Mortgage 101: Basics You Need To Buy Your First Home

​​For renters, it's simpler than ever to buy your first home. 

The government has expanded its low- and no-down payment mortgage coverage over the last year. Currently, there are two bills in Congress to give grants and federal tax credits to first-time home buyers.

Buying your first home doesn't have to be scary. Six million people buy properties each year, and there's a clear path forward for renters who want to own.

This mortgage 101 guide walks you through the homebuying process. It explains the concepts, strategies, and action plans you'll need to stop renting and start owning.

Let's get started on the road to your mortgage pre-approval.

Table of Contents

What Is a Mortgage?

A mortgage is a loan used to finance a home. 

Eighty-seven percent 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:

  • 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.

Mortgage 101: A mortgage is a type of loan used to purchase a home.

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 pre-existing 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

It's wise to apply early — even before you find a home to buy. 

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

Learn about mortgages through our Homebuyer Curriculum.

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 rules to qualify.

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

Let's look at all five options.

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

Mortgage 101: Conventional loans are the most common mortgage type. Fannie Mae or Freddie Mac usually backs them.

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. 

Mortgage 101: FHA loans are ideal for low- to moderate-income buyers, backed by the Federal Housing Administration (FHA).

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.

Mortgage 101: Active duty military service members and veterans, surviving spouses, and Reserves and National Guard members may receive VA loans backed by the U.S. Department of Veterans Affairs.

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.

Mortgage 101: USDA loans are backed by the U.S. Department of Agriculture (USDA) and are for home buyers of modest means purchasing modest homes.

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 there are no standard means of approval. 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. 

Mortgage 101: Jumbo loans are the most common non-conforming loan, ideal for when home costs exceed conforming home loan limits. Freddie Mac and Fannie Mae can't buy jumbo loans.

 

How Do Mortgage Rates Work?

Twelve factors make up your mortgage rate. 

Some factors are within your control, such as the state you buy your home in and your FICO credit score. Other factors are outside your control, such as inflation rates.

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 should fall
  2. When the U.S. dollar is weak, mortgage rates should 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 terrible.

You can't affect geopolitics or the world economy, though, so focus on your personal traits.

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

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

As a home buyer, present yourself as a low-risk buyer, and you'll get the lowest rate. If you need help with this step, ask us how.

 

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 the same way a stockbroker won't provide you with yesterday's stock price.

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

Mortgage 101: Interest rates change every weekday, Monday through Friday. 

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. When in doubt, choose fixed.

There are scenarios when ARMs make sense, though. 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.

At today's mortgage rates, adjustable-rate mortgage rates can be 0.75 percentage points below comparable fixed-rate mortgage rates, saving home buyers $500 per year for every $100,000 borrowed.

Annual savings change after the teaser period ends.

Since 2003, ARMs have adjusted downward. However, when ARMs adjust higher, it's not all terrible. 

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. If that sounds scary to you, remember that the same forces that make ARM rates go up are the ones that push your savings account rates higher, too.

Fixed-Rate Mortgage Adjustable-Rate Mortgage
  • Interest rate never changes
  • Mortgage payments are predictable
  • May have lower mortgage fees
  • Interest rate changes after teaser period expires
  • Mortgage payments are unpredictable 
  • May have a lower beginning mortgage rate

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 you can get to an actual mortgage approval without making an offer.

By contrast, pre-qualifications are the farthest you can get.

Pre-qualifications are like credit card offers that come to you by mail. There are no verifications or quality control. Pre-qualifications are worthless PDFs, and sellers don't accept them as evidence that you're credit-worthy.

If you're serious about buying a home, get pre-approved instead. Mortgage pre-approvals are valid for 90 days.

 

What Do You Need for Mortgage Approval?

Getting an official mortgage approval is a cinch if you're already pre-approved.

A final mortgage approval requires a signed purchase contract for a home — a pre-approval doesn't. Your verifications may also require an extra level of detail. 

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 be fast 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 this isn't 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 support U.S. home 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. In 95 percent of them, the 2021 conventional mortgage loan limits are:

  • 1-unit home: $548,250
  • 2-unit home: $702,000
  • 3-unit home: $848.500
  • 4-unit home:: $1,054,500

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: $822,375
  • 2-unit home: $1,053,000
  • 3-unit home: $1,272,750
  • 4-unit home:: $1,581,750

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 that exceed the local loan limits are also 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.

Minimum Credit Score by Loan Type
Conventional Loan 620
FHA Loan 580
VA Loan* 580
USDA Loan* 620
Jumbo Loan 680

 

*No official credit score minimums. Minimums enforced by lenders.

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.

 

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. 

So, now you're a mortgage pro who's prepared to make your first home purchase. If you're hungry for more knowledge, our Homebuyer Curriculum covers the entire homebuying process from start to finish. 

Happy homebuying!

Dan Green

Dan Green

Dan Green is a former mortgage loan officer and an industry expert. He's appeared on NPR and CNBC, and in The Wall Street Journal, Bloomberg, and dozens of local newspapers. Dan has helped millions of first-time home buyers get educated on mortgages, real estate, and personal finance. Have mortgage questions? Ask Dan in the chat.

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