Taking out a mortgage is the biggest financial obligation most of us will ever assume. So it’s essential to understand what you’re signing on for when you borrow money to buy a house.

What is a mortgage?

A mortgage is a loan from a bank or other financial institution that helps a borrower purchase a home. The collateral for the mortgage is the home itself. That means if the borrower doesn’t make monthly payments to the lender and defaults on the loan, the lender can sell the home and recoup its money.

A mortgage loan is typically a long-term debt taken out for 30, 20 or 15 years. Over this time (known as the loan’s “term”), you’ll repay both the amount you borrowed as well as the interest charged for the loan.

You’ll repay the mortgage at regular intervals, usually in the form of a monthly payment, which typically consists of both principal and interest charges.

“Each month, part of your monthly mortgage payment will go toward paying off that principal, or mortgage balance, and part will go toward interest on the loan,” explains Robert Kirkland, vice president, Divisional Community and affordable lending manager with JPMorgan Chase. Over time, more of your payment will go toward the principal.

If you default on your mortgage loan, the lender can reclaim your property through the process of foreclosure.

“You don’t technically own the property until your mortgage loan is fully paid,” says Bill Packer, executive vice president and COO of American Financial Resources in Parsippany, New Jersey. “Typically, you will also sign a promissory note at closing, which is your personal pledge to repay the loan.”

How does a mortgage work?

A mortgage is a loan that people use to buy a home. To get a mortgage, you’ll work with a bank or other lender. Typically, to start the process, you’ll go through preapproval to get an idea of the maximum the lender is willing to lend and the interest rate you’ll pay. This helps you estimate the cost of your loan and start your search for a home.

Starting the mortgage process

Applying for a mortgage is a thorough process, involving many steps on your end. To start, you’ll need proof of income (through paystubs and previous year’s tax returns), a list of assets (including brokerage statements, if applicable), a list of debts, personal data for credit inquiries, and letters explaining any financial gifts you receive for the home purchase such as help with a down payment from family members.

Once you gather your documents, you’ll apply for the mortgage through the lender’s website. Having all the documents ready to go can expedite the process of earning a pre-approval, since they can show their underwriters you indeed have the qualifications to pay for the mortgage.

Types of mortgages

There are several types of mortgages available to borrowers, including conventional fixed-rate mortgages, which are among the most common; adjustable-rate mortgages (ARMs); FHA, VA and USDA loans; jumbo loans; and reverse mortgages.

• Conventional loans – A conventional mortgage is not backed by the government or government agency; instead, it is made and guaranteed through a private-sector lender (bank, credit union, mortgage company).
• Jumbo loans – A jumbo loan exceeds the size limits set by U.S. government agencies and has stricter underwriting guidelines. These loans are sometimes needed for high-priced properties — those well above half a million dollars.
• Government-insured loans – These include VA loans, USDA loans, and FHA loans, and have more relaxed borrower qualifications than many privately-backed mortgages.
• Fixed-rate mortgages – Fixed-rate mortgages have a set interest rate that remains the same for the life of the loan (terms are commonly 30, 20, or 15 years).
• Adjustable-rate mortgages – An adjustable-rate mortgage (ARM) has interest rates that fluctuate, following general interest-rate movements and financial market conditions. Often there’s an initial fixed-rate period for the loan’s first few years, and then the variable rate kicks in for the remainder of the loan term. For example, “in a 5/1 ARM, the ‘5’ stands for an initial five-year period during which the interest rate remains fixed while the ‘1’ indicates that the interest rate is subject to adjustment once per year” thereafter, Kirkland notes.

What is included in a mortgage payment?

There are four core components of a mortgage payment: the principal, interest, taxes, and insurance, collectively referred to as “PITI.” There can be other costs included in the payment, as well.

1. Principal – the specific amount of money you borrow from a mortgage lender to purchase a home. If you were to buy a $100,000 home, for instance, and take out a loan in the amount of $90,000, then your principal is $90,000.
2. Interest – interest, expressed as a percentage rate, is what the lender charges you to borrow that money. In other words, the interest is the annual cost you pay on the loan principal.
3. Property taxes – your lender typically collects the property taxes associated with the home as part of your monthly mortgage payment. The money is usually held in an escrow account, which the lender will use to pay your property tax bill when the taxes are due.
4. Homeowners insurance – homeowner’s insurance provides you and your lender a level of protection in the event of a disaster, fire or other accident that impacts your property. Often, your lender collects the insurance premiums as part of your monthly mortgage bill, places the money in escrow, and makes the payments to the insurance provider for you when the premiums are due.
5. Mortgage insurance – your monthly payment might also include a fee for private mortgage insurance (PMI). For a conventional loan, this type of insurance is required when a buyer makes a down payment of less than 20 percent of the home’s purchase price.

How to find the best mortgage rate

To identify the mortgage that’s best for your situation, assess your financial health, including your income, credit history and score, and assets and savings. Spend some time shopping around with different mortgage lenders, as well.

“Some have more stringent guidelines than others,” Kirkland says. “Some lenders might require a 20 percent down payment, while others require as little as 3 percent of the home’s purchase price.”

“Even if you have a preferred lender in mind, go to two or three lenders — or even more — and make sure you’re fully surveying your options,” Pataky says. “A tenth of a percent on interest rates may not seem like a lot, but it can translate to thousands of dollars over the life of the loan.”

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