Mortgage 101: Basics Every Home Buyer Should Know

​​For renters, there are more ways than ever to buy your first home.

The government has expanded its low- and no-down payment mortgage coverage, and several bills in Congress propose grants and federal tax credits to first-time home buyers.

This Mortgage 101 guide explains concepts, strategies, and action plans you’ll need to stop renting and start owning.

What Is a Mortgage?

A mortgage is a loan used to finance a home.

87% of home buyers use mortgages to buy homes. Mortgages are popular because few home buyers have hundreds of thousands of dollars in their bank account.

The majority of mortgages pay off over 30 years.

Before we go deep into your mortgage education, let’s review a few key mortgage terms:

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• Lender: the company that funds your mortgage loan
• Borrower: the person receiving the mortgage loan — you!
• Down payment: the amount of cash you bring to the transaction. Down payments may be described in dollar terms (e.g., $10,000) or as a percentage of the home’s sale price (e.g., 3 percent)
• Loan amount: the amount of money still owed on your mortgage loan. Loan amounts are sometimes called principal.
• Loan term: the amount of time you have to pay back your loan. Loan terms are expressed in years (e.g., 30 years, 15 years) or months (e.g., 360 months, 180 months).
• Interest rate: The borrowing rate on your mortgage.
• Fannie Mae & Freddie Mac: the two government organizations that support most first-time home buyer mortgages.

How Does a Mortgage Work?

Mortgage loans are like other loans in your life. You borrow some amount, you get an interest rate at which to pay it back, and there’s a schedule to make your monthly payments.

Mortgage payments are due on the first of each month. Lenders grant a 15-day grace period, then late fees are assessed. Many homeowners use their lender’s autopay features to prevent late payments.

You don’t need a bank account or a pre-existing banking relationship to get a mortgage loan. You can get a mortgage loan at any of the following places:

• Local retail bank branches, such as Chase or Wells Fargo
• Neighborhood mortgage companies, such as Cross Country Mortgage or Caliber Home Loans
• Online mortgage lenders such as Rocket Mortgage or Homebuyer.com / Novus Home Mortgage

Learn more about the differences between mortgage lenders, brokers, and banks.

It’s always good to start your application early — even before you find your first home.

Studies show that home buyers who learn about mortgages get lower rates than those who do not. Educated buyers often pay fewer closing fees, too.

5 Types of Mortgages

The U.S. government created the modern mortgage market in the 1930s. Today, there are five basic mortgage types, each with different qualifying rules.

• Conventional mortgages
• FHA mortgages
• USDA mortgages
• VA mortgages
• Portfolio mortgages

Let’s look at all five options.

Conventional Loans

Conventional loans are usually best for home buyers with salaried or hourly income, some amount of money saved up, and good credit. Conventional loans require a minimum three percent down payment. For smaller down payments, private mortgage insurance (PMI) may be required.

Eighty-one percent of first-time home buyers use conventional mortgage loans, so you probably will, too.

FHA Loans

FHA loans are a fallback option for first-time buyers who fall short of the conventional loan requirements. FHA mortgages allow down payments as low as 3.5 percent and credit scores down to 500.

Approximately 10 percent of first-time home buyers use FHA mortgage loans. They’re popular with home buyers who purchase multi-unit homes for house hacking.

VA Loans

VA loans are loans backed by the Department of Veterans Affairs. Created as part of the G.I. Bill in 1944, VA loans are available to current and past members of the U.S. military. VA loans don’t require a down payment nor mortgage insurance.

Certain veterans are exempt from standard VA closing costs.

USDA Loans

USDA loans are guaranteed by the U.S. Department of Agriculture and designed to promote homeownership in rural and low-density areas. USDA loans are 100 percent mortgages with subsidized interest rates. Home buyers must be of modest means to use the program and purchase a modest home for the area.

Portfolio Loans

Portfolio loans are loans that mortgage lenders make and hold on their balance sheets (i.e., in their portfolios). Government groups don’t back portfolio loans so mortgage guidelines vary by lender. Each lender makes its own rules. Jumbo mortgages are a type of portfolio loan. In general, getting a portfolio loan requires better-than-average income and credit.

