What Is a Mortgage?

The spooky thing about the word mortgage is that it means dead pledge. To put it another way, you can either pay it back quickly until it’s dead, or slowly until you’re—well, you get the idea. Understand what a mortgage really is and how it works so you can get one that helps you pay off your house as fast as possible.

What Exactly Is a Mortgage?

A mortgage is debt—money you borrow from a lender to buy a house when you don’t have the full price in cash. The lender sets up your repayment plan, and if you start missing payments, the lender can legally take your house in foreclosure.

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At Ramsey, the first thing we teach people is that debt is dumb! And since a mortgage is debt, we’ll always tell you the best way to purchase a house is with 100% cash. And people do this all the time. In fact, 42% of buyers paid cash for their homes last year, according to Ramsey Solutions’ Real Estate Report.

But we know saving up that much money isn’t always realistic for everyone’s timeline. Plus, your house is one asset that actually grows in value over time. That’s why we don’t yell at you for getting a mortgage—as long as it’s one you can afford and pay off fast.

How Do Mortgages Work?

First, you pay a portion of the home price up front (a down payment), then borrow the rest from a lender and pay it back with interest over a set term.

Aim to save 20% of the total home price by yourself in cash before you borrow the other 80% from a lender. That allows you to avoid being charged private mortgage insurance (PMI), which doesn’t benefit you. If you’re a first-time home buyer, a smaller down payment—at least 5%—is okay too, but be ready to pay PMI.

You’ll also sign a mortgage note—the legal document that sets the terms of the mortgage. This includes:

• Amount of money borrowed
• Costs your lender will charge you
• Repayment plan
• Timeline of money to be paid back
• All the nitty-gritty details

Then comes the interest. Whatever amount of money you put down on your house will affect how much your lender charges you in interest for your mortgage. The less you need to borrow, the less interest you’re required to pay—and the sooner you’ll pay off your house!

Who’s Involved in the Mortgage Process?

The mortgage process involves two main parties—the borrower and the lender.

Borrower

The borrower is you—the person borrowing money from a lender to pay for a house. You might be told you can get a bigger loan to buy a bigger house if someone cosigns for you. But cosigning is a bad idea because it usually means you’re not financially ready to buy a house.

Lender

A lender loans out money so a borrower can buy a house. But first, the lender decides how much they’re willing to loan by examining the borrower’s personal finances. If there are no red flags in the borrower’s financial history, the lender will likely approve the borrower for the loan.

There are different kinds of mortgage lenders. You might work with a mortgage broker to help you pick the right lender. Or you might work with one of these lenders right off the bat:

• Bank
• Credit union
• Nonbank mortgage lender

Whatever you do, make sure you work with a mortgage professional you trust—someone who takes the time to explain things to you, like our friends at Churchill Mortgage.

How Is Prequalification Different From Affordability?

Prequalification is a lender’s estimate of how much they’re willing to loan you—but real affordability is what actually fits your budget. And those are almost never the same number. It’s the same story with preapproval—that’s a lender’s green light based on your paperwork, not proof you can actually afford the payment.

A lender bases prequalification and preapproval on their risk, not your financial peace. Here’s Ramsey’s guideline: Never buy a house with a total monthly payment (principal, interest, taxes, insurance, PMI and HOA fees) that’s more than 25% of your monthly take-home pay. Run your numbers in EveryDollar—the budgeting app built by Ramsey to help you find margin—before you ever fall in love with a house at the top end of what a lender will approve.

What Should You Know Before Getting a Mortgage?

Before you sign anything, get familiar with the details of how a mortgage works: amortization, down payments, mortgage rates, mortgage types, what makes up your monthly payment, and the other fees that come with the loan.

Amortization

Amortization is how your mortgage gets paid down over time through monthly payments. Your lender will probably walk you through an amortization schedule, which is basically a visual countdown to the end of your mortgage. It shows you how much of each payment will go toward interest and principal until you pay off the house.

Down Payment

This is the cash you pay up front—a percentage of the total home price. Remember, 20% down allows you to skip PMI. And 5% is okay if you’re a first-time home buyer—you’ll just pay PMI until you reach 20% equity. For help reaching your down payment faster, check out our Saving for a Down Payment Guide.

Mortgage Rates

A mortgage rate or interest rate is a fee a lender collects for letting you borrow money. It’s based on a percentage of your mortgage balance. As you pay down your mortgage principal, you’ll pay less in interest.

Your lender will determine the interest rate on your mortgage based on the length of your repayment plan, your personal financial history, and the current economy. Most buyers have to pay fees called loan-level price adjustments in the form of a slightly higher interest rate.

There are two mortgage rate options you should know about:

• Fixed-rate mortgages: These keep the same interest rate over the life of the loan. You’re locked into your rate once you sign those mortgage documents—regardless of market changes. This is the only type of mortgage rate we recommend at Ramsey since it helps you avoid rising rates.
• Adjustable-rate mortgages (ARMs): An ARM loan usually has a set period of time when the interest rate doesn’t change. But after that, your rate can change based on several different factors—like market trends. ARMs transfer the risk of rising interest rates to you. No thanks!

