What is a mortgage and how do they work?

What is a mortgage and how do they work

For most people, buying a house is synonymous with getting a mortgage.

But what is a mortgage? Mortgage definition: informally referred to as a home loan, a mortgage is a legal contract and specific debt instrument that uses the property in question as a form of collateral.

How do mortgages work? A mortgage involves a predetermined set of payments over a period of many years, with the borrower paying back the value of the property plus the interest incurred over this period.

This ongoing method of repayment is the only way that most people are able to make large real estate purchases. Depending on the loan and property in question, a residential mortgage can last anywhere from a few years to a few decades.

Mortgages come in many forms and are usually obtained from banks and other large financial institutions. Like most things in life, it's important to shop around for a mortgage to make sure you're getting the best deal.

Along with interest rates and repayment timelines, it's important to be aware of additional charges and terms and conditions. The process of applying for a mortgage can be time-consuming and complicated, with mortgage pre-qualification typically preceding pre-approval and final approval. While large banks are the normal one-stop shop for mortgages, non-bank lenders and mortgage brokers can also play an important role.

Types of mortgages

Now that you know what is a mortgage, you can learn about its variety. Before applying for a mortgage, it's crucial to understand the differences between mortgage products. With so much money on the line, this is certainly not a one-size-fits-all scenario. Mortgages can be compared based on a range of criteria, with the following three categories often used:

  • fixed-rate vs adjustable-rate

  • government insured vs conventional loans

  • conforming vs non-conforming loans

Fixed-rate vs adjustable-rate

Interest makes up a huge proportion of any home loan, with fixed-rate and adjustable-rate loans being the primary way to distinguish mortgage products. While there is a combination or "hybrid" category that has a fixed rate for a specified time period, the majority of loans are one of these two types.

A fixed-rate mortgage has the same interest rate for the entire repayment term. While this adds a degree of stability and can be cost-effective, it can also be more expensive if interest rates go down over time.

In the United States, a fixed-rate mortgage can last the entirety of the loan amortization. So your interest rate could be for 15, 20, or even 30 years. In Canada, the interest rate is applicable only to the term of the loan, typically 5 years.

In contrast, an adjustable-rate mortgage (ARM) has an interest rate that changes with the times, depending on central bank interest rates and wider economic conditions. A hybrid ARM loan typically starts off with a fixed rate before changing to an adjustable rate.

In Canada, an ARM is referred to as a variable rate loan, as the interest rates fluctuate up or down depending on the benchmark rate from the Bank of Canada.

Government-insured loans

Government-insured home loans were initially created during the Great Depression, with modern examples including FHA loans, VA loans, and USDA loans. While these loans are not available from the Government directly, they are insured by the Government in the case of default or fraud.

In Canada, these loans are referred to as high-ratio loans, and they are insured by the Canadian Mortgage and Housing Corporation (CMHC). Any mortgage where the borrower has less than 20% down payment, will be insured by CMHC. Therefore, CMHC fees will be added to your mortgage. At times, banks will provide you with a lower interest rate if you are insured by CMHC, because it is less risky to the lender, so be sure to ask your broker or lender for the rate both for a CMHC-insured mortgage, and one that isn’t.

In the U.S., the Federal Housing Administration (FHA) mortgage insurance program is the most popular example, with FHA loans managed by the Department of Housing and Urban Development (HUD).

First-home buyers often choose FHA loans due to lower down payments and less strict credit score requirements. For example, people with a 500 FICO score can qualify for an FHA mortgage with a 10% down payment.

Borrowers with a 580 or higher FICO score may qualify for an FHA loan with a 3.5% down payment. Unlike many other mortgages, the down payment for FHA home loans can be a gift from a family member or friend.

The Department of Veterans Affairs (VA) offers a different Government mortgage directly to military service members and their families. The big benefit of these loans is that they require zero down payment, with VA loans also not needing mortgage insurance and offering protection against any losses that may result from borrower default.

The United States Department of Agriculture (USDA) also offers a loan program for rural borrowers who meet certain income requirements, with this program managed by the Rural Housing Service (RHS).

