payment, some part of it goes toward the principal and some part of it goes toward the interest.

Read on:

How do I apply for a mortgage?

The first part of the mortgage process is to find your dream home in your price range. Then, find a financial institution you trust and let them know you’re interested in purchasing the home. The bank will estimate how much you can borrow and let you know if you’re preapproved for the loan.

Wondering how much house you can afford? Try our mortgage calculator.

The uniform residential loan application

The lender will have you fill out the residential loan application, which contains information about you, your finances (such as your assets and liabilities), and the home you’re purchasing. The mortgage application asks you to fill in the following information:

  • Type of mortgage
  • Details about the property, including purchase price
  • Information about you, your spouse, and anyone else who’s buying the home with you
  • Your income, your assets, and any debts you owe

Documents you need

The lender needs to know that you can afford to pay back your mortgage. You need to show up with several key documents that give a picture of your financial health and creditworthiness. These include:

  • Pay stubs, bank statements, any supplemental income
  • W-2 forms, or tax returns if you’re self-employed
  • Information about your debts, including credit card balances, student loans, auto loans, and any other mortgages you have

Commitment and closing

Take a look at all the costs associated with your mortgage. They should be outlined in detail on the preapproval letter provided by your loan officer. If it all looks good, it’s time for the lender to process your application. When you get approved, you’ll receive a commitment letter, that, once signed, means you’re ready to close on the mortgage.

The next step is closing. There are some fees involved with closing that you should keep in mind, but once you pay these fees and agree to the terms of the closing disclosure letter, then it’s time to close. Everyone involved – you, any co-signers, the lender’s closing agent, and the real estate agents of both parties – will sign the closing documents. The house will be transferred to you.

How do I know if I’m preapproved?

Preapproval is mostly synonymous with prequalification and conditional approval. You’ll see this if you ever get online ads or mail from lenders, which means the lender already looked at your credit and decided you were a prime candidate for a loan. If you know you have good credit, you may already be prequalified.

If you’re not already preapproved, then you can ask your lender to preapprove you. This usually means a credit inquiry without having to submit any supporting financial documents.

Preapproval is an estimate of the costs you’ll pay for a certain mortgage amount. You should get a preapproval or prequalification letter from the lender describing all the components of your potential mortgage. However, it’s not set in stone. Actual approval is still up to the lender, and your costs can increase or decrease as the lender learns more about your finances.

Your ability to pay back a mortgage may also change between preapproval and closing, and this can make your actual closing costs much different than the initial preapproval. You may decide, for example, to pay a higher down payment, or you might find a better deal on the home inspection.

Learn more about getting preapproved for your mortgage.

How much does a mortgage cost?

Mortgages are divided up into two main components:

  • The principal is the amount you still owe on the mortgage
  • The interest is the amount you pay to the bank for the benefit of extending you such a large amount of money.

While your monthly projected payment is the same each month, the percentage of it that goes toward the interest decreases with every payment while the percentage that goes toward the principal increases with every payment. Eventually, you’re paying off more of the principal than you are of the interest, which is called amortization.

Mortgage lenders use an amortization table to show precisely how much of your payment goes toward which component each month. Say you take out a mortgage worth $150,000 with a 4.5% interest rate for a term that lasts 30 years. That’s 360 equal monthly payments, with interest compounding every month. By the time you’ve paid off your mortgage, you paid $123,610.07 in interest.

Barring your down payment, any extra payments, missed payments, or changes to your interest rate, your amortization schedule should look like this:

Payment #BalancePaymentPrincipalInterestRemaining BalanceCumulative Interest Paid
Payment 1$150,000.00$760.03$197.53$562.50$149,802.47$562.50
Payment 2$149,802.47$760.03$198.27$561.76$149,604.20$1,124.26
Payment 3$149,604.20$760.03$199.01$561.02$149,405.19$1,685.28
Payment 4$149,405.19$760.03$199.76$560.27$149,205.43$2,245.54
Payment 5$149,205.43$760.03$200.51$559.52$149,004.93$2,805.06
Payment 10$148,195.35$760.03$204.30$555.73$147,991.05$5,591.33
Payment 20$146,117.57$760.03$212.09$547.94$145,905.48$11,106.04
Payment 40$141,721.26$760.03$228.57$531.45$141,492.69$21,893.81
Payment 60$136,983.22$760.03$246.34$513.69$136,736.88$32,338.55
Payment 120$120,442.52$760.03$308.37$451.66$120,134.15$61,337.51
Payment 180$99,736.95$760.03$386.01$374.01$99,350.93$86,155.97
Payment 240$73,817.80$760.03$483.21$276.82$73,334.58$105,741.30
Payment 300$41,372.31$760.03$604.88$155.15$40,767.43$118,775.82
Payment 360$757.19$760.03$757.19$2.84none!$123,610.07

Learn more about how mortgage interest works.

