Your guide to mortgages We lead you from start to finish

Chances are that if you want to buy a home, you’re going to have to take out a mortgage.

But that doesn’t mean the dream of homeownership needs to turn into a nightmare of debt.

Knowing what to expect when you’re looking for a mortgage and understanding everything that’s involved means you won’t have to sleepwalk your way to owning a home.

Mortgage basics

When you think of a mortgage, you probably think about homeownership.

A mortgage is a loan you take out from a lender in order to buy a property. Often you get a mortgage from a bank, but you can also get one from a private lender.

Understanding the types of loans available and what they offer can help you make an informed decision, whether you’re signing your first mortgage or are renewing your current one.

How does a mortgage work?

In order to get a mortgage, you put up your property as collateral against the loan you receive. That means that if you fail to meet the payment schedule of your loan, you could lose your property to the lender. Since you risk losing something for not making payments, this makes mortgages a “secure” loan. In contrast, credit cards are typically “unsecured.” 

When you take out a mortgage, you agree to the loan for a set period of time. The most common loans for property are 15- or 30-year mortgages.

When you pay back the loan, you pay money to both the principal of the mortgage and the interest that the lender charges. The principal is the total sum of the money you borrowed, and the interest rate is a percentage of your monthly payments.

In order to get a mortgage, the lender will check your financial history, including things like credit score and any outstanding debts you have. They will also require a downpayment for the property you buy: you will never be able to get a loan for 100% of the money required to purchase a home.

As you pay back your mortgage, you build equity in your home. Initially, you will be paying a higher amount in interest than principal. As time goes on, and you start to chip away at your repayment, you will owe less in principal and therefore be paying less in interest.

Types of mortgage loans

There are numerous mortgages offered via banks or private lenders, which will all have different rates, requirements and lengths. For new homebuyers and those looking to refinance their mortgage, there's quite a few options.

 Understanding how each mortgage loan type works is key to determining which one to apply for.

• Conventional loans - Conventional loans are not financed by the federal government, and have stricter requirements to qualify. With a conventional mortgages, you can get either a conforming (available to a maximum amount, which is established by Freddie Mac or Fannie Mae) or non-conforming loan (higher limits and typically have higher interest rates and greater down payment requirements).
• Jumbo loans -  Jumbo loans do not conform to limits set by Freddie Mac or Fannie Mac. They require a higher down payment and a credit score and you will probably undergo a more rigorous underwriting process as the lender will want to know you will be able to manage the debt.

• FHA loans - Federal Housing Administration (FHA) loans are primarily (though not exclusively) for first-timers since they generally have lower credit scores.
  

• USDA loans - United States Department of Agriculture (USDA) loans are for people who live in a rural area or a less populous region. They are backed by the Department of Agriculture, so if you fail to make payment the government will step in. These loans typically offer lower interest rates and require no down payment.
  

• Construction loans - These loans generally last for around one year, and typically have higher interest rates and are for shorter terms than conventional mortgages. Construction loans are lent out in phases and need to be paid back once the home is complete, at which point the lender will want to see an occupancy certificate to ensure the work is done and the space is livable.

• VA loans - Veteran Affairs (VA) loan provides active service members, veterans, and some surviving military spouses with loans to purchase property. These loans are guaranteed by the Department of Veterans Affairs, and require no down payment or mortgage insurance.

Fixed-rate vs. adjustable rate mortgages

When it comes to home loans, you generally have two options - a fixed-rate or variable-rate (adjustable rate) mortgage. Each type of loan has its pros and cons, so if you’re deciding between the two, it’s important to know what they offer.

Fixed-rate mortgages

Fixed-rate mortgages offer you the same interest rate for the term of the loan. Your monthly payments will remain constant, but additional fees like property tax and insurance can change.

Eli Sklar, SVP of mortgage lending with Guaranteed Rate, observes that fixed rate mortgages offer “the knowledge and the assurance that the payments on the mortgage will not increase no matter what the future brings in terms of rates and economy.“

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

Pros

• Same monthly payments over the life of loan.
• Easier to budget.

