What is a Mortgage and How Does it Work?

A mortgage is a loan offered by a financial institution or bank to help the borrower to buy a house. The home itself is used to secure the mortgage, which means that if you take out a mortgage and then default on the loan, the bank is authorized to sell your home to recoup its costs.

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Mortgage Terms and Conditions

You may use a mortgage loan to make a large real estate purchase, without having to pay the property’s entire value up front. Then, over a period of many years, you repay the loan to your lender – including interest – until you are free and clear to fully own the property.

Before you are offered a mortgage, you will have to agree to the terms and conditions of the loan. These terms specify the repayment period, which often spans as many as three decades, the amount of money you should repay each month or year, as well as the amount of down-payment you may need to pay when signing for the mortgage, which is usually a percentage of the total cost of the home.

The terms will also state what the interest rate for the loan is, and whether the rate will remain fixed over the repayment term, or whether it will be adjusted upward or downward periodically.

How a Basic Mortgage Works

Once you have been approved for a mortgage, you will be expected to make regular repayments of the loan, usually every month. These payments will go towards the payment of the principal amount of money borrowed, as well as towards the tax-deductible interest at an agreed-upon rate. The process of paying off your mortgage is known as amortization.

Mortgages are considered to be secured loans since they are backed by the property in case of default in payment. If you default, the bank or financial institution has the right to take the house, a process known as foreclosure. Because of this, many lenders will require you to have either homeowner’s insurance to cover any damage to the property, or mortgage insurance to cover their costs in case you default on payment.

Generally, most lenders offer either fixed rate, adjustable rate or balloon mortgages, which are three of the most common types of loan.

Fixed Rate Mortgages

A fixed rate mortgage is one of the most common loans that financial institutions offer to prospective homeowners. The loan’s interest rate is fixed, and the payments remain steady over the repayment term. Because the interest rate chargeable on every installment is known, this type of mortgage allows you to set up a payment schedule that has constant payments over the entire repayment term.

Also known as fixed-rate amortization, each payment you make includes both the principal amount and the interest charged. However, with each payment you make, the amortization schedule will be adjusted to have you pay more of the principal and less of the interest with each subsequent installment.

Adjustable Rate Mortgages

An adjustable rate mortgage (ARM) is a home loan where the applied interest rate charged on the loan’s outstanding balance remains variable though the repayment period. If you take out an adjustable rate mortgage, you will normally be quoted a fixed interest rate for an initial period. At the end of this period, the rate will be continually reset – often yearly, but sometimes monthly, depending on the mortgage terms. The interest rate charged on your ARM may decrease or increase after the initial period on the basis of an index rate and set margin combination. Most mortgages in the U.S. are based on one of three main indices: the one-year Treasury bills maturity yield, the 11th District cost of funds index, or the LIBOR (London Interbank Offered Rate). While the index rate can change, the margin stays fixed throughout the life of the loan. For instance, if the margin is 2% and the index stands at 5%, then your mortgage rate would be adjusted to 7%. On the other hand, at the next rate adjustment, if the prevailing index rate is 2%, your mortgage rate would drop to 4%.

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Balloon Mortgages

Balloon mortgages work in a very different way to fixed rate 15- or 30-year mortgages. This is because balloon mortgages are structured in such a way that since the payments are too low to cover the entire loan, a large balance remains at the end of the loan period. The borrower will then need to make a large payment at the end of maturity date and because of its big size, it is referred to as a balloon payment. While this type of mortgage is used for residential estate, it is more common in commercial real estate. Balloon mortgages are usually offered to borrowers who expect to be able to quickly sell off their homes or to those who expect a significant increase in their income within a few years.

Final Word

While there are many options available when it comes to purchasing a property and taking out a mortgage, take the time to understand your financial circumstances and commitments before you take out a loan.