Mortgages: What You Need to Know

Because people often don't have enough cash available to purchase a home outright, they usually take out a loan when buying real estate. A bank or mortgage lender agrees to provide the funds, and the borrower agrees to pay it back over a specific period of time, say 30 years.

If you're shopping for a new home and planning on taking out a loan to finance the purchase, read on.

What Is the Difference Between a Promissory Note, Mortgage, and Deed of Trust?

Depending on where you live, you'll likely either sign a mortgage or deed of trust when you take out a loan to purchase your home. This document provides security for the loan that's evidenced by a promissory note, and it creates a lien on the property. Some states use mortgages, while others use deeds of trust or a similarly-named document. The mortgage or deed of trust gives the loan owner the right to sell the secured property through the foreclosure process if you don't make the payments or if you breach the loan contract in another way.

While most people call a home loan a "mortgage" or "mortgage loan," it's actually the promissory note that contains the promise to repay the amount borrowed.

Different Types of Mortgage Loans: FHA, VA, Conventional

Most mortgage borrowers get an FHA, VA, or a conventional loan.

What Is an FHA-Insured Loan?

The Federal Housing Administration (FHA) insures some home loans. If you default on the loan and your house isn't worth enough to fully repay the debt through a foreclosure sale, the FHA will compensate the lender for the loss. A borrower with a low credit score might want to consider an FHA-insured loan because other loans usually aren't available to those with bad credit.

What Is a VA-Guaranteed Loan?

A VA-guaranteed loan is, as you might guess, a loan that the U.S. Department of Veterans Affairs (VA) guarantees. This type of loan is only available to specific borrowers through VA-approved lenders. The guarantee means that the lender is protected against loss if the borrower fails to repay the loan. A current or former military servicemember might want to consider getting a VA-guaranteed loan, which could be the least expensive of all three loan types.

What Is a Conventional Loan?

Conventional loans aren't insured or guaranteed by the federal government. So, unlike federally insured loans, conventional loans carry no guarantees for the lender if you fail to repay the loan. (Learn more about the differences between conventional, FHA, and VA loans.)

What's the Difference Between Being Pre-Qualified and Pre-Approved for a Mortgage Loan?

Homebuyers sometimes think that if a lender pre-qualifies them for a mortgage loan, they've been pre-approved for a home loan. But the terms "pre-qualified" and "pre-approved" have very different definitions.

Getting Pre-Qualified for a Mortgage Loan

Pre-qualifying for a loan is the first step in the mortgage process. Typically, it's a pretty easy one. You can pre-qualify quickly for a loan over the phone or Internet (at no cost) by providing the lender with an overview of your finances, including your income, assets, and debts. The lender then does a review of the information—based on only your word—and gives you a figure for the loan amount you can probably get.

The main reason to get pre-qualified for a loan is so that you get an idea in advance of how much you can afford when shopping for a new home. It's important to understand that the lender makes no assurance that you'll be approved for this amount.

Getting Pre-Approved for a Mortgage Loan

With a pre-approval, though, you provide the mortgage lender with information on your income, assets, and liabilities, and the lender verifies and analyzes that information. The pre-approval process is a much more involved process than getting pre-qualified for a loan.

Once the lender completes the analysis, you'll receive a conditional commitment in writing. You can then look for a home at or below that price level. As you might guess, being a pre-approved buyer carries much more weight than being a pre-qualified buyer when it comes to making an offer to purchase a home; once you find the home you want and make an offer, your offer isn't contingent on obtaining financing.

Principal, Interest, Taxes, and Insurance

After taking out a mortgage loan to buy a home, the borrower typically has to make monthly payments of principal and interest, as well as taxes and insurance if the loan is escrowed. Collectively, these items are called "PITI."

• Principal. The "principal" is the amount you borrowed. For example, suppose you're buying a home that costs $300,000. You put 20% of the home's price down ($60,000) so that you can avoid paying private mortgage insurance (PMI), and you borrow $240,000. The principal amount is $240,000. Each month you'll pay back a portion of the principal.
• Interest. The interest you pay is the cost of borrowing the principal. When you take out the home loan, you'll agree to an interest rate, which can be adjustable or fixed. The rate is expressed as a percentage: around 3% to 6% is more or less standard, but the rate you'll get depends on your credit history, your income, assets, and liabilities. Mortgages are set up so that at the beginning of the repayment period, you pay mostly interest. Eventually, though, you'll pay mostly principal.
• Taxes. When you own real estate, you have to pay property taxes. These taxes pay for schools, roads, parks, and the like. Sometimes, the lender establishes an escrow account to hold money for paying taxes. The borrower pays a portion of the taxes each month, which the lender places in the escrow account. When the property tax bills are due, the lender pays these bills with money from the escrow account.
• Insurance. The mortgage contract will require you to have homeowners' insurance on the property. Insurance payments are also often escrowed.

Getting Help

If you need more information about mortgages, are having trouble deciding what loan type is best for your circumstances, or need other home-buying advice, consider contacting a HUD-approved housing counselor, a mortgage lender, or a real estate attorney.