Cons

• If interest rates fall, you’ll still be paying higher fees.
• The longer the term, the more you pay in interest.

Adjustable-rate mortgages

An adjustable-rate mortgage (ARM) starts out with a fixed-rate for a certain number of years. After that, the interest that you pay will adjust with the market. This means that your monthly payments will change as well.

ARMs will be expressed as a combination of two numbers, like “5/1 ARM” or “3/5 ARM”. The first number indicates how many years your initial interest rate will hold for; the second number indicates after how many years the interest rate will adjust. So for a 5/1 ARM, you will have the same interest rate for the first five years, but it will adjust every year after that term.

Pros

• Lower initial monthly payments.
• Can pay more to principal of loan at start.

Cons

• Interest rate can rise after the initial term.
• Difficult to budget for interest rate changes.

If you’re planning on selling your home in a few years, an ARM can be a good option as you will enjoy the benefit of lower interest rates. 

A fixed-rate mortgage is beneficial if you want to remain in your home for a long time as you can budget around the monthly payments.

With both ARMS and fixed-rate mortgages, you have the option of refinancing your loan. This allows you to take advantage of potentially lower interest rates.

“Most people historically do not hold on to a mortgage for more than seven years,” observes Sklar. With an ARM you will not have to worry about rates escalating if the rate is locked for the seven to 10 years.

Test your mortgage knowledge

What is the average mortgage payment (as of March 2022) for a 30-year fixed mortgage?

A) $4,562 B) $3,092 C) $1,230 D) $2,472

Answer: $1,230

Mortgage term lengths

When it comes to choosing a mortgage, there are a lot of factors to consider. How much of a debt load can you handle on a monthly basis? Do you want lower monthly payments or a shorter-term for your mortgage?

• 30-year mortgage rates — The most popular type of home loan. This mortgage is a great solution if you plan on living in your home for an extended period.  While it offers low monthly payments, you will pay more in interest over the duration of the mortgage.

• 20-year mortgage rates — While not as common as some other forms of mortgages, 20-year terms give you a lower interest rate than a 30-year, and cheaper monthly payments than a 10- or 15-year loan. Despite offering predictable monthly payments, 20-year mortgages are more difficult to qualify for. Lenders will want to ensure you can afford the higher fees and have a low debt-to-income ratio.

• 15-year mortgage rates — One of the most common mortgage types, the 15-year amortization period offers lower monthly payments than a 10-year mortgage, and less money going to interest than with a longer term. You’ll probably get a smaller loan with a 15-year mortgage than a 30-year one, and therefore won’t have as much money to buy a more expensive home. Despite this, you will be building equity in your home faster.

• 10-year mortgage rates — If you can afford the higher monthly fees that come with a 10-year mortgage, they offer some big advantages. The shorter-term means that you’ll own your home faster, and you’ll also be paying a lot less in interest over the years. To get a 10-year mortgage, you’ll require a low debt-to-income ratio and good credit, as your monthly costs are going to be a lot higher. You’ll probably also have less purchasing power with a 10-year mortgage, unless you have the cash and can afford a substantial downpayment.

Compare mortgage rates

There's a lot that goes into your mortgage rate. Firstly, they can differ depending on your location. States such as New York and California are infamous for having high mortgages, while Iowa and Indiana are known for being more affordable. 

The federal lending rate also impacts the overall rate that banks and other lenders are offering.

Your credit score, the amount of loan your seeking and the length of your mortgage all contribute to the rate you are offered.

Use our rates comparison tool to see today's interest rates.

Before refinancing, Sklar recommends that you check the cost of the mortgage, and how much you are saving, based on how long you hold on to the new mortgage.

Mortgage rate trends

If you’re in the market for a home, keeping an eye on mortgage rate trends can help save you thousands of dollars on your home loan.

With rates varying from week-to-week, watching when rates climb or start to descend can help indicate when it’s a good time to get pre-approved for a mortgage.

Similarly, if you’re looking to refinance your mortgage or are in an adjustable rate mortgage, it pays to pay attention to what’s going on in the market.

