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The Ascent's Complete Guide to Mortgages

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Mortgages are a big decision. With all of the potential options on the market, where do you start? If you're a first-time homebuyer looking for the best lender for you or a homeowner looking to refinance to take advantage of some of the lowest mortgage rates we've ever seen, we've got you covered.

What is a mortgage?

A mortgage is a loan that you can use for the purchase of a home. Mortgages are secured by the house you're borrowing money to buy, so the house serves as collateral. If you don't pay your mortgage, the lender can foreclose and take your home. Most mortgages are paid off over a long period of time, with borrowers generally choosing either a 15-year or a 30-year repayment term.

There are different kinds of mortgages, including conventional loans, which are not insured by any government agency, and loans that are guaranteed by one of several agencies including the Federal Housing Administration (FHA), the Veterans Administration (VA), or the U.S. Department of Agriculture (USDA). Both government-guaranteed loans and conventional loans are made by private lenders, including banks, online lenders, and credit unions.

There are also conforming loans and non-conforming loans. Conforming loans fall below financing limits set by the Federal Housing Finance Agency and non-conforming loans -- known as jumbo loans -- are for higher amounts. Fannie Mae and Freddie Mac, two government-sponsored entities, buy conforming loans on the secondary mortgage market so lenders can package and sell them.

If you are new to the world of mortgages, check out our beginner's guide to home loans.

Types of mortgages

Not all mortgages are created equal. Here are the different types of mortgages you should know about:

Conventional mortgages

Conventional home loans adhere to the maximum limits set by Fannie Mae and Freddie Mac, which are the agencies that back most U.S. mortgages. As mentioned, you'll pay PMI if you fail to put down 20% on a conventional mortgage, but you may be able to put down as little as 3%. The borrowing limits for conventional mortgages change from year to year. In most of the U.S., the maximum conforming mortgage for one-unit properties is $510,400 in 2020.

Jumbo mortgages

These are conventional mortgages that exceed the maximum borrowing limits. Jumbo mortgages are harder to qualify for than conventional mortgages, and you'll generally need at least a 10% down payment, if not 20%.

FHA loans

These mortgages are backed by the Federal Housing Administration and are geared toward applicants who don't have great credit or don't have the funds for a substantial down payment. You can put as little as 3.5% down with an FHA loan if you have a 580 credit score or above. But, you pay certain premiums with an FHA loan (similar to PMI) that can make your mortgage more expensive.

VA loans

These mortgages are available to active members of the U.S. military as well as veterans. VA loans don't require a down payment and don't charge PMI. There are, however, funding fees involved that get tacked onto your mortgage costs.

USDA loans

Backed by the U.S. Department of Agriculture, USDA loans help lower-income borrowers buy homes in rural areas. If you qualify, you won't have to make a down payment on your home, but that home must be located in a designated zone (buying in a suburb alone does not guarantee that you'll qualify).

Mortgage refinancing

Got a mortgage and looking to refinance?

What does it mean to refinance a mortgage?

In the financial world, the term refinancing means using a new loan to replace an existing one. So, refinancing a mortgage means obtaining a brand-new mortgage to replace your current one.

There are several reasons people refinance their mortgages, which we'll get into in detail later. But for the time being, know that refinances are generally done to improve the terms on your mortgage, to save money on interest by getting a lower mortgage rate, to cash out some of your home equity, or a combination of the three.

Types of refinancing

There are several types of refinancing loans, but most fall into these broad categories:

  • Rate and/or term refinancing: This is a "standard" refinance. Essentially, this involves replacing your existing mortgage with another for the same principal amount, with the goal of lowering your interest rate, changing your loan term length, or both.
  • FHA refinancing: FHA mortgages can be excellent tools to open the door to homeownership but aren't as great after the homeowner has built up significant equity. There are streamlined FHA mortgage refinancing programs designed to quickly and easily refinance these loans for borrowers who would benefit from such a move.
  • Cash-out refinancing: Another type of refinancing loan allows homeowners to take cash out of their property's equity.

For more on refinancing, check out our refinancing guide, The Truth About Refinancing Your Mortgage.

How are mortgage rates determined?

Borrowers applying for a mortgage loan should compare rates and terms among multiple lenders because mortgage rates can vary substantially. Each individual lender uses both economic factors and the borrower's credentials to set rates.

Mortgage rates are affected by the federal funds rate, which is the rate set by the Federal Reserve (the U.S. central bank). Banks use the federal funds rate when making overnight loans to other banks. Rates are also affected by what investors are willing to pay for mortgage-backed securities, which are groups of mortgage loans put together by institutional investors who buy loans on the secondary mortgage market. Because investors looking for fixed-income investments tend to compare mortgage-backed securities with 10-year Treasury yields, the Treasury yield affects rates as well.

The financial credentials of each individual borrower also have an impact on what rates will be available. Lenders price loans based on the perceived level of risk that a particular borrower won't pay back their debt. Some of the factors lenders consider when setting rates for individual borrowers include:

  • The borrower's credit score: A higher credit score will result in a lower loan interest rate with the best mortgage companies.
  • The borrower's debt-to-income ratio: This is the total amount of debt payments (including the mortgage payment) vs. the borrower's income. The lower the amount of debt the borrower has relative to income, the less risk is presented to the lender and the lower the interest rate on the mortgage loan.
  • The size of the borrower's down payment: A larger down payment reduces the risk to the lender. This is both because borrowers themselves have money at stake and if the lender has to foreclose, the larger down payment reduces the chance the home will sell for less than the outstanding loan balance.
  • The loan term: Loans with shorter repayment terms come with lower interest rates. While 30-year mortgages are very popular because they provide lower payments due to the long repayment timeline, a 15-year loan would typically come with a lower interest rate.
  • The borrower's employment history: A borrower with a stable employment history presents less risk to a lender as there's a reduced chance the borrower will suffer a decline in the income they're using to repay the debt.

