Mortgage Basics Explained: Key Terms and Concepts

What is a mortgage?

A mortgage is a loan used to purchase a home or other type of real estate. The home itself serves as collateral for the loan, which means if you fail to repay the mortgage, the lender has the right to take the title to your property.

Mortgages are typically repaid over a set period, such as 15 or 30 years, through monthly payments that include principal and interest. Understanding the basics of how mortgages work is the first step toward making informed decisions about buying a home.

Sources: Freddie Mac

Key mortgage terms

To navigate the mortgage process, you need to understand several key terms that will appear in loan documents and discussions with lenders.

• Principal: The amount you borrow from a lender to pay for a home before any interest is added. It is the total financed amount on which interest begins to accumulate.
• Interest: The amount you must pay in addition to the principal amount borrowed, typically represented as a percentage rate based on the total balance remaining on the loan.
• APR (Annual Percentage Rate): The effective percentage you pay for your mortgage each year, including not only interest but also extra costs such as broker fees, points, closing costs, and other fees. APR is usually higher than the nominal interest rate because it incorporates additional fees beyond interest. Comparing APRs is important because different lenders can offer the same interest rate but different APRs due to different fee amounts.
• PMI (Private Mortgage Insurance): Insurance that may be required if your down payment on a conventional loan is less than 20% of the home purchase price. PMI protects the lender, not the buyer, if the borrower stops making mortgage payments. Once you reach 20% equity, you should request to cancel PMI to reduce your monthly payment.
• Equity: The difference between your home's current market value and the outstanding balance of your mortgage and any other monetary liens against the property.
• Escrow: An account set up by the lender to pay property-related expenses like property taxes and homeowners insurance. It is funded by the borrower as part of the monthly mortgage payment.

Sources: Fannie Mae, Consumer Financial Protection Bureau (CFPB), Freddie Mac

The home loan process overview

The mortgage application process typically involves several steps, from initial preparations to the final closing. Knowing what to expect can help you move through the process with confidence.

• Get preapproved: This involves a lender reviewing your financial situation to determine how much you can borrow.
• Submit a formal application: You provide detailed information about your income, assets, and employment. Common documents include recent pay stubs, W-2 forms, tax returns, bank statements, and proof of employment.
• Underwriting: The lender verifies your information and assesses your creditworthiness.
• Appraisal: An independent assessment of the property's value to verify collateral.
• Title search: Ensures the property is free of liens or other issues.
• Closing: You make the down payment and sign the mortgage documents.

Sources: Freddie Mac, Consumer Financial Protection Bureau (CFPB)

Common types of mortgages

There are several types of mortgages available, each designed to meet different needs and financial situations.

• Fixed-rate mortgage: Locks in one interest rate for the life of the loan, so your monthly payment for principal and interest remains the same for the entire term.
• Adjustable-rate mortgage (ARM): Has an interest rate that can change over the life of the loan. Rates for ARMs typically start off lower than those of a fixed-rate mortgage.
• Conventional loan: A home loan that is not insured or guaranteed by a government agency such as FHA, USDA, or the VA.
• Conforming loan: A type of conventional loan that meets the terms and conditions set by Fannie Mae, Freddie Mac, and the Federal Housing Finance Agency.
• Government loans: Such as those issued by the FHA, which require mortgage insurance (MI) similar to PMI but typically do not have the option to cancel once you reach 20% equity.

Sources: Freddie Mac, Fannie Mae, Consumer Financial Protection Bureau (CFPB)

How mortgage payments are calculated

Your monthly mortgage payment typically includes principal, interest, and any escrowed property taxes and insurance. It may also include homeowners association fees if applicable.

The principal and interest portion is determined by the loan amount, the interest rate, and the loan term through a process called amortization. Amortization is the process of paying off a loan in regular installments over a period of time.

Over time, the interest portion decreases and the principal portion increases, so the loan is paid off by the end of the term.

Sources: Fannie Mae