First-time homebuyers

A home is probably the most expensive purchase you’ll ever make. As a first time home-buyer, you might be overwhelmed by the entire process. But there’s no reason to get discouraged.

The first thing you need to consider when buying a home is how much you can afford. When you buy a home, you typically are going to have to make a downpayment, then be prepared to make monthly mortgage payments.

A common rule of thumb is not to spend more than 25% of your take-home income on monthly mortgage payments. This provides you with a nice cushion so you won’t be living beyond your means. Try using a mortgage income calculator to help give you an idea of what your budget might look like when you consider your down payment and interest on your loan.

You’ll also need to consider things like closing costs, taxes, home insurance, and maintenance when figuring out what you can afford.

When it comes to buying a home, there’s a pretty good chance you won’t be able to pay cash for the entire purchase. Instead, you’ll make a downpayment, and the rest you’ll take out in the form of a mortgage. If you make a down payment of less than 20%, you’ll also have to purchase mortgage insurance, which will be folded into your monthly payments.

Mortgages are loans that lenders give you using your home as collateral. Failure to make your monthly payments can result in you losing your home.

Mortgage approval

Getting pre-approved for a mortgage can help make the homebuying process faster. A mortgage pre-approval is a formal letter that a lender gives you, stating how much money you are able to borrow and what interest rate you’ll get.

Another advantage is that it lets you lock into an interest rate before you buy your home.

As you start your search for a home, you’re going to want to find out your credit score. This is a number between 350 and 850 that’s used to measure how you handle debt. The higher the score, the better your credit rating. In order to get a mortgage, most lenders want you to have a score of 620 or greater.

“Make sure to take care of credit scores first,” notes Sklar, “as this will impact best rates and programs in the market.”  

Sklar also recommends that you save as much as possible so you have money to put down for your purchase transaction and have money on [the] side for a rainy day.

When deciding on a mortgage, you’ll also have to choose between a fixed-term or an adjustable-rate mortgage (ARM). Each offers distinct pros and cons, so you’ll want to know what each offers before signing on.

Mortgage type and length

You’ll also want to decide if you want a fixed-term or adjustable-rate mortgage (ARM). Each offers distinct pros and cons, so you’ll want to know what each offers before signing on.

You’ll also need to know how long you want your mortgage term to be — that is, how long it will take you to pay it off. The longer the term, the lower monthly payments you’ll have, but you’ll also be paying more in interest.

When figuring out what your mortgage term should be, Sklar recommends taking into account how long you intend to stay in the home for. Your term should be based on things like “growth of [your] family,  change of work, and market expectations.”

Be sure to compare mortgage rates among lenders to ensure you’re getting the best possible price. Different lenders offer different rates, and a difference of a few percentage points can mean thousands of dollars.

Once you’ve figured out the details of what you can afford, find a realtor or real estate agent that understands your needs and budget. Work with them to find the best home for you, and don’t be afraid to walk away if you find your needs aren’t being met.

After you’ve found a home you like, you’ll make an offer and, if it’s accepted, begin the closing process. A good agent will be extra helpful at this stage, as they will help negotiate the best deal for you, and take care of much of the paperwork.

Using a mortgage calculator

When determining your budget for a home, you have multiple factors to consider. What’s your monthly income? What will your housing expenses be? What will your mortgage payments look like? The best way to know for sure what you can spend is to work with real numbers, and get real answers by using one of these mortgage calculators: 

• Home affordability calculator - Ensure that your mortgage payment is manageable without compromising your other financial priorities by using this calculator.
• Mortgage required income calculator -  Use this calculator to find out if you can afford a mortgage on your dream home, given your income and your other expenses.
• Maximum mortgage calculator - There could be a big discrepancy between what you can and what you should borrow. Find out the max mortgage you could afford based on your income, interest rate and more.
• Mortgage payoff calculator - You could save money on interest and pay off your mortgage sooner, by increasing your monthly mortgage payment. Use this mortgage payoff calculator to see how that works.

Federal programs and grants

Homeownership might feel out of reach at times, especially for low- and moderate-income Americans. You may have shaky credit, or may not have enough saved to make a downpayment. The good news is that there are a number of federal programs and grants aimed to help close the financial gap.

