What Is a Mortgage? A Guide for First-Time Home Buyers

The word “mortgage” gets thrown around a lot when you’re buying a house. And that totally makes sense. Unless you’ve got high-earner, “Selling Sunset” money, you’ll probably need a mortgage loan to buy a home.

Here’s what we don’t recommend: walking into the mortgage process blindly. 

What we do recommend: learning everything you need to know about mortgages – what they are, how they work and how to get the right one for you and your budget. 

You deserve to feel confident and ready to tackle this crucial part of your home buying journey.

How Do Mortgages Work?

A mortgage defines the financial relationship between you as the borrower (aka the mortgagor) and the lender who provides the mortgage (aka the mortgagee).

For most mortgages:

• The lender agrees to provide you with the money you need to buy a home.
• You agree to pay back the loan (plus interest). Most home loans require you to make monthly mortgage payments over a 10-, 20- or 30-year loan term (aka how long you have to repay the loan).
• You agree to use the home you’re buying as collateral to get the loan. (Mortgages are secured loans and secured loans are backed by an asset.)  
• Once the loan is paid off, you become the owner of the home.

With a mortgage, you’re a homeowner with all the rights and responsibilities involved and can build equity in your home, as long as you continue to meet the terms of the mortgage. 

Why Do Mortgages Matter?

A mortgage is a type of loan used to buy a home or another form of real estate. 

Mortgages matter because – for many of us – if we tried to save money to buy a home outright, we’d be saving for most of our working lives.

Mortgages have a long history. They’re regulated by the federal government and help people become homeowners. The federal government encourages homeownership because it can help build wealth and economic security for individuals and families and provide a sense of stability for a community.

Parties Involved in Mortgages

It takes two to tango. And in the world of home loans, every mortgage needs two main parties: a borrower and a mortgage lender. 

Both you and the lender will likely bring a few plus ones to the party. Some will help you find the right dance partner, and others will keep everyone from stepping on each other’s toes.

Borrower

That’s you.

You’re the one taking out a mortgage because you want to buy a home. And you need to find a lender who will give you the money you need to achieve this major life milestone. 

Before they can approve you, your mortgage lender is going to take a long, hard look at your finances. Your primary objective is to provide your lender with all the information they’ll need to decide whether to approve your loan. 

Mortgage lender

A mortgage lender is usually a bank, financial company or institution that can loan you money.

To find a lender for your mortgage, you can:

• Visit your local commercial bank, community bank or credit union
• Apply for a mortgage online through a “non-bank” or online mortgage lender

Mortgage broker

A mortgage broker works like a matchmaker for borrowers and mortgage lenders. You won’t get a mortgage from a broker, but they have access to lots of different lenders and can help you find the best mortgage for your situation.

Loan servicer

Once you’ve received your mortgage loan, someone will be responsible for managing it. That someone – you guessed it … your loan servicer – will make sure your payments are collected and the money goes where it’s supposed to. Sometimes the lender will take care of this. And sometimes the lender will hire a third party to manage their loans.

In either case, the person responsible for managing your loan is the loan servicer.

When you’re ready to begin the mortgage process, you’ll need someone to usher you through all the steps and find the mortgage that’s best for you. Find a reputable lender like our MoneyTips vetted recommendation:

Types of Mortgage Loans

Like so many things in life, mortgages require you to make choices. One of the biggest decisions you’ll make is deciding what type of mortgage loan to take out – and there are several types of mortgages to choose from. 

Conventional mortgages 

This will likely be the first mortgage loan type you’re introduced to. Conventional loans (aka conforming loans) are the most common type of mortgage loan available. You can get one from a bank or other mortgage lender. 

Government-backed mortgages

The federal government plays an active role in encouraging homeownership, offering government-backed loans to borrowers who might not qualify for conventional loans because they have less-than-perfect credit or faced another credit or debt issue in the past.

Some of the more popular government-backed loans include:  

• Federal Housing Administration (FHA) loans: Anyone can apply for an FHA loan, but it’s designed for first-time home buyers and home buyers with lower credit scores or past credit issues.
• Department of Veterans Affairs (VA) loans: VA loans come with low interest rates. They are available to eligible veterans, active duty service members and surviving spouses. 
• U.S. Department of Agriculture (USDA) loans: USDA loans aren’t just for farmers. They’re available to anyone who wants to buy or build a home in a designated rural area and meets the loan’s income requirements.

How Does the Mortgage Process Work?

The mortgage process is the steps you’ll need to take to apply for a mortgage. 

If you’re working with (or planning on working with) a real estate agent, they can help you navigate the application process. Your loan officer is also a key point of contact. It’s their job to make sure that you’ve given the lender everything they need to help them decide on your loan approval. 

Mortgage preapproval

When you’re preapproved for a mortgage, that means a lender has performed a preliminary review of your finances and has figured out how much money they’re willing to lend you. Sellers take offers that come with preapprovals pretty seriously. 

Being preapproved is a signal to the seller that your finances have been evaluated, and you have a lender that is willing to lend you money to buy their house. 

To get preapproved, lenders will request:

• A completed application authorizing them to perform a credit check
• Proof of employment and income (If you’re self-employed, you’ll need to provide an accounting of your income history.)
• A statement of assets (If you have financial assets that don’t appear in your bank statement, you may need to provide these to help make your case.)

Once your paperwork has been reviewed, the lender will give you a letter that says you’re preapproved – and for how much. You’ll show that letter to potential sellers when you make your purchase offers. 

