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What is a mortgage, and how does it work?

Yahoo Personal Finance· Getty Images
Updated 4 min read

A mortgage is a specific type of loan used to purchase a home. It’s a secured loan where the home is used as collateral — which means your lender can take your home if you fail to repay the loan.

A mortgage allows a home buyer to buy a house without having to pay the full cost up-front. Instead, the home buyer pays a down payment and repays the mortgage lender via monthly payments until the loan is repaid.

Whether or not you are currently looking to buy a home, it’s important to understand what a mortgage is and how mortgage lending works so you can make the best housing decisions for your situation. Here’s what you need to know.

Read more: How much house can I afford?

A home is likely the most expensive purchase you will ever make — to the tune of several hundred thousand dollars. That’s more money than the average American has available to pay out of pocket, which is why mortgage lending is such a vital part of the housing market.

Instead of paying the full price of the home up-front, a home buyer only needs to contribute a much smaller amount for the down payment because the mortgage lender loans the remaining balance.

Your mortgage lender charges you interest on that remaining balance, which you must repay throughout the life of the loan. Interest is expressed as a percentage, representing the cost of your mortgage on an annual basis.

The amount of money you can borrow for your mortgage depends on several things, including your financial profile and the size of your down payment. Minimum down payment requirements range from 0% to at least 5%, depending on the loan program. However, putting more money down can lower your monthly payment, save you money in interest, and even remove the need for private mortgage insurance in some cases.

Read more: How to get a mortgage with just 3% down

Most home buyers get preapproved for a mortgage before they start looking for a house to buy. When a lender preapproves you for a mortgage, the lender is saying that it is provisionally offering you a loan up to a certain dollar amount and at a particular interest rate. Generally, a preapproval expires within 30 to 60 days of issue.

Typically, you will need these documents to get preapproved for a mortgage loan:

  • State or government-issued identification (such as driver’s license or passport).

  • Your most recent two years’ worth of federal tax returns.

  • Your most recent two months’ worth of paystubs.

  • Statements for bank and investment accounts.

Read more: How to get a mortgage in 2024

Your mortgage interest rate will depend on several factors, including your credit score and history, the size of your down payment, and how much you are borrowing. Lenders determine your rate based on how likely you are to repay your mortgage. If you have a high credit score and a large down payment (thereby lowering the amount you are borrowing), you are a lower risk and can generally qualify for a lower interest rate.

Financial educator Jonathan Thomas says he wishes more people understood how much of their mortgage interest rate is potentially under their control. Thomas explained to Yahoo Finance via email that home buyers can work to reduce their mortgage costs even before they start house hunting.

For example, paying down debt, improving your credit score, and saving for a larger down payment will increase your chances at qualifying for the lowest rates, Thomas said.

Your loan may be either a fixed-rate or an adjustable-rate mortgage (ARM). Typically, lenders will offer ARMs with a lower introductory interest rate compared to a fixed-rate loan. However, the introductory rate will change after a certain period — anywhere from a few months to a few years.

Read more: Adjustable-rate vs. fixed-rate mortgage

In addition to the interest rate, there are additional costs associated with a mortgage.

Specifically, closing costs are the expenses associated with finalizing the sale of the house. For the buyer, closing costs are typically equal to about 3% to 4% of the purchase price of your home. For example, a home with a sale price of $200,000 may have closing costs of about $6,000 to $8,000.

Common closing costs include lender fees, title insurance, appraisal fees, and prepaid property taxes, interest, or homeowners insurance. Some home buyers can roll these costs into the mortgage so they are not paying them out of pocket.

Read more: Closing on a house: What to expect and how to prepare

A traditional mortgage will be repaid over a long period of time — typically 30 years. However, there are shorter terms available, including 15-year mortgage loans. The shorter your repayment period, the more you will pay per month. However, shorter terms tend to have lower interest rates and will cost less over the life of the loan.

Dig deeper: 15- vs. 30-year mortgage

Through a process known as amortization, each monthly mortgage payment consists of a principal portion and a portion that pays the interest you owe. Over time, the portion going to principal will increase while the portion going to interest will decrease. This means your equity increases over time as you pay down more and more of the mortgage balance.