Mortgage Basics

Lesson 3.1

How a Mortgage Actually Works

A mortgage is a loan secured by real property. That means if you stop making payments, the lender can foreclose — take the property — to recover what they're owed. The property itself is the collateral. This is worth understanding upfront, because it explains why lenders scrutinize your income, credit, and savings so carefully. They're taking a 30-year bet on your ability to pay.

One thing that surprises many first-time buyers: unlike a car loan — where the lender holds the title until the loan is paid off — a mortgage does not work that way. You own the home outright. Your name is on the title from the day you close. The lender simply has a lien on the property, which gives them the right to foreclose if you default. But they don't own the home. You do.

The Amortization Schedule

When you take out a mortgage, your payments are calculated to pay off both the loan principal and interest over the loan term. This calculation is called amortization. Here's what surprises most borrowers: in the early years of a 30-year mortgage, the vast majority of each payment goes to interest, not principal.

Take a $300,000 loan at 7% interest. Your monthly principal and interest payment is about $1,996. In Month 1, roughly $1,750 of that goes to interest, and only $246 reduces the loan balance. By Month 180 (year 15), the split is closer to half and half. By the final payments, nearly all of each payment is principal.

This is why the early years of a mortgage feel expensive relative to how quickly your loan balance shrinks. It's also why extra principal payments made early in the loan have an outsized impact — they reduce the balance that future interest charges are calculated on.

Why Extra Payments Matter More Than You Think

On that same $300,000 at 7%, if you pay just $100 extra per month toward principal, you'll pay off the loan approximately 3.5 years early and save over $50,000 in total interest. If you pay $250 extra per month, you'll cut six or more years off the loan term. The math is powerful because every dollar of principal you eliminate now avoids all the future interest that would have been charged on it.

You don't need to commit to a higher payment permanently to benefit. Most loans allow you to make additional principal payments whenever you choose, even just once or twice a year.

The Difference Between Principal and Interest

• Principal — the actual loan balance. When you make a payment, a portion of it reduces this number.
• Interest — the lender's fee for lending you the money, expressed as a percentage of your outstanding balance. As your balance decreases, so does the interest portion of each payment.

Your total monthly payment typically includes more than just principal and interest. Property taxes, homeowners' insurance, and (if applicable) mortgage insurance are usually collected monthly and held in an escrow account. We cover that full payment picture in Module 4 and Module 6.

Lesson 3.2

Fixed vs. Adjustable Rate Mortgages

Every mortgage falls into one of two categories: fixed rate or adjustable rate. The difference determines how predictable your payment will be over time — which matters a lot when you're planning a budget around a 30-year commitment.

Fixed Rate Mortgages

With a fixed rate mortgage, your interest rate is locked for the entire loan term — typically 15 or 30 years. Your principal and interest payment will never change. Taxes and insurance can shift year to year, but the core mortgage payment stays constant.

This predictability is valuable. Most homebuyers who plan to stay in their home long-term choose a fixed rate, especially when rates are reasonable. The tradeoff is that if market rates drop significantly after you close, you'll need to refinance to take advantage — and refinancing costs money.

Adjustable Rate Mortgages (ARMs)

An ARM starts with a fixed rate for an initial period, then adjusts periodically based on a market index. Common products include:

• 5/1 ARM — fixed for 5 years, adjusts annually after that
• 7/1 ARM — fixed for 7 years, adjusts annually after that
• 10/1 ARM — fixed for 10 years, adjusts annually after that

ARMs typically offer a lower initial interest rate than fixed loans — often noticeably lower. That lower rate saves money during the fixed period. The risk is what happens when adjustments kick in.

ARM Caps — Your Protection Against Rate Spikes

All ARMs have caps that limit how much the rate can change. A typical cap structure looks like this: 2/1/5

• 2 — maximum increase at first adjustment (2% above the initial rate)
• 1 — maximum increase at each subsequent annual adjustment (1% per year)
• 5 — maximum total increase over the life of the loan (5% above the initial rate)

So if you start at 6%, your rate can never exceed 11% no matter what happens to the market. That's still a significant payment increase, which is why ARMs require careful planning.

When an ARM Makes Sense

ARMs make the most financial sense when you don't expect to stay in the home past the fixed period — for example, if you're buying knowing you'll move or sell in 5–7 years. In that case, you capture the lower rate without ever experiencing an adjustment. They can also make sense if you're confident rates will drop and you plan to refinance before the fixed period ends, though market timing is always uncertain.

Lesson 3.3

Loan Types: Conventional, FHA, VA, and USDA

Not all mortgages are the same product. The loan type affects your minimum down payment, credit score requirements, mortgage insurance costs, and what properties you can use it on. Here's what each one actually means.

Conventional Loans

Conventional loans are not backed by any government agency. They conform to guidelines set by Fannie Mae and Freddie Mac — the two government-sponsored enterprises that buy most mortgages after they're originated. Because there's no government guarantee, lenders apply stricter credit standards.