Conventional loans

Also known as conforming loans, conventional loans are offered by private lenders and do not come with any form of Government insurance. Conventional loan requirements are more stringent than Government loans and do require mortgage insurance unless you're putting down a deposit of 20% or more.

In the United States, a credit score of 620-640 will be needed to secure a conventional loan, with a down payment of between 5% and 20% typically required. A conventional 97 mortgage is named after its 97% loan-to-value ratio, with the small 3% down payment even smaller than FHA loans. The situation in Canada is similar, with a credit score above 650 probably enough to qualify for a standard loan and anything under this likely to bring difficulty in receiving new credit.

Non-conforming loans

A non-conforming loan describes any mortgage that exceeds the loan limits set by Fannie Mae and Freddie Mac. The conforming loan limit is $424,100 in most areas of the United States and goes up to $635,050 in certain high-cost areas.

These loans are commonly referred to as Jumbo loans and are normally more difficult to qualify for because of the higher loan amount. Jumbo loans are normally available up to $1 million, with Super Jumbo Loans also available when needed.

Types of mortgage lenders

Not all money lenders are created equal, especially when it comes to mortgages. Before getting a home loan, it's important that you can distinguish between lenders and find the perfect fit for you.

Along with large banks and other direct lenders, there's also mortgage bankers and brokers, wholesale lenders, warehouse lenders, and the secondary loan market. Most lenders fall into one of three categories: direct lenders, mortgage brokers, and secondary market lenders.

What are direct lenders?

Direct lenders include many large banks and credit unions, with these institutions loaning money directly to the borrower. Also known as mortgage lenders as opposed to mortgage brokers, these lenders use their own money and only offer loans after certain criteria have been met.

Your credit score and down payment amount are of maximum importance here, with lenders also looking at your income, employment history, assets, and liabilities. Before the secondary market was established (see below), only larger banks had enough funds to provide long-term mortgages.

What is a mortgage broker?

Unlike direct lenders, mortgage brokers don't actually make loans themselves. Instead, they act as an agent by working with multiple lenders in an effort to find the ideal loan for you. Mortgage brokers may be able to access loans from wholesale lenders, who often discount their rates when they work with brokers.

While a mortgage broker can be a great way to access the most competitive rates and terms available, they may also charge processing or origination fees.

Mortgage originators vs secondary market lenders

Mortgage originators include wholesale and warehouse lenders, both of who do not deal directly with customers. Wholesale lenders include many large banks and financial institutions, who often deal exclusively with mortgage brokers, credit unions, and other banks.

Warehouse lenders are similar, although they lend money directly to intermediaries rather than provide loans.

Retail lenders issue mortgages directly to individual consumers, after sourcing either money or loans from mortgage originators. A large percentage of newly originated retail mortgages are sold into the secondary market, where they are packaged into mortgage-backed securities and sold to investors.

Even when the bank has used their own money to make the loan, they will often sell the loan to the secondary market to replenish their funds.

Federal National Mortgage Association (FNMA or Fannie Mae), Government National Mortgage Association (GNMA or Ginnie Mae), and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) are all examples of secondary market lenders.

Prior to the establishment of the secondary market in 1968, potential home buyers faced higher interest rates and had a more difficult time finding mortgage lenders.

Mortgage loan interest rates

Other than the value of the loan itself, interest rates represent the biggest cost of a mortgage. The primary difference is between fixed and adjustable/variable rates, with fixed rates staying the same for the entire term of the loan and adjustable rates changing over time.

Remember, in the U.S. interest rates can be applied for the entire loan period, whereas in Canada the interest rate only applies to the term of the loan, usually 5 years.

Standard interest rate categories include:

  • 30 year fixed term

  • 20 year fixed term

  • 15 year fixed term

  • 10 year fixed term

  • 10 year adjustable rate mortgage (ARM)

  • 5 year ARM

  • 3 year ARM

  • FHA insured loan

  • VA loan

  • 30 year fixed jumbo mortgage

  • 20 year fixed jumbo mortgage

  • 15 year fixed jumbo mortgage.

