Solved! What Is a Mortgage, and Do I Need One to Buy a Home?

Mortgages, interest rates, DTI ratios, and FICO scores: the word salad involved in buying a home can feel like a whole new language, but understanding the terminology is critical to getting the best loan for your home purchase.

By Meghan Wentland | Updated Jun 16, 2022 3:11 PM

What is a Mortgage

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Q: I’m in the process of buying my first home, and there are so many complexities to the process that I’m overwhelmed. I’ve also realized that while I know I probably need a mortgage, I’m not exactly sure what a mortgage is and whether all mortgages are the same. Do I need one? What decisions do I need to make?

A: This happens to many first-time home buyers, so don’t be embarrassed. There are probably quite a few terms you’ve heard people throw around for years—and maybe even used yourself—that when push comes to shove, you realize you can’t actually define. It’s no surprise that phrases like “mortgage meaning” and “mortgage definition” are some of the first things many new home buyers search for as they begin their process. But you’re right to ask the question, because your mortgage is likely one of the biggest financial decisions you’ll ever make, so it’s a good idea to be as educated as possible before you make the commitment to finance your home purchase.

A mortgage, which is needed by most home buyers, is a secured loan that helps a buyer purchase or refinance a home. 

Most first-time home buyers experience a certain amount of sticker shock when they begin looking at homes for sale, and the shock only increases once the home buyer realizes that they’ll need to pay for homeowners insurance and potentially mortgage insurance on top of the price of the home and closing costs. It’s easy to get overwhelmed. Of course, some home buyers have the ability to pay cash for their home, but that’s pretty unusual; home prices are usually well beyond what most people, especially first-time buyers, can pull together in cash. Home prices also exceed what most borrowers can qualify for through a personal loan. As a result, most home buyers use a mortgage to finance their purchase.

A simple way to describe a mortgage is that it’s a loan a borrower takes from a qualified lender to pay for a home. In taking the loan, the borrower uses the home itself as collateral to guarantee that they’ll pay back the money. If the borrower can’t pay their mortgage, the lender can take the house and sell it themselves to reduce the financial loss. There are types of mortgage loans that can also be taken to refinance or remodel a property. This sounds fairly straightforward, but there are quite a few different types of mortgage loan programs, and there is a certain amount of preparation that borrowers should undertake before they apply to make sure that the most favorable rates and programs are available to them.

What is a Mortgage

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There are several types of mortgage loans available, including conventional, FHA, USDA, and VA. 

Conventional mortgages are the most common home loan product, and these are what most people think of when they consider a mortgage. There are two types: conforming loans and nonconformaing loans. Conforming conventional loans comply with the requirements provided by the Federal Housing Finance Agency, which allow them to be purchased by large loan servicers Fannie Mae and Freddie Mac. These companies purchase loans from lenders after the loans have closed and maintain the servicing of the loan (collecting payments and making sure that homeowners insurance premiums are paid). This is the most traditional type of mortgage loan. Conforming conventional loans typically require a minimum down payment of 3 percent for borrowers with an excellent FICO credit score, but a down payment of less than 20 percent will result in the borrower paying an additional cost for private mortgage insurance (PMI). Borrowers with average credit scores may be required to contribute a larger down payment. A borrower’s credit score and the likelihood that Freddie Mac or Fannie Mae will purchase the loan reduces the overall risk to the lender meaning that the interest rates will typically be lower than they would for borrowers with lower credit scores. Nonconforming conventional loans don’t have to meet the standards for Freddie Mac and Fannie Mae, so those loans may be larger than the maximum allowed or offered to borrowers with less-than-optimal credit.