Closing costs

Interest isn’t the only cost you have to pay. You’ll also need to pay some additional fees involved with applying for the mortgage in the first place. Some of these are to make sure the house is in tip-top shape; others are tax liabilities; still more help protect the lender’s investment in you. Before you sign the mortgage documents, but sure to look out for the following closing costs:

  • Down payment: A lump sum payment equal to a percentage of your loan amount. The higher the down payment, the less you’ll have to pay over time.
  • Origination fees: The lender’s costs for processing your application. Usually a percentage of your loan amount (called “points”), plus set dollar amounts for application, underwriting, credit check, appraisal and titling fees. (Learn more about loan origination.)
  • Inspection fees: Home inspection, pest inspection, and survey fees.
  • Taxes: Including transfer tax, recording fees, and a certain number of months of property taxes.
  • Homeowners insurance: Required as a condition of taking out a mortgage. Usually paid directly to the insurance company.
  • Mortgage insurance: Required if you put down a down payment of less than 20%. Paid monthly to the mortgage lender, but a certain amount of premiums may be due at signing.

What types of mortgages are there?

When you first take out a mortgage, you have the option of selecting from several different mortgage types.

Fixed-rate mortgage

With a fixed-rate mortgage, your loan amortizes at the same interest rate throughout its lifetime. The 30-year fixed-rate mortgage is the most common type, but 15-year mortgages are also common.

Adjustable-rate mortgage

Adjustable-rate mortgages (ARMs) have an interest rate that may go up or down, depending on changes in market rates. Typically, ARMs start with a low interest rate that increases years later. Check with your lender about the highest possible interest rate (the cap) and the lowest possible interest rate (the floor) to make sure you’re getting the right deal.

7/1 ARM

The 7/1 ARM has a fixed-rate period of seven years, after which the adjustable-rate period begins. Lenders may offer 5/1 ARMs and 10/1 ARMs in addition to the 7/1 ARM. The “1” means that the interest rate can be adjusted once a year after the fixed-rate period ends.

Government loan

While the U.S. government doesn’t write mortgages itself, the Federal Housing Administration (FHA) and the Department of Veterans Affairs do back lenders’ mortgages for certain borrowers. FHA loans and VA loans can usually only be used for certain mortgage amounts, but they have lower closing costs, including lower down payments, than conventional loans.

Jumbo loans

Jumbo loans do not adhere to the maximum loan amounts set by Freddie Mac and Fannie Mae. For this reason, they are considered nonconforming mortgages. As of 2018, the maximum conforming mortgage amount is $453,100.

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What happens if I stop making mortgage payments?

When you miss a mortgage payment, you won’t necessarily see any negative results right away. You’ll have a two-week grace period to make the payment and, depending on your lender, a late fee may apply during that time, but not always.

But if the mortgage payment becomes 60 days past due, then you could start the see some severe consequences. For one, your credit score will drop – dramatically. In fact, becoming delinquent on your mortgage is one of the worst things you can do to your credit. That’s in addition to high late fees that you’ll definitely need to pay.

Keep missing payments beyond that and you’re staring down foreclosure. That’s when the bank seizes your home and kicks you out. Because you’re no longer the owner and a financial institution has no need for a house, the lender will sell the home and subtract whatever it makes on the market from the remaining mortgage amount.

If the foreclosed house sold for less than the mortgage, then you’re still on the hook for the remaining balance on a home you no longer own. Can’t pay that? The bank may get a court order to start garnishing your wages.

How are home equity loans related to mortgages?

The more you pay your mortgage, the more equity your home has. Roughly, your home equity equals the amount your home is worth minus your remaining mortgage balance, which means it’s sometimes possible to have negative equity.

See the table below for some home equity scenarios. This table assumes you purchased a house worth $200,000 and took out a mortgage for $200,000, but paid a down payment on the mortgage of 20%, or $40,000.

ScenarioValue of HouseRemaining Mortgage BalanceEquity
At closing with 20% down payment$200,000$160,000$40,000
Mortgage halfway paid off$200,000$80,000$120,000
Mortgage halfway paid off, but house drops in value$100,000$80,000$20,000
Mortgage halfway paid off, but house drops in value by a lot$50,000$80,000-$30,000
Mortgage halfway paid off, and house increases in value$250,000$80,000$170,000
Mortgage fully paid off$250,000$0$250,000

A home equity loan uses the equity of your home as collateral, allowing you to borrow an amount equal to a certain percentage of the equity.

The home equity loan can be an important source of cash if you’re in a bind; you can also get a home equity line of credit (HELOC), which functions like a credit card in that as long as you keep paying the balance then you can keep using the available credit.

But if you don’t pay back a home equity loan or HELOC, then, like a mortgage, you can seriously hurt your credit, and the bank can eventually foreclose on the home.

What is a reverse mortgage?

A reverse mortgage is when the bank extends a loan to you based on the equity of your home, and you don’t have to pay it back as long as you keep living in the home. If a reverse mortgage sounds too good to be true, that’s because not everyone is eligible for one. The following conditions apply:

  • You must be at least 62 years old,
  • Your mortgage must be entirely paid off, and
  • If you want to sell the home, the proceeds will go toward paying off the remaining loan balance

With a reverse mortgage, you’re essentially spending your home equity to get cash now. Reverse mortgages can help supplement your income in retirement, but the longer you continue receiving reverse mortgage payments, the more your home equity diminishes. Additionally, the bank may charge high fees for processing and closing on the reverse mortgage.

When you die, if your home equity exceeds the amount of the reverse mortgage, your heirs could be entitled to the excess amount after the loan has been paid off. But if you die with a balance left, the bank will keep the home, and your heirs could get nothing from the sale of the home. Reverse mortgages may not be useful for someone who has the option to simply sell their home and move to a smaller one, pocketing the profit.