How Do Mortgages Work?

Owning your first home can be a joyful and life-changing event. But the process of buying a home can be intimidating, particularly for first-time homebuyers, who must learn an entirely new way of purchasing and often a new vocabulary as well.

One of the most important things to learn when buying a home is how mortgages work. Simply put, a mortgage is a special kind of loan that is used to purchase real estate, such as a single-family house, duplex, condominium, or another piece of property. The real estate serves as the collateral for the loan and the borrower agrees to repay the lender (oftentimes a bank) over a set period of time, typically in regular monthly payments.

A mortgage is often the most significant financial commitment an individual or family will ever make, and it can feel overwhelming to navigate the various types of mortgages, interest rates and terms.

Whether you’re just starting your home search or you’re ready to take the next step and make a purchase, this guide will provide you with information and resources you'll need to feel more confident and in control of the homebuying process.


What’s in a Mortgage Payment?

Components of a mortgage payment often include:


  • Principal: The amount of money borrowed to purchase the home.
  • Interest: The amount of money charged by the lender for borrowing the money.
  • Taxes: While rules vary by location, it's possible that property taxes will be included in your mortgage payment. This might be calculated on an annual basis and divided by 12.
  • Insurance: Lenders require homeowners insurance to cover your home in the event of a disaster or accident. The cost of that insurance may also be included in your monthly mortgage payment, depending on the amount of your down payment or loan type.


What a mortgage payment includes can vary, so it's important to understand yours by asking your lender the right questions.



Qualifying for a Mortgage

House hunting can be an exciting step in your journey. However, it’s important that you go through a mortgage pre-approval process before you even begin visiting homes, so that you know what you can afford in advance.

When you apply for a mortgage, lenders will consider factors such as your credit score, income and debt-to-income ratio. These factors help determine whether you are eligible for a loan and at what interest rate.

Here are a few common components that lenders consider when going through the mortgage pre-approval process:

Credit Score

A good credit score is important to securing a mortgage because it helps lenders evaluate your creditworthiness and likelihood of being able to repay the loan. When someone mentions a credit score, it's most likely they're referring to the FICO score, the most widely adopted credit score in the United States. The system scores credit holders on a scale of 300 to 850.

Credit scores are based on various factors, such as a person's:

  • Credit utilization.
  • Payment history.
  • Age of oldest credit account.
  • Types of credit.
  • Recent credit.

The higher your credit score, the lower your interest rate may be, which means your monthly mortgage payments may be lower.  A lower credit score, on the other hand, may result in more restrictive loan terms or even disqualification.

FICO defines a good credit score as being within the range of 670 to 739. This range places borrowers at near or slightly above the average U.S. consumer's score.

Broad FICO credit score requirements for mortgage loans include:

  • 620 for a fixed-rate or adjustable-rate conventional mortgage.
  • 500 to 640 for government-backed loan programs, which we'll define below.

Since each lender has different credit score requirements, understanding your credit score helps explore the options available to you. You can learn how to get your credit score from the Consumer Financial Protection Bureau.

Debt-to-Income Ratio

Your debt-to-income (DTI) ratio helps lenders evaluate your ability to manage your payments and how much money you can borrow. This number is calculated by taking your total outstanding debt and dividing it by your monthly income.

Debt in DTI ratio calculations often includes:

  • Car payments.
  • Minimum monthly credit card payments.
  • Existing monthly mortgage payments.
  • Outstanding student loans and personal loans.
  • Child support and alimony payments.



Lenders typically view a lower DTI ratio as indicative of a stronger financial position. Each lender has their own definition of a good DTI ratio. Generally speaking, many of them look for a DTI ratio between 36% and 49%. Since each lender has unique parameters for DTI, a general best practice is to try and keep yours as low as possible.

If you need to, take time to reduce your debt before applying for a loan. Doing so may help broaden your options when looking for a home.


Your income will help determine whether you can afford to repay a loan and is used to calculate your debt-to-income ratio. Keep in mind that lenders have different income requirements and may have different methods for calculating DTI, so compare lenders to find the best mortgage that suits your finances.

As a general rule of thumb, many financial experts recommend that your mortgage payment should not exceed 36% of your gross monthly income, with no more than 28% of your debt coming from a mortgage or rent payment.

Down payment

A higher down payment usually leads to a lower monthly payment. It can also help you secure more favorable terms on the loan, such as a lower interest rate or shorter repayment period.

Depending on your loan type, the amount you contribute as a down payment may vary somewhere between 3% and 25% of your total loan amount. However, if you make a down payment of less than 20% you will likely be required to pay for private mortgage insurance (PMI), which can increase your monthly payment. This insurance protects the lender in the event that a borrower fails to repay their mortgage.

However, as described below, you might have the opportunity to drop PMI from your payments over time.


Fixed vs. Adjustable-Rate Mortgages

A mortgage rate represents how much you pay to borrow money for your home or property. It can significantly impact the affordability of your loan and your overall cost of homeownership.

