What is a Mortgage? A Look at How Home Loans Work and the Approval Process

I still remember getting my very first mortgage as if it happened just yesterday. It was like climbing a mountain every month to keep up with the payments.

But as my hair has gone gray, and I’ve gotten a little more sense, I’ve come to greatly appreciate the chance it gave me to build equity, snag a tax deduction, and, most importantly, have my own home — well, mine and the bank’s, anyhow.

A mortgage is a loan, typically for a home, in which the real estate serves as collateral. In general, you obtain a mortgage loan to purchase a property and make regular payments of principal plus interest over a stated period.

However, if you stop making payments and don’t come to an agreement, the lender can seize ownership of the property through foreclosure.

A mortgage is a type of loan typically issued for the purchase of a home that uses the property as collateral. Failure to repay the loan can result in foreclosure, which is when the lender takes the home back. 

Thanks to mortgages, millions of folks have turned their dreams of owning a home into reality. So, if you’re looking to buy a home, let me break down everything you need to know about a mortgage, including some tips and a few key terms.

Now, regarding mortgages, you’d be best off if you knew the lay of the land. Understanding the key terms and how these loans work will save you from confusion down the line.

Secured Loans for Home Purchases 

Mortgages are secured loans, which means the lender holds your house as collateral. If you don’t pay, the lender can come in and take the home right out from under you. That may sound a tad rough, but for most folks, it’s the only way to afford a place of their own.

Think of a mortgage like this: You borrow a sizable sum of money to buy a home, and you promise to pay it all back over time — with a little (or a lot) extra for the interest. And as long as you pay on time, you get to keep your house as you build up your ownership. 

By staying on top of things, you aren’t just paying for a roof over your head; you’re slowly making more and more of the place yours.

The beauty of a mortgage is that, unlike rent, your money is buying something that belongs to you, not to a landlord. You get the security of a place to call your own, plus the satisfaction of knowing that you are building equity–meaning you own more and owe less as time goes on.

Key Mortgage Terminology

Before we dive into the mortgage universe, you should get familiar with some of the terminology. Some of these terms may be fancier than a prize hog at the county fair, but don’t worry, I’ve laid it out for you in this list:

• Adjustable Rate: This is where the interest rate isn’t set in stone and can go up or down over time.
• Amortization: How do your payments get split between paying off the loan and the interest over the loan’s term?
• Conventional Loan: A mortgage is not backed by the government, meaning you must meet stricter rules to get one.
• Down Payment: The cash you fork over upfront when buying a house is usually a chunk of the total price.
• Earnest Money: A good-faith deposit you make to show you’re serious about buying the property; it’s part of the down payment later.
• Equity: The part of the home you truly own is equal to the home’s current value minus the mortgage balance.
• Fixed Rate: A loan where the interest rate stays the same from start to finish—no surprises.
• Government Loan: Mortgages backed by Uncle Sam, like FHA or VA loans, tend to have easier requirements.
• Loan-to-Value Ratio: The percentage of the home’s value that you’re borrowing, compared to how much you put down.
• Mortgage Insurance: You’ll need insurance if your down payment is less than 20%, protecting the lender in case you can’t pay.
• Mortgage Term: The amount of time you have to pay off the loan, usually stretching out 15 or 30 years.
• Non-Qualified Mortgage: A mortgage that doesn’t meet the typical guidelines is usually for folks with trickier finances.
• Prepayment Penalty: A fee you might face if you pay off the mortgage too early—some lenders don’t like losing the interest money.
• Principal: The original amount you borrowed does not include the interest.
• Qualified Mortgage: A mortgage that meets the government’s guidelines protects both you and the lender from risky loans.

You don’t have to memorize all these terms because you can always come back if there’s any confusion. But now that you have the gist of the vocabulary, you’ll be ready to talk about mortgages like a seasoned pro. It’s just like knowing the secret recipe to Aunt Mabel’s famous meat loaf — it makes the whole process go a lot smoother!

How Mortgages Differ from Other Loans 

A mortgage loan is quite different from other types of loans you may have heard about. First, it is secured, so the house itself is considered collateral to mollify the lender. Compare that with unsecured credit cards and personal loans, where, short of taking you to court, there’s nothing for the creditor to grab if you don’t pay.

In contrast, a mortgage gives lenders an asset to fall back on, and that’s why interest rates tend to be lower for mortgage loans than for other loans.

The second big difference is payback time. While most loans get paid off in a few years, a mortgage can stretch out for 15, 20, or even 30 years. That long span gives you manageable payments, but it also means you’re in it for the long haul (although you can sell the property at any time). 

