What Is a Mortgage? A Comprehensive Guide to Home Loans

Most people need to borrow money to buy a house. A loan used to buy a house is called a home loan or a mortgage. According to the National Association of REALTORS®, 74% of all homebuyers last year used a mortgage. For first-time homebuyers, 91% financed their home purchase. Even though mortgages are common — millions of people take out mortgages each year — it benefits you to learn about the different mortgage types and how they work so you can choose the right mortgage product for you.

What is a mortgage and how does it work?

A mortgage allows people who don’t have hundreds of thousands of dollars saved up to own a home. But there’s also risk involved. The Consumer Financial Protection Bureau defines a mortgage as “an agreement between you and a lender that gives the lender the right to take your property if you don’t repay the money you’ve borrowed plus interest.”

To be approved for a mortgage, you need to demonstrate to lenders that you can afford to make the mortgage payment each month. This payment consists of the loan’s principal and interest, in addition to property taxes and homeowners insurance. When you apply for a mortgage, lenders will often want to see proof of income, employment history, how much debt and savings you have, and your credit score.

What are the different types of mortgages available?

There are three types of mortgages available:

• Conventional: This is the most common mortgage loan type. Because conventional loans are backed by private lenders and not the government, it’s typically more difficult to qualify for one. You might need a higher credit score to be approved, for example. Conventional loans typically cost less in interest and fees than government loans.
• Government: The government backs certain mortgage loans, making them more accessible for people who otherwise might not be able to get a mortgage. FHA loans are useful for first-time homebuyers who may not have an extensive credit history or large down payment. There are also government-backed loans for veterans (VA loans) and rural homebuyers (USDA loans).
• Special program: State and local mortgage programs might be available in your area for low- to middle-income first-time homebuyers or public service employees. Programs are also available for low- to middle-income borrowers in targeted communities.

What is involved in the mortgage application process?

You’ll go through several steps in the mortgage application process:

• Pre-approval: You should apply for a mortgage pre-approval before you start looking for a home. When you’re pre-approved, a lender provides you with a letter that states how much of a loan you qualify for. You (or your real estate agent) can present the pre-approval letter to a seller to show you’re a serious buyer. To be pre-approved, you’ll typically provide a lender your driver’s license or passport, pay stubs from the last two months, federal income tax returns from the last two years, and bank account statements. The lender will also run a credit check-. A lender pre-approval is typically good for 60 to 90 days. You’ll still need to apply for the final mortgage.
• Apply for a mortgage: When you’ve found a house you want to buy, you’re ready to apply for a mortgage loan. The process is similar to the pre-approval process, but this time, your application goes through underwriting to determine whether you’ll be granted final approval.
• Close on the loan: The last stage in the mortgage process is closing. At this time, you’ll need to pay the down payment on the house and the closing costs on the loan, which are usually between 2% and 5% of the loan amount. 

How do mortgage rates affect home loans?

The interest you pay on your mortgage loan becomes part of your mortgage payment. The higher the interest rate, the more you’ll pay each month, so you’ll want to choose a mortgage type and lender that provides you with the lowest interest rate.

Here's an example of how much interest rates can affect your mortgage payment: In January 2021, the average interest rate on a 30-year fixed-rate mortgage dipped to a low of 2.65%. Since then, interest rates climbed to 7.79% by October 2023. On a $400,000 mortgage loan, the monthly payment on a loan with a 2.65% interest rate would be about $1,612, compared to $2,877 with a 7.79% interest rate (a difference of $1,265 a month). As of December 2024, 30-year loan interest rates were hovering just below 7%.

What are FHA loans and how do they differ from other mortgages?

FHA loans differ from conventional loans in several ways:

• Backed by the government: FHA loans are backed by the Federal Housing Administration, a government agency. Because these loans are insured by the government, lenders are more willing to give borrowers with a lower credit score and less money for a down payment a mortgage loan with more favorable terms. Conventional loans aren’t backed by the government, making it riskier for lender. As a result, the requirements for approval are typically higher. You might, for example, need a higher credit score, a lower debt-to-income ratio, and a bigger down payment to qualify for a conventional loan.
• Mortgage insurance: You’ll need to pay for mortgage insurance as long as you have an FHA loan. To stop paying this mortgage insurance, you’d need to refinance the loan to a conventional loan. On the other hand, with a conventional loan, your lender may require private mortgage insurance (PMI) if you have less than 20% equity. If you can make a 20% down payment on a conventional loan, you won’t pay PMI at all. If you make a smaller down payment, you’ll pay PMI until your equity reaches 20%. 
• Loan limits: Both FHA and conventional loans have limits to how much you can borrow. The Federal Housing Administration sets the loan limits for FHA loans, and the Federal Housing Finance Agency (FHFA) sets the loan limits for conventional loans. Loan limits for both loan types vary based on geographical area.