Rates vary widely according to many factors, including your credit score, type of loan, down payment amount, and location.    

Mortgage timelines

The mortgage process can be daunting, complex and long-winded, from pre-qualification and pre-approval through to finding a home and closing the deal. While this process shouldn't be rushed, it's important to do everything you can to make it as quick and seamless as possible.

It takes an average of 50 days to close on a home loan, with market conditions, potential repairs, mortgage paperwork, and home appraisals all likely to cause roadblocks if you don't know what you're doing.

What is a mortgage and how do they work - mortgage timeline

Step 1 - pre-qualification

Getting pre-qualified is the first step in mortgage approval process. While this quick and simple process is not the same as getting mortgage approval, it does provide you with a small degree of certainty and an overall budget to work with.

It allows you to understand exactly what your financial limits are and the type of home you can afford. A mortgage pre-qualification is always best to get before you start looking at homes.

During pre-qualification, you provide your lender with financial information such as your income, debts, and assets. Once this information has been evaluated, the lender will give you an idea of the size of the mortgage that you are likely to qualify for.

Step 2 - pre-approval

Getting pre-approved for a home loan is next, with this step much more time-consuming and involved. During pre-approval, you need to complete an official mortgage application and pay an application fee.

Unlike pre-qualification, which tends to be informal and involves little-to-no paperwork, this step requires a lot of documentation. Lenders will not take you on your word before offering pre-approval, they will take a detailed look at your financial records and credit score.  

Step 3 - finding a home

Once you've received pre-approval, you can start house hunting with a solid working budget. A pre-approval letter is normally needed before you can make an offer on a property, so you really can't skip a step or do things in the wrong order.

While it often makes sense to develop a relationship with a trusted real estate agent, private sales and online portals can also be valuable in certain locations.

Step 4 - making an offer

Once you're ready to make an offer, it's important to move quickly and beat the competition. This can be a stressful part of the process, especially with so much money on the line. While making a low ball offer could work in your favour and save you tens of thousands of dollars, it may also cost you your future family home.

Base your offer on the home’s actual value rather than the list price, by looking at similar local sales, time on market, and wider supply and demand data. If your offer is accepted, the sale goes into escrow and the clock starts ticking.

Step 5 - home inspection

A home inspection serves as a safety net in the case of any structural problems or defects. While an inspection is not required by law, it can highlight significant problems that may affect the safety, livability, or resale value or a property. A professional inspection report can also serve as a powerful tool if you need to negotiate repairs with the current owner.

Step 6 - home appraisal and title search

A home appraisal will be organized by your lender to make sure that the home is valued correctly and aligned with similar homes in the area. Once the appraisal has been completed, a title company will research the legal history of the home to check for claims, liens, pending legal actions, or other encumbrances on the property.

Step 7 - closing disclosure review

It's important to review the terms of your mortgage before you sign the contract, including your closing costs. A closing disclosure is a five-page document that normally arrive three days before closing and includes the following information: mortgage information, transaction summary, settlement charges, final loan terms.

Step 8 - closing day

Closing day is when you finally get to sign on the dotted line and take ownership of your new property. There is likely to be a mountain of paperwork, so try to take the day off and enjoy the process. Remember to pay your closing costs with cash or certified funds and bring along official identification to speed up the process.

Mortgage application checklist

A large number of documents are needed to support a mortgage application, with lenders only able to move forward with the approval process after certain information has been provided.

  • Identification and address details

  • W2's and T4’s from current and past employers

  • recent bank statements

  • tax returns for two or three years

  • pay stubs

  • employment confirmation

  • proof of downpayment

  • documentation for your debts

  • documentation for your assets

  • gift letter if using gift funds

  • rental documents and records

  • profit and loss statements if relevant

  • credit report

  • bank account numbers

Mortgage qualification and approval

Before getting a mortgage, it's important to have a rough idea of how much you can afford. Different lenders evaluate loans in different ways, with mortgage pre-qualification giving you a good idea of how much you can take on.