Another thing about mortgage loans is that you have to jump through a bunch of hoops to get one. You must show you have a good enough credit rating, adequate income for payments, and cash for your down payment, 

Personal loans or credit cards? Those get approved much faster and with fewer headaches. Still, they also come with higher interest rates and no avenue to ownership of something of value (except perhaps a good credit score if you pay on time).

Unlike almost any other loan, you usually can deduct a mortgage’s interest from your taxes. In some states, you can also deduct your property taxes. There’s occasionally talk in Washington of revoking these deductions – I would hate to be the politician responsible for that!

Lastly, every time you pay down that mortgage, you are building up equity in your home — giving you real wealth that no personal loan or credit card can offer.

You really should know, when thinking about getting a mortgage, the types available. Not all mortgages are created equal, so the type may make a huge difference in how comfortably you can afford the payments. Here are some of the main types you are likely to come across to help you choose the best one for your situation.

Fixed-Rate Mortgages

A fixed-rate mortgage is as steadily reliable as that faithful mule you keep out back. It carries the same interest rate for the entire life of the loan. This means your monthly payments never change, no matter what happens to interest rates elsewhere–so you’ll never be caught off guard by a bigger bill. 

It’s a good option if you love the comfort of knowing exactly how much you’ll pay each time.

Fixed rates depend on how long your loan is and your credit situation, and they can also vary based on current market conditions. But those rates will rise and fall as the economy goes through its ups and downs. 

What’s great about this is that once you lock in that rate, it stays locked, come what may to the economy or interest rates. That kind of predictability helps you sleep at night, except for that talkative mule back there.

Adjustable-Rate Mortgages (ARMs)

An ARM starts off with a lower interest rate than a fixed-rate loan, but don’t get too cozy — after a while, that rate almost certainly will go up. Sure, things may be all peachy for the first few years with those smaller payments, but when that adjustable part kicks in, your rate and payments start changing. 

This means that the rate will be set by the lender according to what’s going on in the credit market, so you could actually be paying more or less, depending on how it all shakes out.

Most ARMs provide a fixed rate for the first 3, 5, or 7 years in which your payments are nice and steady. After that, the rate can change, sometimes as often as yearly.

A low-rate ARM can save you some cash if you’re planning to move or refinance before the fixed term ends. However, if you stick around after that adjustment period, well, you’d better hope interest rates don’t skyrocket, or you could be shelling out more each month than you bargained on.

Now, something that can sneak up on you is an arrangement called a balloon payment. That’s where the lender hits you with one gigantic payment at the end of your ARM term. The good news is, you don’t have to let that balloon pop your wallet. 

You can roll that payment right into a nice, predictable fixed-rate mortgage, paying it off over time instead of all in one go. The only fly in the ointment will be a new set of fees you’ll have to cough up. 

Thankfully, most ARMs have caps on how high the interest rate can jump in any one year (and overall) to keep things from getting too wild. 

Same with ARMs. Those interest rates may start off low and increase little by little. The next thing you know, if you aren’t careful, you could be stuck with steamy payments that put you in financial hot water.

Government-Backed Mortgages 

Government-backed mortgages are a helping hand from Uncle Sam when you’re trying to buy a house. The loans — from the FHA, USDA, and VA — are backed by the government, which means it takes some of the risk off the lender.

What that means for you is easier qualifying, lower down payments, and a better chance of getting into a home without having perfect credit or a huge amount of money saved up. 

Take FHA (Federal Housing Administration) loans, for example. They are a favorite among first-time homebuyers because they do not require much of a down payment. With just 3.5% down, you can get yourself into a home, and you don’t need a perfect credit score, either.

USDA (U.S. Department of Agriculture) loans are designed for folks living in rural areas. These loans will let you buy a home with no down payment whatsoever so long as you meet the income requirements. That is one of the best deals you can find!

And if you served in the military, well, first off, thank you for your service! You’ve got access to VA (Veterans Administration) loans, the holy grail of home loans. No down payment, no mortgage insurance, and you can often get a lower interest rate. It’s the government’s way of saying, “Thanks for your service.” 

Now, all these government-backed loans have certain quirks and rules, but for many people, they are the golden ticket to getting into a place they can call home.

When you are in the market for a mortgage loan, it becomes pretty necessary to know what lenders are looking for. They do not offer loans to everyone who comes knocking on their doors. No, indeed, they have certain things they check to ensure that you are capable of managing the commitment. Lenders look at credit scores, current levels of debt, income, and even your cash at hand for down payments.

