What is a mortgage?
A mortgage is a loan from a bank or a financial institution that helps the borrower purchase a house. A mortgage is secured by the home itself, so if the borrower defaults on the loan, the bank can sell the home and recoup its losses. Mortgage payments are usually monthly and consist of four components: principal, interest, taxes and insurance.
Before getting a mortgage, the borrower agrees to certain terms and conditions. These specify how long she has to pay the mortgage back, which can span decades, and how much she has to pay each year as well as what she’s required to pay at signing, which is a percentage of the home’s cost called a down payment.
These terms and conditions also specify the rate at which interest accrues, and whether it accrues at a fixed rate, which means the rate stays the same for the entire term of the loan; or at an adjustable rate, where the interest rate can be raised or lowered. Some mortgages are a hybrid of both, like the 7/1 adjustable-rate mortgage (ARM), which accrue interest at a fixed rate for the first seven years of its term, after which the lender may adjust the interest rate.
Borrowers pay back the bank for their mortgage at regular intervals, usually monthly. The payments go toward the total amount of money borrowed, which is called the principal, and the interest, although the latter is tax-deductible. The process of paying off a mortgage is called amortization.
Mortgages are considered secured loans, meaning that they’re backed up by an asset — the house — should the homeowner default. When the borrower defaults, lenders are permitted to take back the house, which is called foreclosure. For this reason, some lenders require borrowers to take out some kind of insurance, such homeowners’ insurance, which covers material damage to the property, or mortgage insurance, which protects the lender in case the borrower defaults.
Beyond the basic mortgage, a borrower has several options to choose from when deciding what’s right for her:
- Balloon mortgages: In a balloon mortgage, the borrower’s monthly payments don’t fully amortize the loan at the end of the period, with payments starting low but ballooning to a much larger amount at the end of the term. They’re good for people who expect to have a higher income at the end of the borrowing period than when they started, or who expect to sell their home before the loan period ends, but they may require borrowers to refinance their loan or sell the property.
- Government-backed mortgages: The U.S. government issues mortgages to certain qualifying citizens. These include the U.S. Department of Agriculture (USDA) loan, which is given to rural property owners without adequate housing, and the Federal Housing Administration-insured loan, which gives federal assistance to lower-income citizens. Veterans of the armed forces can also qualify for special mortgages.
- Second mortgage: Also called a home equity loan, a borrower may take out a second mortgage to acquire a loan using the home’s equity as collateral.
Check out Bankrate’s list of the best mortgage rates.
Sandra’s mortgage loan totals $100,000, meaning her principal balance is $100,000. She negotiates a 30-year loan and a 3.7 percent interest rate. The total cost of her mortgage is $165,702 after factoring in interest. That means her monthly payment is $460. She also takes out homeowners’ insurance, which costs an additional $300 per year.