• Minimum down payment: 3% for first-time buyers, 5% for most others
• Minimum credit score: typically 620, with better rates above 740
• Mortgage insurance: required if down payment is below 20%, but can be removed when you reach 80% LTV
• Loan limits: set by the Federal Housing Finance Agency (FHFA), adjusting annually by county

Conventional loans tend to have the best rates for borrowers with strong credit and larger down payments. They're the most common loan type for repeat buyers and anyone who can hit the 20% mark.

One important note on loan limits: when a loan amount exceeds the FHFA conforming limit for that county, the loan no longer qualifies as a conventional loan. At that point, borrowers move into what are called jumbo loan programs. Jumbo loans are not backed by Fannie Mae or Freddie Mac, so lenders take on more risk — and they price that risk accordingly. Qualifying standards are typically stricter: expect higher minimum FICO score requirements, larger down payment requirements (often 10–20% or more), and more thorough documentation of income and assets.

FHA Loans

FHA loans are insured by the Federal Housing Administration, which allows lenders to offer more flexible terms. This makes FHA a common choice for first-time buyers and those with less-than-perfect credit.

• Minimum down payment: 3.5% with a 580+ credit score; 10% with a 500–579 score
• More flexible debt-to-income ratio requirements
• Mortgage insurance: an upfront premium of 1.75% of the loan amount plus an annual premium — and unlike conventional PMI, it often lasts for the life of the loan

The downside of FHA is the cost of mortgage insurance. For many borrowers, once their credit improves, refinancing into a conventional loan and eliminating mortgage insurance makes financial sense.

VA Loans

VA loans are backed by the Department of Veterans Affairs and available only to eligible veterans, active-duty service members, and qualifying surviving spouses. They offer terms unavailable on any other loan type:

• No down payment required
• No private mortgage insurance
• Competitive interest rates
• A VA funding fee (which can be financed into the loan) instead of traditional closing costs

If you qualify for a VA loan, it should almost always be your first consideration. The lifetime savings compared to a conventional loan with a 5% down payment — and compared to FHA — are substantial.

USDA Loans

USDA loans are backed by the U.S. Department of Agriculture and designed to encourage homeownership in rural and suburban areas. They have two eligibility requirements that both must be met: the property must be in a USDA-eligible geographic area (you can check at the USDA's online map), and the borrower's household income must fall within the program's limits for their county.

• No down payment required
• Competitive rates with government backing
• Annual guarantee fee instead of traditional PMI

USDA-eligible areas are broader than many buyers expect — they include many smaller cities and suburban communities, not just rural farmland.

Lesson 3.4

Interest Rate vs. APR — The Number That Actually Matters

When lenders advertise mortgage rates, they always show two numbers: the interest rate and the APR (Annual Percentage Rate). Both numbers have their uses, but neither one — on its own — tells you what you actually need to know when comparing lenders.

What the Interest Rate Is

The interest rate is the base cost of borrowing money. It's used to calculate your monthly principal and interest payment. Period. It doesn't capture the full cost of the loan.

What APR Includes

APR is the interest rate plus most of the fees and costs associated with the loan, expressed as an annualized percentage. It includes:

• Origination fees and points
• Mortgage broker fees (if applicable)
• Certain prepaid items
• Mortgage insurance premiums (for FHA)

In theory, APR lets you compare the total cost of two loans. In practice, most borrowers — especially first-time buyers — find the two numbers more confusing than helpful. Chasing APR can lead you in the wrong direction. Here's the method that actually works.

How to Shop for the Best Rate

Contact at least three lenders and give each of them the exact same scenario: same purchase price, same down payment, same loan term, same location. Do all three on the same day — rates move daily, and a quote you got on Monday is not comparable to one you get on Thursday. To make the comparison valid, the market has to be the same for all three.

Then ask each lender to quote the same interest rate — not a similar rate. If the first lender quotes 6.00%, ask the other two to quote 6.00% as well. Not 5.875%. Not 6.125%. The same rate.

With all three quotes locked at the same interest rate, the comparison becomes simple: whoever has the lowest lender fees has the best deal. Those are the fees in Section A of the Loan Estimate — origination charges, discount points, underwriting fees, processing fees. That's the only thing you need to compare.

Two things to leave out of this comparison: title fees and escrow charges. Those appear elsewhere on the Loan Estimate and can be presented differently by each lender in ways that distort the comparison. Stick to lender fees only.

This method also cuts through the points problem. A lender might quote you 5.875% with a point attached — which costs $3,500 upfront on a $350,000 loan to get a rate that's 0.125% lower than 6.00%. That may or may not be worth it depending on how long you stay in the home. By keeping all three quotes at the same rate and comparing only what the lender charges to deliver that rate, you're making a clean apples-to-apples comparison without any of that noise.

Understanding Discount Points

When a lender quotes a rate with "points," they're offering you the option to pay upfront to buy a lower rate. One point equals 1% of the loan amount. Paying one point on a $350,000 loan costs $3,500 upfront and might reduce your rate by 0.25%.

