For most people, a mortgage is the largest financial commitment they'll ever make. You're signing up for decades of payments, and the terms you agree to—the interest rate, the loan type, the length—will determine whether you build wealth steadily or struggle under a burden you didn't fully understand when you signed. The difference between a good mortgage and a mediocre one can be tens of thousands of dollars over the life of the loan.
Understanding how mortgages work isn't just about passing an interview with your lender. It's about knowing which questions to ask, which options to consider, and which traps to avoid. This knowledge puts you in control of one of the most important financial decisions of your life.
How Mortgages Work
At its core, a mortgage is a secured loan—the property you're buying serves as collateral. If you stop making payments, the lender can take the property through foreclosure and sell it to recover their money. This security is why mortgage rates are lower than credit card rates or personal loans: the lender's risk is reduced by having the house as backup.
When you take out a mortgage, you receive a lump sum to purchase the home and agree to repay it over time—typically 15 or 30 years—with interest. Each monthly payment includes four components, often called PITI: Principal (paying down what you borrowed), Interest (the cost of borrowing), Taxes (property taxes, typically held in escrow), and Insurance (homeowner's insurance and, if applicable, private mortgage insurance).
In the early years of your mortgage, most of your payment goes toward interest rather than principal. On a 30-year loan at 7%, nearly 80% of your first payment is interest. This ratio gradually shifts over time—a process called amortization—until your final payments are almost entirely principal. This is why building equity feels slow at first but accelerates as you approach payoff. Our amortization calculator shows exactly how your payments break down over time.
Types of Mortgages
The mortgage market offers a variety of loan products, each designed for different situations. The right choice depends on your finances, how long you plan to stay, and your risk tolerance.
Fixed-rate mortgages are the most straightforward: your interest rate stays the same for the entire loan term. Whether rates rise to 10% or fall to 4%, your payment remains constant. This predictability makes budgeting simple and protects you from rising rates. The tradeoff is that fixed rates are typically higher than initial adjustable rates, and if rates drop significantly, you'd need to refinance to take advantage—a process with its own costs and complexity.
Adjustable-rate mortgages (ARMs) offer a lower initial rate that's fixed for a set period—typically 5, 7, or 10 years—then adjusts periodically based on market conditions. A 5/1 ARM, for example, has a fixed rate for five years, then adjusts annually. ARMs come with caps limiting how much the rate can change at each adjustment and over the loan's life, but your payment can still increase substantially. ARMs make sense if you're confident you'll sell or refinance before the adjustment period, but they carry real risk if your plans change.
Beyond the rate structure, mortgages fall into different program categories. Conventional loans aren't backed by the government and typically require good credit (620+) and standard down payments. FHA loans are government-insured and accept lower credit scores and smaller down payments, but require mortgage insurance for the life of the loan. VA loans offer eligible veterans and service members remarkable benefits: no down payment, no PMI, and competitive rates. USDA loans provide similar benefits for properties in eligible rural areas.
Understanding Interest Rates
Your interest rate is the single most important factor in your mortgage cost. On a $300,000 loan, the difference between 6% and 7% is about $200 per month—and over 30 years, that's more than $70,000 in additional interest. Small differences compound into large sums.
Rates are influenced by factors you can't control—Federal Reserve policy, inflation, bond market movements—and factors you can. Your credit score has the biggest impact on the rate you personally receive. Borrowers with scores above 740 get the best rates; each tier below pays incrementally more. Improving your score before applying can save thousands over the life of your loan.
Your down payment also affects your rate. Larger down payments signal lower risk to lenders. Putting 20% down typically gets you better rates and eliminates private mortgage insurance entirely. The loan term matters too: 15-year mortgages carry lower rates than 30-year mortgages because lenders are repaid faster. The higher monthly payment on a 15-year term is offset by less total interest paid—often dramatically less.
A 1% difference in interest rate on a $300,000 loan costs over $60,000 in additional interest over 30 years. Shopping multiple lenders is one of the highest-ROI activities in the home buying process—it requires only time, not money, and can yield substantial savings.
Choosing a Lender
Where you get your mortgage matters as much as which mortgage you choose. Rates, fees, and service quality vary significantly between lenders, and most borrowers leave money on the table by not shopping around.
Banks and credit unions offer mortgages as part of their broader financial services. If you have an existing relationship, you may get preferential treatment or rate discounts. Credit unions, as member-owned institutions, sometimes offer lower rates than for-profit banks.
Mortgage brokers work with multiple lenders and can shop your loan across their network. They can be particularly valuable if your situation is complex or if you don't have time to compare lenders yourself. Brokers are paid by the lender (built into your rate or closing costs), so their service doesn't cost you out-of-pocket—but understand that their compensation may influence which loans they recommend.
Online lenders have streamlined the application process and often offer competitive rates due to lower overhead costs. The tradeoff is less personalized service; if you value being able to sit across from your loan officer, online may not be ideal.
Regardless of which type you choose, get Loan Estimates from at least three lenders. These standardized forms make it easier to compare rates, fees, and total costs. Don't just compare interest rates—a loan with a lower rate but higher fees might cost more overall. Focus on the APR (Annual Percentage Rate), which incorporates fees into a single comparable number.
Getting Pre-Approved
Before you start house hunting, get pre-approved for a mortgage. Pre-approval involves submitting a full application with documentation—pay stubs, tax returns, bank statements—and having the lender verify your financial situation. The result is a letter stating how much they're willing to lend you, subject to finding a property and final underwriting.
Pre-approval serves two purposes. First, it tells you your actual budget—not what you hope you can afford, but what a lender will actually finance. This prevents the disappointment of falling in love with homes you can't buy. Second, it signals to sellers that you're a serious, qualified buyer. In competitive markets, offers without pre-approval are often dismissed outright.
Don't confuse pre-approval with pre-qualification. Pre-qualification is just an estimate based on information you provide verbally—the lender does minimal verification. Pre-qualification letters carry little weight with sellers because they don't represent a meaningful commitment.
Pre-approval typically lasts 60-90 days. If you haven't found a home by then, you can usually get it renewed, though the lender may need updated documents if your financial situation has changed.
Calculate Your Monthly Payment Pre-Approval Guide
Frequently Asked Questions
Pre-qualification is an informal estimate based on self-reported information. Pre-approval is a formal process involving documentation verification and credit checks, resulting in a conditional loan commitment.
Down payment requirements vary: Conventional loans (3-20%), FHA (3.5% minimum), VA (0%), USDA (0%). Putting 20% down avoids private mortgage insurance (PMI).