The Federal Housing Administration (FHA) recognized that the high credit score and down payment requirements for conventional loans were shutting many home buyers out of the market, either because they had struggled with credit problems in the past or had been unable to save the requisite down payment. These borrowers were fully capable of making monthly mortgage payments but struggled to meet the standard to apply. The FHA mortgage program was designed to address these issues. These loans require a FICO score of 580, which is lower than the standard 620 that many conventional loan programs require. Borrowers with a credit score of 580 or higher can make a down payment of as little as 3.5 percent on their home, but borrowers with a score as low as 500 can qualify if they’re able to put down 10 percent on an FHA loan. Because the FHA guarantees these loans (in other words, should a borrower default, the FHA will cover the lender’s financial loss), FHA loans usually have excellent interest rates. FHA loans do require mortgage insurance premium (MIP) payments for the life of the loan or until it is refinanced, but even with that additional monthly expense, FHA loans offer a path to homeownership for buyers who otherwise may not qualify for a mortgage.

The U.S. Department of Agriculture (USDA) also offers a loan program for buyers who might not qualify for a conventional loan. The purpose of these loans is twofold: They offer a way for low- to moderate-income buyers to achieve homeownership sooner, and they bolster the economy and boost the population of rural areas where both may be sagging. USDA loans are available for buyers whose incomes fall below the required limit for their area (limits vary based on the location) who are willing to purchase a home in designated rural areas. The loans are offered with no requirement for a down payment or mortgage insurance. Because the loans are guaranteed by the USDA, lenders can offer extremely favorable interest rates despite the absence of a down payment or insurance. These loans make homeownership a reality for those who have the ability to relocate and who may not be able to afford to buy a home otherwise.

Finally, the U.S. Department of Veterans Affairs (VA) developed a home loan program to recognize the unique challenges to homeownership that active duty and retired military service members experience. Years of public service can result in lower earnings (and therefore less savings) than for those in the public sector, and frequent relocation can make the purchase and sale of homes difficult. The VA loan program requires no down payment and offers low interest rates with no mortgage insurance requirement. While there’s a small funding fee required at closing, it can be rolled into the loan itself, and closing costs are capped to keep them manageable. These loans are available to current or former members of the military and their families.

In addition to the mortgage programs mentioned above, other state and local mortgage programs may be available for members of various organizations, professions, or localities. Therefore, it’s a good idea to do a thorough investigation or choose a mortgage broker who is familiar with the options in your area before deciding what kind of mortgage to apply for.

What is a Mortgage

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Mortgage lenders determine the amount of the loan and the interest rate based on the borrower’s credit score, debt-to-income ratio, down payment, proof of income, tax returns, and more.

The weight of a monthly mortgage payment is significant, and it’s something many first-time home buyers underestimate. Lenders do not want borrowers to struggle to make their payments. Borrowers who find their monthly payments to be a strain are more likely to default, and lenders would rather not undergo the expensive process of foreclosure (where the bank takes the borrower’s home and sells it to recoup its own losses after nonpayment). To make this less likely, a lender will do a thorough review of the borrower’s credit history, income, and other factors before deciding whether it will grant the borrower a loan, and how much of a loan the lender believes the borrower can manage. Essentially, the mortgage application will help the lender assess how big a risk the borrower is to the lender, and then the lender will decide how much risk it wants to take and at what cost. The lender definition of what makes a borrower a good risk will vary slightly with each situation.

In order to apply for a mortgage, the borrower should be prepared to produce documentation of their entire financial history. Prior to the application—ideally long before the application—the borrower should access their credit reports from all three major credit reporting bureaus and check them for accuracy, then begin working to correct any negative items on the report before applying for the mortgage. While the precise formula that lenders use to determine loan amounts and interest rates varies somewhat from lender to lender, the borrower’s credit history and credit score are a significant portion of the calculation. The lender will also consider the buyer’s income, income history as shown on tax returns, and their debt-to-income ratio (DTI). Lenders are interested in the percentage of the borrower’s income that goes toward debt payments each month, as they use the number as a bellwether for how much the borrower will struggle with the payments. Using their credit report, borrowers can calculate this number themselves by adding the minimum payments due on debts each month (such as other loans, credit card payments, and car payments) and the estimated mortgage payment including property taxes, homeowners insurance and mortgage insurance, and then dividing it by the gross monthly income. The total debt payments shouldn’t make up more than 43 percent of the borrower’s monthly income; this is the highest DTI ratio most lenders will allow.