Mortgage Types

The main types of mortgages are conventional, FHA and VA loans—but we only ever recommend a 15-year fixed-rate conventional loan.

Conventional Mortgages

Conventional loans generally require a 5% down payment.¹ They’re backed by the mortgage lender themselves—so if you don’t make your mortgage payments, the lender loses money on the loan. Conventional mortgages can be more difficult to qualify for, and they require higher down payments than government-backed loans.

Here are two of the most common conventional mortgages:

• 15-year fixed-rate mortgage: This is a home loan designed to be paid over a term of 15 years. It’ll likely have a higher monthly payment and a lower interest rate than a 30-year mortgage. This is the lowest total cost mortgage—which is why it’s the only one we ever recommend at Ramsey.
• 30-year fixed-rate mortgage: This loan term is set for 30 years and will probably have the lowest monthly payment amount but the highest interest rates—which means you’ll pay much more over the life of the loan. In other words, it’s a rip-off!

Unconventional Mortgages (Government Loans)

There are a few government-backed ways to step onto the housing ladder, and they’re built to “help” buyers who aren’t in strong financial shape yet—usually with a low or no down payment. But the catch is they tack on extra fees and interest that cost you more over the life of the loan. And since the government backs these loans, your lender won’t lose money if you stop making payments—but you’ll still lose the house.

Bottom line: A government loan might get you in the door, but it doesn’t help you in the long run.

Here are two of the most common government loans:

• FHA loans: These loans require a down payment of as little as 3.5%—which looks pretty nice. But a lower down payment now means you’ll pay way more in interest later.² Plus, they come with a form of PMI that you pay for the entire life of the loan—which only protects the lender, not you. Bad deal!
• VA loans: These are backed by the U.S. Department of Veterans Affairs and available to veterans, service members and survivors. They don’t require down payments or mortgage insurance (but there is a funding fee).³ This may be tempting, but it’s risky. If you can’t put any money down on your home, you'll have high monthly payments—which makes it difficult to keep your home.

What Type of Mortgage Should You Get?

Remember, the only mortgage we ever recommend at Ramsey is the 15-year fixed-rate mortgage. That’s because it has the lowest total cost compared to every other option.

Now, you might be tempted to choose the 30-year over the 15-year mortgage simply because the 30-year offers a lower monthly payment. But the 30-year mortgage is tens of thousands of dollars more expensive and keeps you stuck in debt twice as long!

Monthly Mortgage Payment

Your monthly mortgage payment includes principal, interest, taxes and insurance (PITI)—we also count PMI and homeowners association (HOA) fees.

Here’s how your monthly mortgage payment breaks down:

Use our Mortgage Calculator to enter your down payment amount and try out different home prices within your budget.

Other Mortgage Fees

Here are some other fees related to getting a mortgage:

• Closing costs: These are all the fees associated with processing and closing a mortgage, including an appraisal of the property, home inspection, the real estate agent’s commission, prepaid insurance and property taxes. These vary from lender to lender, so pay close attention and don’t be afraid to negotiate lower closing costs.
• Prepayment penalties: These might show up if you want to sell your home before the end of your loan term, or if you want to pay off your mortgage early. Never sign up for a mortgage with prepayment penalties.
• Interest rate versus annual percentage rate (APR): Don’t be fooled—your interest rate isn’t the whole cost of the loan. APR is a comparison tool that rolls your interest rate together with the up-front fees you pay to get the mortgage (like mortgage points and loan processing fees) into one yearly percentage. You pay those fees at closing, not every month. APR just folds them in so you can compare different loan offers apples-to-apples. That’s why APR is usually a little higher than your rate.
• Balloon payments: These are large, lump-sum payments due at the end of some loan terms. You’ll see these with super short-term loans usually from nonbank lenders. While we usually associate balloons with celebrations, these are some balloons you want to avoid. You don’t want to be on the hook for a large payment due all at once when you could be paying down your principal with steady, predictable payments.
• Negative amortization: If you fail to make your loan payments or only pay enough to cover the interest amount due, what you owe will be added to your loan’s principal. This will make your principal larger and your payments even bigger. The lesson here is this: Don’t miss your payments!

How Does the Mortgage Process Work?

The mortgage process runs through five steps, from finding a lender to closing on your new house:

1. Find a lender you trust.
2. Get preapproved for a mortgage.
3. Make an offer on a house.
4. Wait for loan documents to finalize.
5. Close on your house!

Sound simple enough? Most of the work will be on your lender. All you need to do is have your personal financial records readily available—and be prepared to sign a mountain of paperwork!

Ready to Get a Mortgage?

If you want more help understanding mortgages and how to make the best decision for your budget when buying a house, connect with our friends at Churchill Mortgage. They actually care about helping you pay off your house fast.

Frequently Asked Questions