In most instances, the home being purchased with the assistance of a government loan needs to be used as your primary residence.

Good Neighbor Next Door Program:

• For public servants like teachers, firefighters, paramedics, and police officers
• Must live in the home purchased and work in the area for a minimum of three years
  
• Can purchase a home for half of the listed price
  
• Can use any mortgage type as long as it meets the eligibility requirements
  
• Bids must be made by a HUD registered real estate agent

Freddie Mac and Fannie Mae First-Time Homebuyer Program

• Down payments as low as 3%
• Generally requires a credit score of 620 or more
  
• If your income is below the area’s median, you may qualify for special loans
  
• HomeReady and Home Possible loans offer things like alternative paths to prove creditworthiness other than credit score and the ability to use home repair investments as part of downpayment

Getting pre-approved for a mortgage

Getting pre-approved for a mortgage has a lot of benefits. Beyond giving you a better idea of how much home you can afford, it can make the sale of the home quicker, and give you leverage when negotiating a deal - especially if there are multiple bids.

Here’s what you’ll need to get a mortgage pre-approval.

Proof of income: You’ll probably be required to show your W-2 wage statements from the last two years, as well as pay stubs from the last 30 days. Mortgage providers want to know you have an income incoming.

If you have alternative income, like rental property income or you drive for a car sharing company on the side, you’ll want to have this proof of income as well.

Down payment: You’ll need to show that you can make the downpayment for the house, as well as having the cash to cover closing statements. For this you’ll need bank statements or a proof-of-funds letter. You may require a gift letter as well if a family member is helping you with the cash to buy the home.

Credit score: Your credit score demonstrates how much risk you pose as a borrower. The higher the score, the more likely you are to get a mortgage and the lower rate you’ll get.

You can get a copy of this from Transunion, Experian or Equifax, but be careful not to request it too many times as this can affect your score.

DTI: Your debt-to-income ratio (DTI) compares your existing debt to your income. This lets mortgage lenders know whether or not you can handle the additional debt. Generally the lower your DTI, the better the mortgage rate you’ll get.

Other: Be prepared to provide things like proof of identity, bank statements, and rent checks if you’re a renter.

What credit score do you need to get a mortgage?

When applying for a mortgage, generally you’ll require a credit score of 680 or above.

Generally, you’ll want as high of a credit score as possible. A score of above 700 is what many lenders consider average. 

• 740-850 - Excellent — Lenders will feel very confident granting you a home loan if your credit score falls into this category.
• 720-739 - Very good — A 740 credit score is generally the threshold most lenders look for in order to feel comfortable with a borrower.
  
• 700-719 — Average — Many lenders will provide home loans for people with these credit scores, though those at the lower end may have trouble getting a decent mortgage rate without a hefty down payment.
  
• 680-699 — Below Average — A credit score in this range is generally the result of questionable credit decisions, and many lenders will want to stay away. But consumers with these scores may be able to get Federal Housing Administration (FHA) loans.

Refinancing your mortgage

Refinancing your mortgage involves taking out a new mortgage to pay off the remaining loan that you currently have.  

There are a few reasons why you may want to refinance your mortgage:

• To lock into a lower interest rate
• To modify your loan terms. Shorter terms generally mean less interest
  
• To change your mortgage type from an adjustable rate to a fixed-rate or vice-versa
  
• To access the equity you have built into your home

If you’re considering refinancing your mortgage, be sure to consider things like closing costs, potential penalties, and what the current interest rate is. You’ll want to carefully examine these additional costs to determine if refinancing is the right move for you.

Mortgages FAQ

About our author

James Battiston, Staff Reporter

More from this author

Prior to joining Moneywise, James Battiston was a frequent contributor to Ratehub where he wrote extensively on mortgages, home and life insurance, and has broadened his expertise to include retirement. Additionally, he has written content for companies such as Applied Systems, Access Storage and Aphria Inc. He holds an honours BA from the University of Toronto and is a graduate of the Canadian Film Centre. He loves to spend his spare time with his family and drinking copious amounts of coffee.

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