What Is a Mortgage and How Does it Work?

FT Contributor  | 

A mortgage is a type of loan that allows you to buy or refinance a home. While they are commonly used to purchase a home, mortgages can also go toward any large real estate purchase, such as an office space or commercial property.

Mortgages are legal documents that allow the lender to possess the property in the event that you default on the loan. As such, mortgages can also be referred to as liens, as a legal claim against the home, or a deed of trust.

When obtaining a home loan, the borrower must agree to the terms and conditions of the loan, which outline the length of the mortgage, the monthly payment amount, and the interest rate. The amount that the borrower pays each month is determined by the down payment they make on the property.

Gain a better understanding of what you need to know to qualify for a mortgage and what it means to take out a loan of this type.

How Does a Mortgage Work?

A lot of documents must be filled out in order to get pre-approved for a mortgage, including:

  • Promissory note: This outlines how the loan will be repaid, including the total amount of the loan, interest rate, term of the loan, and principal and interest payments.
  • Deed of trust: Because this agreement is between you and the lender, some states require a trustee to be added to the mortgage through a deed of trust. The mortgage will default to them in the event of the original borrower’s inability to pay.

There are several factors that make up your monthly mortgage payment. Your down payment amount is a factor that can significantly impact what you owe monthly on your mortgage. The more money you put down on the deposit, the lower your mortgage payments will be. Other factors used to calculate what you owe on a mortgage include the interest rate (which depends on the type of mortgage you take out), the principal balance of the loan, the taxes in your city and state, and your homeowner’s insurance.

Types of Mortgages

There are a variety of mortgages available. The most common mortgages are either fixed-rate or adjustable, but there are also interest-only and reverse mortgages. Learn more about each mortgage type below.

Fixed-Rate Mortgage

A fixed-rate mortgage offers you a fixed interest rate for the life of the loan. You have the option between a 15-year and 30-year mortgage, and over that time your monthly mortgage payments will remain the same. In some cases, what you pay each month may change depending on your property taxes or homeowner’s insurance provider.  

With 15-year fixed-rate mortgages, the interest rate is often lower, but your monthly payments are higher because you’re paying the loan off in less time. Conversely, with 30-year fixed-rate mortgages, your monthly payments are lower, but your interest rate is higher. Often, you end up paying more in interest with a 30-year fixed-rate mortgage than you would with a 15-year option.

There are many benefits that come with a fixed-rate mortgage. For one, you’re able to build equity faster even though your monthly payment is higher. Fixed-rate mortgages also allow you to budget better, which is beneficial for individuals with a fixed income.

Adjustable Mortgage

With an adjustable-rate mortgage, the interest rate is based on the outstanding balance of the loan throughout the life of the loan. Initially, the interest rate is fixed for a period of time. Then, typically yearly or monthly, the interest rate will change to reflect the amount owed.

Also called a variable-rate mortgage, this type of loan’s interest can also adjust based on factors like the market rate. Unpredictability can make it difficult for the borrower to understand what their monthly mortgage payment is going to be, but an adjustable-rate mortgage is good for someone who knows they’ll have funds at the ready.

Interest-Only Mortgage

The interest-only mortgage option allows you to pay interest during the first few years of the loan — none of the balance is paid whatsoever during that time. This makes monthly payments substantially lower, but after the interest-only term expires, payments can skyrocket.

Borrowers may make payments toward the principal on the loan, but it’s not required during the interest-only period.

Unlike fixed-rate mortgages, the interest rate that you pay fluctuates. There are interest-only fixed-rate mortgages, but they are not common. Interest-only mortgages are risky because they don’t allow you to grow equity and the interest rate can fluctuate. If you have a substantial income or are looking to buy a second home as part of an investment strategy, this may be a beneficial mortgage option.

Reverse Mortgage

Like traditional mortgages, a reverse mortgage allows you to borrow money to pay for a property. Instead of the borrower making monthly payments, the loan is repaid when the borrower no longer occupies the home. As the balance of a reverse mortgage grows, interest and other fees are applied to the principal balance.

Homeowners are required to pay property taxes, and insurance, but a reverse mortgage allows someone who can no longer afford their monthly mortgage payments to stay in their home and be entitled to the property. This is common in families with elderly relatives. When the relatives pass away, the family will typically sell the home to pay the outstanding balance on the reverse mortgage. Reverse mortgages can also be helpful to those experiencing financial hardship, such as single parents struggling with mortgage payments.

Mortgage Terms

Below, learn more about the different mortgage terms to gain a better understanding of mortgages.

Principal

Principal is the amount of money borrowed for the mortgage. This amount will decrease as payments are made.

Interest

Interest is a percentage of the loan to be paid to the lender for supplying the loan. The interest rate is based on the principal of the loan, so it can fluctuate in certain mortgages. The down payment made on a mortgage can also affect the interest rate. Generally, the more you put down, the lower your interest rate.

Taxes

Property taxes are another aspect that affects mortgage payments. This amount varies based on the location of your home and the property’s assessed value. Most often, property taxes are lumped into the sum of your monthly mortgage payment.

Homeowners Insurance

This insurance protects your property and covers any losses or damages that occur. It also provides liability coverage to the homeowner. Proof of insurance is required in order to apply for and maintain a mortgage.

Mortgage Insurance

If your down payment is less than 20% of the total principal, you are required to take out mortgage insurance. This allows borrowers to obtain mortgages for larger amounts than they would be able to otherwise. Your mortgage insurance payment is included in the monthly escrow payment to your lender. This insurance protects the lender in the event that the borrower defaults on their payments. It is often part of FHA mortgages.

Understand the many mortgage options available to you and educate yourself about the benefits of each to make the decision that’s right for you.


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This post was updated December 19, 2019. It was originally published December 19, 2019.