What is a Mortgage? Types & How They Work

Vault’s Viewpoint

• Mortgages are loans people use to purchase real estate
• Mortgages get paid back with interest, and the interest rate depends on the financial profile of the borrower and the property they’re buying
• Plenty of types of mortgages are available in 2024 and homebuyers should look carefully at their options before choosing

Home Mortgage 101

What is a mortgage? In its simplest terms, a mortgage is both the loan used to buy real estate and the agreement between you and the lender regarding that loan. 

Here, we’re going to focus primarily on the home mortgage: a loan you use to buy your primary residence. But there are other types of mortgages, like loans used to buy land or commercial property. 

How Does a Mortgage Work?

Mortgages work similarly to other types of debt you may have taken on, like a car or student loan. You borrow money from a lending institution. In exchange, you agree to pay them that sum back plus interest. The amount you can borrow and the interest you get charged depend on factors that are specific to you (like your credit score) and the house you’re buying (like its value as determined by an appraisal). 

The amount of time you have to pay back your mortgage is called its term. Most mortgages come with a term of 15 or 30 years.  

How Mortgage Lending Institutions Protect Themselves

As you might expect, mortgage lending institutions aren’t keen to hand out hundreds of thousands of dollars with little certainty that they’ll get it back. So they put a few safeguards in place: 

• Collateral. The house you’re buying serves as collateral for your home mortgage. In other words, your mortgage acts as a lien, or claim, on your home. If you stop making your mortgage payments for long enough—lenders call this going into default—your lender can take the house. They’ll then usually sell it to recover their losses. 
• Underwriting. Before you can get a mortgage, you have to go through an approval process called underwriting. During underwriting, the mortgage lending institution will look at your financial history, your income and more. They use that info to decide if they think you’ll be able to repay your home mortgage. 
• Personalized interest rate. If the lender does approve you, they adjust the amount they charge you in interest based on how risky they deem you. Things like a steady income and a high credit score can help you secure a lower interest rate, while bad credit or a lot of other debt usually means a higher rate. 

Types of Mortgages

There are many types of mortgages, from land loans and commercial mortgages to a variety of home mortgage options.

If you’re hunting for your primary residence or a vacation home, your choices as far as types of mortgages include:

• Conforming loans. Most homebuyers go this route. These loans conform to the loan limits laid out by the Federal Housing Finance Agency (FHFA) each year. In 2024, that’s $766,550 for single-family homes in the majority of the country—although the limit goes up if you live in an area where homes are pricier. 
• Nonconforming loans. If you want a loan over the FHFA’s limit for your area, you’ll need a jumbo loan, one type of nonconforming loan. Other nonconforming loan types include interest-only loans, hard-money loans and holding mortgages. Nonconforming loans come with more risk, which usually gets passed on (at least in part) to the homebuyer in the form of a higher interest rate. 
• Government-backed loans. If you qualify for one of these loan programs insured by the federal government, it can help you score a lower interest rate. Government-backed mortgages come in three forms:
  • FHA loans. Backed by the Federal Housing Administration (FHA), these loans make it possible to buy a house with a credit score as low as 500. That said, these loans come with a lower loan maximum ($498,257 for most of the country in 2024) and an added cost called a mortgage insurance premium (MIP). 
  • USDA loans. To qualify for these loans backed by the United States Department of Agriculture (USDA), you need to be below a certain income level and buy in a designated rural or agricultural area. If you can qualify, these mortgages come with the added perk of no down payment requirement. 
  • VA loans. If you’re active-duty military or a veteran, the Department of Veterans Affairs can back your loan. VA loans also don’t require a down payment.  

Fixed vs. Adjustable-Rate Mortgages

Whichever type of home mortgage you choose, it will fall into one of three categories: fixed-rate, adjustable-rate or hybrid. 

How do mortgages work within these buckets? Let’s take a closer look:

• A fixed-rate mortgage is a type of home loan where the interest rate doesn’t change for the entire life of the loan. If you get a 30-year fixed-rate mortgage with a 7.04% interest rate, you’ll pay that much interest on your remaining loan balance for all 30 years. That means that as you pay down your balance, the amount of interest you’re paying shrinks, too. 
• With an adjustable-rate mortgage (ARM), your lender can adjust your interest rate. The rate on an ARM gets tied to a specific benchmark like the ​​Secured Overnight Financing Rate (SOFR). If that rate goes up, your interest rate will too. But if that rate goes down, your interest rate will drop as well. These rate adjustments happen at periodic intervals (usually, annually) as laid out in your loan terms.
• You can also get a hybrid mortgage, which means the loan starts with a fixed-rate period, then moves into an adjustable-rate one. For example, a 5/1 hybrid ARM gives you a fixed-rate mortgage for the first five years. After that point, the interest rate adjusts annually. 