Two of the most common types of mortgage rates are fixed and adjustable:

  • Fixed-rate mortgages have a set interest rate that remains "fixed" throughout the life of the loan. If your mortgage rate is 4%, you’ll pay 4% until you pay off the loan or refinance. These mortgages often have 30-year terms, but can also have shorter terms such as 10, 15 or 20 years.
  • Adjustable-rate mortgages, also known as ARMs, carry interest rates that fluctuate over time. Typically, these loans start at a fixed rate for a specified period, and then the rate "adjusts" up or down based on economic conditions and a benchmark rate outside of the control of the lender. As the rate changes, your payments will change as well.

Which type of loan is right for you depends on your situation. For example, a fixed-rate loan might be best for someone who is looking to stay in their home for the entire length of the loan. An adjustable-rate mortgage might be right for someone who plans on selling their home within a few years.

How Are Interest Rates Set by Lenders?

Keep in mind that interest rates can change frequently and that an advertised rate may not be the one for which you qualify.

Lenders consider a variety of factors when setting interest rates that include:

  • Economic factors.
  • Credit score.
  • Loan amount.
  • Loan term.
  • Loan-to-to value (LTV) ratio, which is a property's value compared to the amount of its loan.
  • Competition.

Contact your financial institution directly or visit their rates page to learn more about current rates.


How Long Do You Pay a Mortgage on a Home?

The length of time that you will be given to pay down your mortgage depends on the terms you agree to, from as little as 10 years to as long as 30 years. Factors such as your down payment, your financial situation and the price of your home will influence the optimum length of your mortgage.

Long-term Mortgage

The most common mortgage term in the United States is 30 years. Some lenders and banks also offer 40-year mortgage options, but these are rare.

Short-term Mortgage

Most common short-term mortgages are for 10- or 15-year terms. While you'll pay less interest with a short-term mortgage, and you'll own your home outright sooner, your monthly payments will be higher.


Types of Mortgage Loans

The process of obtaining a mortgage is complex, and borrowers need to understand the terms and conditions of their loan before signing on the dotted line. A first step can be exploring which type of mortgage is right for you.


A conventional mortgage is a type of home loan that is not guaranteed or insured by a government agency, such as the Federal Housing Administration or the Department of Veterans Affairs. Instead, conventional mortgages are privately backed.

Conventional loan programs typically require a minimum 3% down payment. However, private mortgage insurance (PMI) is required when borrowers make a down payment of less than 20%.


Jumbo loans are considered "nonconforming" because they exceed the loan limits set by two government-sponsored enterprises known as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Jumbo loans are often used for high-value properties or borrowers with high credit scores and income.


Government-insured loans are designed to help borrowers who may have difficulty qualifying for a conventional mortgage, such as first-time homebuyers or those with low to moderate incomes.

FHA Loans

Federal Housing Administration (FHA) loans typically have more lenient qualifications, such as lower credit scores and down payment requirements. The minimum down payment for an FHA loan is 3.5% of either the purchase price or the property's appraised value, whichever is lower. FHA loans require a mortgage insurance premium (MIP) for about 11 years of the mortgage, depending on your down payment.

VA Loans

Veterans Affairs (VA) loans are available to active-duty military members, veterans and eligible surviving spouses who meet certain requirements. Borrowers can typically qualify with lower credit scores,and these loans may not require a down payment or mortgage insurance, but additional fees will apply.

USDA Loans

United States Department of Agriculture (USDA) loans assist low- to moderate-income homebuyers in eligible rural and suburban areas. There might be no down payment and any guarantee fees (instead of mortgage insurance) may be lower than for other loans."ther loans.


Calculating a Mortgage Payment

To calculate a mortgage payment, you will need to know the loan amount, interest ra , loan term, and any applicable mortgage insurance.

Once you have all that information, you can use a mortgage calculator to determine your monthly mortgage payment.


Mortgage FAQs

How Much Can I Afford in Mortgage Payments?

To determine how much house you can afford, consider factors such as your income, debt-to-income ratio, credit score, down payment and other monthly expenses.

It's important to remember that you might not want to purchase a home for the full loan amount you qualify for, because those monthly payments could stretch your budget too far. Instead, consider your financial situation and what monthly payments would be most sustainable for you.

How Do I Get Pre-approved for a Mortgage?

You will provide a lender with information such as yourincome, debt, and credit history, and they will "pre-approve" you for the amount they’re willing to lend you.

How Long Does Mortgage Pre-approval Last?

Mortgages pre-approval tpically lasts between 60 and 90 days, but the exact duration can vary depending on the lender.

How to Remove or Avoid PMI?

The best way to avoid PMI is to make at least a 20% down payment. But if you must pay PMI, you should try to pay down the principal of your loan as quickly as possible. Once you reach an 80% LTV ratio, you may ask your servicer to end PMI (but conditions may apply). Even if PMI does not end when you reach 80%, your servicer must terminate your PMI once you reach a 78% LTV ratio, as long as you are current on your payments.

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This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.

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