Whether buying points makes sense depends on your break-even: divide the upfront cost by the monthly savings. If the break-even is 48 months and you plan to stay 10 years, buying points is a good deal. If you might sell in 3 years, it's probably not.

Lesson 3.5

Mortgage Insurance: PMI and MIP

Mortgage insurance is one of the most misunderstood costs in a home purchase. Many buyers think of it as a fee they pay the lender, or something that protects them. It's neither. Mortgage insurance protects the lender in case you default — and you pay for it.

PMI — Private Mortgage Insurance (Conventional Loans)

PMI is required on conventional loans when your down payment is less than 20%. The rate varies based on your credit score, down payment amount, and loan term — but typically falls between 0.5% and 1.5% of the loan amount per year.

On a $350,000 loan, PMI at 0.8% annually adds about $233 per month to your payment. That's real money — over five years, that's nearly $14,000 in mortgage insurance alone.

When PMI Goes Away

The good news about conventional PMI: it doesn't last forever. By law, lenders must automatically cancel PMI when your loan balance reaches 78% of the original purchase price (assuming your payments are current). You can also request cancellation once you reach 80% LTV, which may require a new appraisal confirming the home's value.

If your home has appreciated significantly, you might reach 80% LTV faster than your payment schedule would suggest — making refinancing or an appraisal-based PMI cancellation worth exploring.

MIP — Mortgage Insurance Premium (FHA Loans)

FHA loans have their own version of mortgage insurance called MIP. It works differently from PMI in two important ways:

• Upfront premium: 1.75% of the loan amount, due at closing (though it can be rolled into the loan)
• Annual premium: approximately 0.55% per year for most 30-year loans, paid monthly

The more significant difference is that FHA MIP often lasts the life of the loan if your down payment was less than 10%. Unlike conventional PMI, you can't simply request cancellation at 80% LTV. The only way to eliminate MIP on an FHA loan is to refinance into a conventional loan once you have sufficient equity.

VA — No Monthly Mortgage Insurance

VA loans are the only loan program with no monthly mortgage insurance of any kind. Instead, there's a one-time VA funding fee (typically 2.15%–3.3% of the loan amount for first use, depending on down payment and service classification) that can be financed into the loan. That's a one-time cost — no ongoing monthly charge.

USDA — Monthly Fee, Different Name

USDA loans do carry a monthly fee. The program calls it an "annual fee," charged at 0.35% of the loan balance per year and collected in monthly installments. There's also an upfront guarantee fee of 1% of the loan amount. The terminology is different from PMI or MIP, but the function is the same — it's mortgage insurance that funds the USDA program and covers losses when USDA loans go into foreclosure. Don't let the name fool you. It's lower than FHA MIP, and generally lower than conventional PMI for buyers with limited down payments, but it is a monthly cost you'll carry for the life of the loan.

Lesson 3.6

How to Read a Loan Estimate

Within three business days of receiving your loan application, lenders are required by law to provide a Loan Estimate (LE). This three-page standardized form is one of the most important documents in the mortgage process — it's your clearest window into what the loan will actually cost you.

Page 1 — The Big Picture

Page one shows the loan terms you applied for: purchase price, loan amount, loan type, interest rate (and whether it can increase), and a projected monthly payment breakdown. It also shows your estimated cash to close — the total you'll need to bring on closing day.

Important: The projected monthly payment here includes principal and interest, estimated mortgage insurance (if applicable), and estimated escrow for taxes and insurance. This is much closer to your real monthly cost than the rate alone suggests.

Page 2 — Closing Cost Detail

Page two breaks down all closing costs into categories:

• Section A — Origination charges (lender fees you cannot shop): origination fee, points
• Section B — Services you cannot shop (chosen by lender): appraisal, credit report, flood determination, tax monitoring
• Section C — Services you can shop: title insurance, settlement/closing agent, attorney fees
• Sections E/F — Taxes and government fees: transfer taxes, recording fees
• Section G — Prepaids: prepaid interest, homeowner's insurance premium, initial escrow payment

The items in Section C are ones where you can shop around and potentially save money. Title insurance in particular can vary significantly by provider.

The Three-Day Comparison Window

When you receive Loan Estimates from multiple lenders, compare them side by side. The standardized format makes this straightforward. Focus on: total origination charges (Section A), total closing costs, APR, and the projected 5-year total cost (shown at the bottom of page 3). The 5-year total includes payments plus remaining principal, giving you a meaningful apples-to-apples comparison.

Loan Estimate vs. Closing Disclosure

Before closing, you'll receive a Closing Disclosure (CD) — the final version of these same numbers. You must receive it at least three business days before closing. Compare it to your Loan Estimate. Under federal rules, certain costs cannot increase at all, others can increase by no more than 10%, and some can change without limit (like prepaid interest, which depends on the exact closing date).

If something changed significantly and you weren't notified in advance, ask the lender to explain it in writing before you close.