While you cannot change the broad macroeconomic factors that affect your rate, you can take steps to lower it by improving your credit, saving for a larger down payment, and choosing a mortgage with a shorter loan repayment term.

Fixed-rate vs. adjustable-rate mortgages

Some mortgage loans have fixed rates while others have adjustable rates. Adjustable-rate mortgages are called ARMs.

Loans with fixed rates have a rate that doesn't change during the entire term of the loan. You will know your monthly payment up front and you will know the total loan cost at the time when you borrow.

ARMs, on the other hand, have a rate that can adjust periodically. Most start with a rate that is fixed for several years and then adjusts on a set schedule. ARMs are named based on the length of the initial fixed rate and the frequency with which rates adjust. For example, a 3/1 ARM will have a fixed rate for the first three years and it can then adjust once a year thereafter. A 5/1 ARM would have a rate fixed for the first five years and it could then adjust once annually.

Adjustable-rate mortgages are attractive to borrowers because the rate generally starts lower than on a fixed-rate mortgage. Monthly payments are more affordable and interest costs are lower, making it easier for borrowers to qualify if they're stretching to purchase a home. But there is a risk.

ARMs are tied to a financial index and the rates could go up, resulting in larger monthly payments. In some cases, those payments could become unaffordable. While borrowers often plan to refinance their mortgage or sell before that happens, this isn't always possible if the real estate market declines in value.

When you get an adjustable-rate mortgage, it's important to read the disclosures carefully to determine how high your payment could go. If that amount is not affordable to you, make sure you realize the risk involved in taking out an ARM.

Why your credit score matters when buying a house

Your credit score is one of the most important factors that determines which mortgage lenders will give you a loan and how much that loan will cost. While you have different credit scores, most are on a scale of 300 to 850 with scores below 669 considered fair or poor; scores between 670 and 739 considered good, and scores between 740 and 850 classified as very good or excellent.

There's no minimum credit score required for VA mortgages insured by the Veteran's Administration, as lenders are instructed to take a borrower's full financial profile into account. But even with VA loans, some mortgage lenders may still impose their own credit score minimum.

All other types of mortgage loans come with minimum credit score requirements. Even loans backed by the Federal Housing Administration require you to have a score of at least 580 if you want to make a 3.5% down payment. If you're able to make a 10% down payment, the minimum score could be as low as 500.

The minimum credit score for a home loan with a conventional lender can vary but in general you will need a score of at least 620 if you have a hefty down payment and a low debt-to-income ratio. Most lenders require even higher scores and you'll need a score of at least 740 to qualify for a loan at the most competitive rate.

Because your credit score has a huge impact on your interest rate, borrowers with good credit will generally pay much less for their mortgage than those with lower scores. For example, the table below shows the current rates you can expect as of April 2020 for a 30-year fixed mortgage on a $300,000 loan with different credit scores as well as the amount of your monthly payment and the total interest you'd pay.

For more on how your credit score affects your mortgage rates, read our guide on the topic.

FICO® Score APR Monthly Payment Total Interest Paid
620-639 4.611% $1,540 $254,366
640-659 4.065% $1,444 $219,664
660-679 3.635% $1,370 $193,143
680-699 3.421% $1,334 $180,218
700-759 3.244% $1,305 $169,667
760-850 3.022% $1,268 $156,615
Source: MyFICO®.com

As you can see, a higher credit score could save you several hundred dollars per month and almost $100,000 in interest costs over the life of the loan.

FAQs

  • To get the best mortgage for you, you should increase your credit score, pay down your debt to improve your debt-to-income ratio, choose a shorter loan term, and make a larger down payment.

  • Banks are one type of mortgage lender, but there are also non-bank lenders whose sole business purpose is offering mortgage loans. There are pros and cons to both banks and mortgage lenders.

    Banks often have stricter qualifying requirements, may charge more fees because of added compliance requirements, and may take longer to get to closing. But you may also be eligible for relationship discounts if you make use of their other banking services. For example, bank customers may get a discount on closing costs or a reduction in their interest rate if they set up mortgage autopay linked to their checking account with the same bank.

    Dedicated mortgage lenders, on the other hand, often make it faster and easier to qualify for a loan. However, many do not have a physical branch where you can go for customer service. And there's also a greater chance the mortgage lender will sell your loan to another loan servicer after you close on it.

  • Ideally, you should make a 20% down payment. This would enable you to qualify for a conventional loan with fewer fees and no private mortgage insurance required. Putting 20% down also reduces the likelihood you'll end up owing more than your home is worth, so it can be easier to get approved for a loan. You may also be charged a lower interest rate if you put more money down.

    If you cannot afford a 20% down payment, some conventional lenders allow you to put down as little as 3%. While it is sometimes possible to find special programs that waive private mortgage insurance, it is almost always required on conventional loans when you put less than 20% down.

    Government-backed loans also allow for lower down payments. The VA doesn't require any minimum down payment unless the home is worth less than you're buying it for and there's no private mortgage insurance required. However, there is an up front mortgage loan fee equal to a percentage of the borrowed amount. FHA loans enable you to buy with as little as 3.5% down, but you then pay mortgage insurance for either 11 years or the life of the loan.

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