See home loans for first-time buyers.

How Do Mortgage Rates Work?

Twelve factors make up your mortgage rate.

Some factors are within your control, such as the state in which you buy your home and your FICO credit score. Other factors are outside your control, such as Wall Street’s attitude on mortgage markets.

The starting point for all mortgage rates is a Wall Street instrument called mortgage-backed securities (MBS).

Mortgage-backed securities are bonds that trade Monday through Friday, from 8:00 AM to 4:00 PM ET. As bond prices change, so do mortgage rates, and bond prices are unpredictable.

However, mortgage bonds are denominated in U.S. dollars, so there are two basic rules:

1. When the U.S. dollar is strong, mortgage rates tend to fall
2. When the U.S. dollar is weak, mortgage rates tend to rise

During periods of low inflation and political stability, the U.S. dollar tends to be strong. That’s good for U.S. mortgage rates. Economic instability, on the other hand, is not.

Mortgage lenders reserve the best mortgage rates for home buyers with high-tier credit scores — 740 and higher. Then, for every 20 points that your credit score drops, mortgage rates often edge higher.

Your mortgage rate is also affected by:

• The state you buy your home in
• The size of your mortgage loan
• The number of years in your loan term

How Often Do Mortgage Rates Change?

The price of mortgage-backed bonds, which are securities bought and sold on Wall Street, determine mortgage rates. Mortgage rates can change anytime the mortgage-backed bond market is open.

Mortgage rates change at least once daily — at the market open. Rates change again when markets are volatile. Several times in the last few years, mortgage rates changed five times in one day, which is challenging to navigate.

When mortgage rates change, open offers for mortgage rates expire. A lender won’t give you yesterday’s rates like a stockbroker won’t give you yesterday’s stock price.

So, when you get a mortgage rate offer you’re comfortable with, lock it.

What Is The Difference Between A Fixed-Rate Mortgage and an Adjustable-Rate Mortgage?

Over the life of the loan, the interest rate on a fixed-rate mortgage doesn’t change — the interest rate on an adjustable-rate mortgage (ARM) can.

For many home buyers, adjustable-rate mortgages are inappropriate. Hence, fewer than five percent of buyers used ARMs over the last ten years.

Here’s how most ARMs work.

• Your mortgage is assigned a teaser interest rate over the first set of years, usually five.
• After the teaser period ends, your interest rate adjusts annually based on a predetermined formula.
• After 30 years, the principal is paid in full, and no more payments are due.

ARMs may show savings in their first few years, but those savings can change once the teaser period ends.

Rules govern ARM interest rates. They can only move a few percentage points per year and can never move more than six points in their lifetime.

What Is a Mortgage Pre-Approval?

A mortgage pre-approval is a dress rehearsal for your actual mortgage approval. Pre-approvals serve three critical functions.

1. They help you determine how much house you can afford.
2. They show home sellers you’re qualified to purchase their home.
3. They reveal potential improvements in your application to get you a better mortgage rate and terms.

Getting pre-approved for a mortgage is different from getting pre-qualified for one.

When you get pre-approved, a mortgage lender reviews your income, assets, and credit report as if you were purchasing an actual home at a specific sale price.

Mortgage pre-approvals are as close as possible to an actual mortgage approval without making an offer. By contrast, pre-qualifications are not close at all.

Pre-qualifications are like credit card offers in your mailbox. There are no verifications or little quality control. Pre-qualifications are worthless PDFs, and sellers don’t accept them as evidence that you’re credit-worthy.

https://youtube.com/watch?v=fKDJkshvvCs

What Do You Need for Mortgage Approval?

Getting a mortgage approval is a cinch after you’re pre-approved.

The specific items you’ll need for your approval will vary based on your mortgage type and how you’re employed. For example, conventional mortgages may ask for two recent pay stubs to show evidence of income. Portfolio mortgages may ask for copies of your federal tax returns.

If you’re salaried, your lender may call your employer to verify your employment. If you’re self-employed, you may be asked to provide an updated profit-and-loss statement with evidence you’re still in business.

If you meet the following criteria, your mortgage approval will usualy be quick and inexpensive.