Between making an offer and closing on a home, interest rates can change. Pro tip: Ask your lender about a mortgage interest rate lock. A mortgage rate lock freezes the interest rate of your loan for a set period.

Shop for your home

Begin house hunting in earnest with your preapproval letter in hand. When you find the home you want, you can confidently make an offer to the seller. 

If your offer gets accepted, it’s time to alert your mortgage lender. If you have preapproval letters from a few mortgage lenders, pick the one you want to work with because the home buying process will get very real from that point. 

Pay into escrow

Once you and the seller agree on a price, you’ll enter the escrow phase of your home buying journey. As the buyer, you will be required to make a “good faith” deposit (aka earnest money deposit), which usually equals 1% – 2% of the home’s purchase price. That money gets deposited into escrow.

An escrow company is a neutral third party that collects the required funds and documents involved in the closing process. Escrow protects you and the seller during the final phase of selling the home.

If you buy the home, the earnest money you socked away in escrow will be applied toward your down payment. If you walk away from the deal, you may or may not get your earnest money deposit back. A refund will depend on the contingencies that were added (or not added) to your purchase agreement. 

Underwriting

During the underwriting step of the mortgage process, the mortgage lender’s underwriter will perform a more thorough review of your finances and credit history. It’s their job to make sure you can afford to pay the loan back.

The underwriter may ask for more information, like previous tax returns, verification of employment, bank deposit confirmations and detailed information about assets and debts you may have to approve you for a mortgage.

Home appraisal

The lender will request a home appraisal. It’s a professional assessment of the value of the home you want to buy. Because the mortgage uses the home as collateral, the lender wants to make sure you aren’t overborrowing.

While the lender schedules and hires the appraiser, the buyer is responsible for the bill. A property’s appraisal value is based on:

• Recent sales of similar properties in the area
• Current market trends
• A visual assessment of the interior and exterior of the home

If the sale price of your home is less than or equal to the fair market value determined by the appraiser, you’re good to go!

Home inspection

Lenders don’t require home inspections, but it’s a good idea to get one. A home inspection is a top-to-bottom examination of the home you want to buy. The objective is to identify potential issues, like needed repairs or structural concerns, with the home. 

Depending on the inspection’s outcome, a buyer and seller might renegotiate over the terms of the home sale. The seller may agree to make repairs before closing or agree to lower the price of the home so the buyer can make the repairs. 

If there are serious problems that could cost you more money than you can afford to pay, it may be a sign that you need to reconsider whether you really want to buy this home.

Closing

The closing or “settlement” is the last step in the mortgage process. During closing, all the parties involved in the sale of the home come together and sign the necessary documents. 

Once you’ve completed this step, the home is yours! You’ve finally made your debut as a proud homeowner.

What Are Mortgage Terms and What Can Affect Them?

A mortgage loan is an agreement between you and your lender. You agree to pay back what you borrowed, including interest, over a set number of years.  

Term

Your loan term is the length of time you have to repay your mortgage. Typically, mortgage loan terms last between 10 – 30 years. 

The longer you take to pay off your mortgage, the lower your monthly payment will be, but you’ll pay more in interest on the loan. 

Pro tip: Lenders may be willing to offer you a lower mortgage interest rate if you opt for a shorter loan term.

Interest rate

Interest is what a lender charges you to borrow money. The higher the interest rate, the more it will cost you to borrow.

The interest rate on your mortgage is usually based on two factors: the current market interest rate and your creditworthiness (read: reliability in paying back debt). The length and type of mortgage you get can also have an impact on the interest rate you get.

Mortgage rates are usually pretty low, especially when you compare them to high-interest debt, like a credit card or personal loan.

Who doesn’t want to get the lowest mortgage interest rate possible? Your credit score will play a big role in helping you get a favorable rate. Learn what your credit score is, and if you need to, look for ways to improve it. Remember, you’ll want to put your best financial face forward with your lender. 

Down payment

Back in the day, lenders typically required a down payment of 20% or more to qualify for a mortgage. Welp, times have changed. 

Many conventional and government-backed loans allow you to qualify for a mortgage with a down payment of 0% – 3%. 

The flip side of the coin is that these low down payment loans may cost you more in interest. And you may be on the hook for mortgage insurance. 

Mortgage insurance comes in two flavors: private mortgage insurance (PMI) and mortgage insurance premiums (MIPs). 

If you put down less than 20% on a conventional mortgage, you’ll likely pay PMI. If you put down less than 20% on a Federal Housing Administration (FHA) loan, you’ll likely pay a MIP. 

Mortgage insurance gets divided into 12 installments and is normally rolled into your monthly mortgage payments. 

Taxes and insurance

Your monthly mortgage payment will include your property tax bill and homeowners insurance. Lots of homeowners choose to make monthly payments to cover these expenses and deposit them into an escrow account.

When the tax and insurance bills are due, the mortgage lender or loan servicer pays them on your behalf. 

Taxes and insurance won’t directly affect your mortgage during your negotiations with your lender, but they will affect the size of your monthly mortgage payment.

If you want to know how much mortgage you can afford, use our mortgage calculator. Play around with different loan terms to see how that changes the cost of a mortgage.  

Take Your Next Step to Homeownership

You may have started this journey asking what a mortgage is, but we’re pretty confident you could give a master class on the topic. Now, go forth and find the mortgage that’s right for you. 

Rule number one: figure out how much home you can afford before you start the mortgage process.