Typical Credit Score Requirements 

Your credit score is your financial report card and carries a lot of weight when trying to qualify for a mortgage loan. That score, plus your credit report, helps the lender figure out how much risk it faces in offering you a loan. The higher your score, the better your chances of getting approved with a competitive interest rate.

If your credit score is on the lower side, you can still get a loan. However, it can carry higher rates and less accommodating terms. Typically, if you apply for a conventional loan, you want a credit score of at least 620. Even a small increase in your credit score can give you a better interest rate, which can dramatically impact how much you pay over the life of the mortgage.

Here is a chart showing examples of how much you will pay on a 30-year mortgage depending on your interest rate:

FHA loans, with government backing, are a bit more lenient — you can qualify with a score as low as 580 and, in some cases, even 500 if you put more money down. 

USDA-backed mortgages typically require a score of 640 or higher. The VA doesn’t set a minimum score requirement for its loan backing, although the banks doing the actual lending usually want to see scores of 580 and up.

Debt-to-Income Ratio Expectations 

Lenders take a long, hard look at your debt-to-income ratio (or DTI), the fancy name for how much of your monthly income is dedicated to paying off debts. They have to be convinced you will have money remaining after you pay your debts each month to repay the mortgage without tying yourself up in knots.

The lower the DTI ratio, the more wiggle room you have, and that’s where lenders start to feel all warm and fuzzy inside. 

Lenders, for most loans, want your DTI ratio to be under 43%. That means that 43% of your monthly income goes toward debts like car loans, credit cards, and, of course, your mortgage.

If your DTI ratio gets too high, you may need to pay off some of your existing debt or increase your income to meet the lender’s standards.

Down Payment Impact 

The more money you can put down, the easier it will be to qualify for a mortgage. Most conventional loans take a minimum of 5%, but if you can swing 20%, then you won’t have to pay for mortgage insurance.

Lenders require insurance when you haven’t put down enough cash. They use it to protect themselves should you be unable to make payments.

FHA loans are more lenient in terms of the down payment. If your credit score is 580 or above, you can get away with 3.5% down. If your score is between 500 and 579, you must make a minimum down payment of 10%. 

The size of your down payment may also come into play when determining the rate you’ll be offered, which means that the more you put down, the more money you’ll save over the life of that loan. 

Putting more down upfront also means you start out with more equity in the home. That gives you a little extra cushion if the value of your home drops or if you ever decide to sell it.

Acquiring a mortgage is not a one-step deal — it is more like a long journey down a bumpy road. That is where you could probably use some guidance through the whole process, from filling out the first application to actually getting the keys to your new place.

Preapproval and Application 

The first big step in the process of getting a mortgage is to get preapproved. Being pre-approved shows sellers that you are serious and gives you an idea of how much house you can afford. 

You’ll have to gather up your financial papers: Pay stubs, tax returns, bank statements, and such. After that, the lender will assess your income, credit history, and debts. If it gives you the thumbs-up, you can start hunting for a home! 

Once you find your dream property, you can fill out the formal application for a mortgage. It probably will require additional documentation and a smidgen of patience — lenders need to have the home appraised and inspected before approving your loan.

Home Appraisal and Inspection 

Before the lender parts with the cash, it’s going to ensure the house is worth what you’re paying. In other words, the loan-to-value (LTV) ratio must meet certain requirements.

That’s where a home appraisal comes in. The appraiser checks out the place to see if it’s priced right, given its current condition and the recent sales of comparable properties. 

The lender (and you) require a home inspection to make sure there aren’t major problems with the property, like leaky pipes or a roof about to cave in.

Both are key steps in protecting your investment.

Closing and Finalizing a Mortgage

Closing is, of course, the final hurdle that lies between you and what you will soon be able to refer to as “home sweet home.”

You’ll sit down with a pile of documents to sign, including that credit agreement and title documents. 

When it’s all signed, sealed, and delivered, the lender wires the money, hands you the keys, and voilà! You’re a new homeowner!

The down payment is due now, as are any other closing costs. In some states, it’s customary to tip the attorney representing the title company. 

I remember being told that about five minutes into my first house closing, and believe me, I wasn’t particularly pleased about handing over $100 to a guy who probably earned three times as much as me.

Now that you have a good idea about the mortgage process, you’re better prepared for it than a squirrel who’s stored a stash of acorns for winter. A little knowledge and some planning will help you obtain that dream home of yours. 

Round up your paperwork, adjust your thinking cap, view the movie “The Money Pit,” and get ready to take the plunge into homeownership!