• You’re a first-time home buyer
• You’re buying a home from a person (i.e., not a builder or corporation)
• You’re salaried at your job and don’t own the company
• You’re making a down payment of at least three percent
• You have a decent history of paying your bills and rent on time

Your mortgage approval may require evidence of assets, landlord contact information, recent W-2s, tax returns, and more if these trait don’t describe you.

Your mortgage lender will make a mortgage approval checklist for you. Most mortgage loans are approved in a few days.

What Is a Mortgage Loan Limit?

Mortgage loan limits are the upper bounds at which government-backed mortgage groups back U.S. buyers.

Loan limits vary by U.S. county and are expressed in dollar terms. Mortgage loan limits are lower in areas where home prices are more affordable. They’re higher in areas with higher home prices.

They also vary by home type.

A one-unit home such as a detached single-family residence or condominium will have a lower mortgage loan limit than a 2-unit home in the same state and county.

Nationwide, there are 3,233 designated counties. The FHFA 2024 conventional mortgage loan limits are:

• 1-unit home: $806,500
• 2-unit home: $1,032,650
• 3-unit home: $1,248,150
• 4-unit home: $1,551,250

The remaining five percent of counties are High-Cost Areas. Loan limits can range as much as 25 percent higher in cities including San Francisco, Los Angeles, and New York City.

• 1-unit home: $1,209,750
• 2-unit home: $1,548,975
• 3-unit home: $1,872,225
• 4-unit home: $2,326,875

Mortgage loan limits are reviewed and updated annually, usually during the last week of November. New loan limits go into effect on January 1 each year.

Mortgage loans exceeding local loan limits are known as jumbo loans. These fall into the category of portfolio mortgages.

What Credit Score Is Needed To Buy a House?

You can buy a home with no official credit rating. Still, the best mortgage rates are for buyers with high credit scores and an excellent financial history.

Mortgage credit scores are different from auto loan credit scores or Credit Karma scores. Mortgage credit scores are based on an algorithm called the FICO model, which is why lenders refer to your score as a FICO.

Your FICO score is a probability statistic scored from 300-850. The higher your score, the more likely you will make on-time payments for the next 90 days. And, if you know how the system works, you can boost your score to get a lower rate.

Your credit score considers five components:

• Your history of making payments on time
• How little of your credit you’re utilizing
• The types of credit you’ve managed in your lifetime
• The number of years you’ve managed credit
• Whether you recently sought out new credit

Payment history and credit utilization account for 65 percent of your overall score. The best way to boost your credit is to pay your bills on time and keep your credit usage down.

Your credit behavior changes will reflect in your score after 30 days, then again after six months. You can increase your score by 100 points or more with diligent effort. Raising your score one hundred points can lower your mortgage rate by one percentage point or more.

https://youtube.com/watch?v=5M4FQOpLwUI

Mortgage FAQs

Now that you’ve learned the mortgage basics, here are answers to other common questions:

What salary do you need to qualify for a mortgage?

Mortgage loans are approved considering affordability and don’t have specific salary requirements.

In general, you may qualify for a mortgage so long as you’re not obligating more than 40-45 percent of your household’s monthly gross income to debt. There are exceptions to this guideline.

What are good mortgage terms?

The 30-year mortgage term is the most popular choice for affordable monthly payments. A 15-year term is also suitable for long-term financial savings and a lower interest rate.

Consult with a mortgage lender to determine which loan term best fits your situation and financial goals.

What is the difference between pre-qualified and pre-approved?

Mortgage pre-qualification isn’t as desirable as pre-approval. Pre-approvals include a credit check and prove your buying power to sellers. Pre-qualifications can provide insight into your financial situation but won’t help you buy a house.

Neither status is a guarantee of loan approval.

What is mortgage insurance?

Mortgage insurance protects your lender if you’re unable to meet contractual obligations. Mortgage insurance may be required depending on your loan choice, down payment, and lender.

There are four types of mortgage insurance available to choose from. Contract length and payment options vary by contract.

What’s the difference between a mortgage cosigner and co-borrower?

A co-borrower owns an equal part of the property along with the buyer. Cosigners hold no homeownership. Learn more about using a mortgage cosigner to buy a home.