Experts often recommend a fixed-rate home mortgage for first-time homebuyers. This way, you’re never wondering, “What is my mortgage going to cost this month?” You get a fixed payment that stays the same for your entire loan term. 

That said, in the high interest rate environment we’ve seen recently, exploring an ARM or hybrid loan could be advantageous. 

The Mortgage Lending Process

If you want to buy a house, you’ll need to know what a mortgage lender will require and how to get the best interest rate possible. Pay attention to the following to get the most affordable home loan with the best terms for you. 

Step 1: Get Pre-Approved for a Mortgage

Pre-approval is the first step in qualifying for a mortgage loan. You give the bank information about your financial status, and they determine how much you’re qualified to borrow, which can then inform your home shopping budget. The steps for getting pre-approved are as follows:

1. Check your credit report and score. Your lender will perform a hard pull on your credit to check your credit score, but you can look at it beforehand from your credit card or bank (many of them allow you to check this for free on their website). You can also get a free copy of your credit report weekly from each of the three credit bureaus (TransUnion, Equifax and Experian) by visiting www.annualcreditreport.com. Aim for the highest credit score you can so you will qualify for the best rates and terms on a loan.
2. Check your debt-to-income ratio. Lenders use this number to make sure you’re not taking on too much debt with a mortgage. To calculate your debt-to-income ratio, add up the monthly total of your debt payments, including credit cards, student loans, etc. Divide the total by your monthly income. Banks like to see a ratio of less than 36%, though some may allow up to 43%.
3. Gather documents. Round up your tax returns, pay stubs, profit and loss sheets (if you’re self-employed), loan documents and bank or investment statements to prove your assets, income and debt amounts.  
4. Shop lenders. Banks and lenders vary in their requirements, terms and interest rates, so don’t be afraid to shop around and get the best rate out there. Even if you get preapproved by multiple lenders, it only counts as one hard pull on your credit if it’s within a 45-day window.

Step 2: Compare Your Options

Don’t just go with the first lender you choose. Even a small decrease in your loan interest rate can save you thousands of dollars over the life of your loan. It’s well worth shopping your options here. 

Do your research into the best mortgage lenders out there. Then, request rate quotes from at least three of them. 

Step 3: Underwriting

Once you settle on a lender, it’s time to apply for your mortgage. When you submit your application, the lender starts this part of the process. Essentially, underwriting means they take a long, hard look at you, your potential loan and the home you’re buying. 

Underwriting usually includes a credit check on you and anyone you’re borrowing with (like your partner) and an appraisal. During the appraisal, a professional determines how much the house you’re planning to buy is worth. If it’s worth less than the loan you’re applying for, you’ll run into issues. 

While underwriting can take a while, you usually don’t need to do much work during this step. Sit tight and wait for the lender to make a decision.

Step 4: Approval and Closing

If the mortgage lending institution approves your loan, you move into the final stage called closing. This means reviewing and signing a bunch of paperwork, plus paying closing costs. Usually, those include the fees the lender charges for originating (like assessing and approving) your loan, plus things like property taxes and home insurance for your future home. 

Once you reach that point, congratulations. You can now buy your house with your newly secured home mortgage.

Mortgage Broker vs. a Bank

Like insurance brokers, mortgage brokers work with a variety of banks and lenders to help you find the right loan for your circumstances. They can help you shop around without needing to contact multiple institutions yourself. But they charge a fee for their services, which may be explicit or built into the mortgage cost.

Working with your bank or credit union directly may cut out the middleman, but a single bank or even two or three may not have the type of mortgage that works with your credit profile or other financial constraints. 

Is it better to use a mortgage broker or a bank?

Each has pros and cons. A mortgage broker may have access to more types of mortgages that you can choose from and offer you more customized assistance. 

On the other hand, you may have a foot in the door if you already have a relationship with your local bank, which could grant you a discount or easier approval as they can see your banking history. Plus, you could save money on fees as you don’t have a broker to compensate.

One isn’t objectively better than the other; it comes down to your preference and the rates and terms you can find with each.

Newsweek writer Jenni Sisson contributed to this post.