Step 2: What’s a Mortgage and How Does It Work?
Let’s break down the loan that helps you buy a home.
A mortgage is a loan from a bank or lender that helps you buy a home. You agree to pay it back every month, with interest, over a set number of years. It’s like renting money—except each payment helps you own more of your home.
When you buy a home, most people don’t pay all cash. A mortgage fills the gap between what you can pay upfront and what the home costs.
Mortgage Basics
Loan Amount
This is the price of the home minus your down payment. It’s the total amount you borrow from the lender to cover the remaining cost of the home.
For example, if a home costs $250,000 and you put down $10,000, your loan amount would be $240,000. This is the figure used to calculate your monthly principal and interest payments.
Interest Rates
This is the percentage the lender charges you for borrowing money. It's what you pay for the ability to use the lender's money. A lower interest rate means you'll pay less over time.
Lenders may advertise a rate, but it's important to also look at the APR, or Annual Percentage Rate. The APR includes the interest rate plus other fees like loan origination or discount points. It gives you a more complete picture of the true cost of the loan.
Loan Term
Usually 15 or 30 years. It’s how long you’ll take to pay the loan back. A longer term, like 30 years, means lower monthly payments but more total interest paid over time.
A shorter term, like 15 years, has higher monthly payments but less interest overall. Some lenders also offer 10, 20, or even 40-year terms. Choosing the right loan term depends on your budget, long-term goals, and how quickly you want to build equity in your home.
Monthly Payment
This includes principal, interest, taxes, and insurance (called "PITI"). Your monthly payment can vary based on the size of your loan, your interest rate, your property tax rate, and the cost of your homeowner’s insurance.
Some loans also include mortgage insurance if your down payment is under 20%. Knowing your full monthly cost—not just the loan part—is key to making sure your new home fits your budget.
What's in a Monthly Payment?
Your monthly mortgage payment is made up of four key parts: principal, interest, taxes, and insurance—commonly referred to as "PITI."
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Principal is the portion of your payment that goes toward reducing the loan balance. Over time, you’ll build equity as this amount increases.
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Interest is the lender’s fee for borrowing the money. It’s calculated based on your interest rate and loan balance.
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Taxes are local property taxes that are typically collected monthly and held in an escrow account until they’re due.
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Insurance includes homeowners insurance, which protects your home against damage or loss, and possibly mortgage insurance, which is required if your down payment is less than 20%.
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These parts work together to make up your total monthly obligation. Understanding how they break down helps you budget and plan with more confidence.
Interest Rates: Fixed vs. Adjustable
When choosing a mortgage, one of the biggest decisions is how your interest rate behaves over time.
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Fixed Rate: The interest rate stays the same for the entire life of the loan—whether it’s 15, 20, or 30 years. This means your monthly principal and interest payment stays the same, making it easier to plan and budget. It offers stability and peace of mind, especially if you expect to stay in the home long term.
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Adjustable Rate (ARM): The interest rate starts lower than a fixed-rate mortgage but can increase or decrease over time, usually after an initial period of 3, 5, 7, or 10 years. After that period, the rate adjusts periodically based on a market index. This can be helpful if you plan to sell or refinance before the rate adjusts—but it does carry risk of your payment rising.​​
How APR Fits In
Regardless of the rate type, you should always check the APR, or Annual Percentage Rate. While the interest rate tells you the cost of borrowing the money, the APR tells you the total cost of the loan over a year, including:
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Loan origination fees​​
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Discount Points (a percentage of the loan amount paid upfront to reduce the interest rate for the life of the loan)
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Mortgage Insurance (if applicable)
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Closings costs (fees like the appraisal, title fees, or home inspection fees are excluded from this)
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The APR gives a more accurate picture when comparing loan offers. A loan with a slightly higher interest rate but lower closing fees may actually have a better APR—and cost you less over time.
What Happens if You Stop Paying?
If you stop making your mortgage payments, the lender has the legal right to take the home back through a process called foreclosure. Foreclosure means the lender will sell your home to recover the money they loaned you. This process can take several months and can cause serious damage to your credit score, making it difficult to qualify for loans, credit cards, or even rental housing in the future.
Most lenders will try to contact you before starting foreclosure. If you ever find yourself in a tough financial spot, it’s important to reach out early—there may be loan modifications or assistance programs available. But to avoid this situation entirely, lenders carefully check your credit, income, and debts before approving the mortgage to make sure you’re in a good position to repay the loan.
Real-life Example:
You buy a home for $300,000 and make a 3.5% down payment of $10,500. This leaves you with a loan amount of $289,500. Let’s say you choose a 30-year fixed-rate mortgage with an interest rate of 6.5%.
Your monthly mortgage payment (just principal and interest) would be about $1,840. But remember—that’s only part of the story. When you add estimated property taxes, homeowners insurance, and possibly mortgage insurance, your full monthly payment could be closer to $2,300–$2,500 depending on your location and the exact terms of your loan.
Over the 30 years, you’ll pay back the original $291,000 plus over $370,000 in interest if you stick to the full schedule. That’s why comparing loan terms and interest rates matters so much—and why buying a home is a long-term financial commitment.
Wrapping Up
A mortgage doesn’t need to be scary or confusing. It’s just a loan—with some specific parts—that helps you buy a home and build equity over time. Now that you understand how a mortgage works, the next step is getting pre-approved, so you know what you can afford and can start shopping with confidence.