The old formula used to determine how much someone could afford was three times their gross annual income. This is far from reliable, with lenders more likely to look at your credit score and the relationship between your income and debt.

Most lenders are not interested in setting up a home loan where the monthly payments exceed 28% to 44% of the borrower’s monthly income. This is a pretty big range, however, with lenders more likely to allow payments that meet or exceed 44% when the borrower has an excellent credit score.

If you're not sure how much you can afford, many banks and third-party websites offer mortgage calculators to help people determine how much they can afford.

The following factors are important when performing a self-evaluation for mortgage qualification:

  • home loan size

  • down payment amount

  • interest rate

  • length of home loan

  • income

  • liabilities

  • credit score

Common mortgage terms and conditions

Each mortgage comes with a complicated set of terms and conditions, some of which are hard to understand. Once your mortgage broker or lender has approved the mortgage and knows the loan amount, they’ll be able to write up your mortgage agreement.

Along with the amount and length of your mortgage, and the interest rate available to you, it's crucial to understand the following terms and conditions and how they may contribute to ongoing costs.  

Collateral vs non-collateral mortgage

A collateral mortgage is a readvanceable mortgage product, which means you are allowed to borrow money from your home for the duration of the mortgage term.

While this can be a flexible solution, a collateral mortgage can't be transferred from one lender to the next, not even at the end of your mortgage term.

Portable vs assumable

This distinction comes into play if you want to sell your home before the mortgage term ends. A portable mortgage means that you can keep your existing mortgage when you move from one home to another.

This is not always an option, however, with most variable rate mortgages unable to be ported. An assumable mortgage works in a similar way, although this time, you can transfer your current mortgage to the buyer of your home instead of yourself.

Prepayment options and penalties

Prepayment options can vary considerably between mortgage contracts, with some home loans allowing you to increase payments in a flexible fashion and others coming with prepayment penalties.

If you want to pay back your home loan sooner and avoid interest, it's important to choose a loan with flexible pre-payment options. Prepayment fees may come into play if you break your mortgage term early, which can happen if you sell or refinance before the mortgage term has been completed.

Pros and cons of fixed-rate mortgage terms

Fixed-rate mortgages come in a range of terms, with 10 year, 15 year, 20 year, and 30 year terms all being popular options. There are pros and cons associated with both medium and long-term contracts, with people choosing loans according to their age, their financial status, the price of the property, and the monthly payment plans that are available. Generally speaking, shorter terms mean lower interest rates with higher mortgage payments.

While a shorter 15-year term mortgage means you will pay off your mortgage faster and spend less money on interest, your debt-to-income ratio will be higher so you won’t qualify for as much money.

In contrast, a long 30-year mortgage is likely to have higher interest rates with lower monthly payments, meaning you will qualify for a larger loan. How long you plan on living in the home and how much you want the mortgage to impact your lifestyle are both important considerations.   

How a mortgage works FAQs

What is a mortgage?

A mortgage is a legal agreement that involves the lending of money for the purchase of a real estate property. In a mortgage contract, a bank or financial institution will lend funds in exchange for the title of the property, with this title becoming void upon final payment of the debt.

What is a reverse mortgage?

A reverse mortgage is a type of home loan that involves no monthly mortgage payments. Typically carried out by older homeowners, a reverse mortgage allows elderly people to access the home equity they have built up over time. While they are still responsible for property taxes and homeowner's insurance, they can defer payment of the loan until they die, sell the home, or move out of the home.

What is the amortization period?

The amortization period is the length of time it takes to pay off a mortgage in full. This can take a few years or a few decades depending on the size of the loan, the length of the contract, the interest rate available, and the repayment schedule. Along with the agreed interest rate, the amortization period is used to calculate the monthly mortgage payment.

What is a credit report?

Along with your income, assets, and liabilities, your credit report is fundamental to your chance of mortgage approval. A credit report is the history of your credit, including how much money you owe, how quickly you pay it back, and how many defaults you have. A credit score is given to each person, with different interest rates and down payment limits available according to your score.