What Is a Mortgage?
It’s a common saying that buying a home may be one of the biggest — if not the biggest — financial decisions you’ll make in your lifetime. It’s potentially one of the biggest investments you’ll make, too, which is why it’s important to understand some of the key financial aspects involved in the purchase and ownership of a home.
If you dream of someday owning your own home, taking out a mortgage will likely be a key element of your purchasing journey. If you're not yet familiar with mortgages and all they entail, learn all you need to know about the basics, from what exactly mortgages are to what the different types look like.
Defining Mortgages: What Are These Loans?
It’s safe to say that most people don’t have lump sums of cold, hard cash sitting in their bank accounts to buy homes outright. But it’s still possible for them to purchase new homes — and that's where a mortgage comes in. A mortgage is a type of loan used to finance real estate or vacant property. If you don’t have the money to purchase a home outright, this type of loan allows you to do so.
With a mortgage, a bank agrees to loan a borrower the money to buy a home with the understanding that the borrower will pay back the amount of the loan, plus interest, over the course of an agreed-upon length of time. But what happens if the borrower stops making payments? A mortgage is a "secured" loan, which means that the lender is protected because the borrower has agreed to offer a form of collateral to back the loan. In the case of a mortgage, the collateral is the home itself. If the borrower stops making payments on the property or is unable to continue doing so, the bank can legally take possession of the home and force the occupants to leave.
How Does a Mortgage Work?
Because you never fully own a home until you pay off your mortgage, it's important to make sure that you never take out a mortgage unless you're reasonably sure you can pay it off. While banks tend to employ a stricter set of lending practices now, the 2008 housing crisis was evidence of what can happen when a large number of people suddenly find themselves unable to repay their mortgages.
When you take out a mortgage, the amount of the loan you'll be able to get will depend on several factors. The first is the value of the home that you hope to buy, which is determined through an appraisal. The bank also takes into account things like your credit history, any assets you have and your employment. This helps the bank determine how much money you can realistically afford to pay back — and thus the amount of money it’ll determine is safe to lend to you.
This is one of many reasons that it's important to make sure your credit score is in the best shape possible. The better your credit score is, the better your chances are of getting the best possible interest rate on your mortgage. When you have a higher credit score, you'll be considered less of a risk to lend to because you’ve demonstrated in the past that you’re responsible with money. You’ll likely enjoy a lower interest rate than someone on the riskier side of the credit score spectrum.
You'll also likely get a better rate if you're able to make a bigger down payment. The down payment is simply the amount that you're able to pay towards the price of the home up front — money you won’t need the bank to loan to you. If your down payment amount is on the higher end, say 20% of the home’s purchase price, you'll likely enjoy lower monthly payments as well as a lower interest rate. If you put down a smaller amount up front, you may be required to pay for private mortgage insurance in addition to your monthly payments.
In essence, the less financially risky you appear to lenders, the lower the rates you'll ultimately pay.
Different Types of Mortgages
Before you set out to get a mortgage loan, it’s important to understand that not all mortgages are the same. You also need to be sure you understand the terms and conditions of your loan before signing on the dotted line. Mortgage types commonly vary based on their interest rates, or an extra percentage on top of your mortgage repayment amount that you pay to the bank for the privilege of being extended a loan. The most common types of mortgages include the following.
A fixed-rate mortgage is the most common type and is also often referred to as a "traditional" mortgage. When you sign up for a fixed-rate mortgage, you agree to pay back your mortgage loan over a set number of years at an interest rate that never changes over the lifetime of the loan.
Your monthly payment amount isn’t likely to change over the entire course of a traditional fixed-rate mortgage. The most common timelines for a fixed-rate mortgage are 15 and 30 years, but they can be shorter or longer, depending on how much you can afford to pay. If you stretch your loan out over a longer term, you'll have lower monthly payments but will also pay more in interest over time.
Adjustable-Rate Mortgages (ARMs)
Unlike a fixed-rate mortgage, the interest rate of an adjustable-rate mortgage can change over time. Sometimes also called "variable-rate mortgages" or "floating mortgages," you'll often get a lower interest rate on this type of loan, but it’ll last only for a set period of time.
After that, the bank can readjust it on a yearly or even monthly basis, based on a benchmark, index or ARM margin. While it can be possible to enjoy savings when the mortgage has a lower interest rate, if that rate rises, you may find your monthly payments are suddenly consuming a much larger portion of your budget. It can seem attractive in the beginning, but your monthly payments will be at risk of rising due to interest throughout the entire course of your loan.
Interest-only mortgages are less common, and you should generally only opt for this type under a few specific circumstances. With any type of loan, you repay both the principal (the amount of money you borrowed) and the interest (the extra percentage of the principal that’s added onto your monthly bill.)
An interest-only mortgage allows you to pay back only the interest for a set amount of time, which is known as the introductory period. While this can be helpful in the short term, be aware that you need to have a very solid plan in place about how you’ll handle the much larger payments once the introductory period ends and you begin repaying the principal, too. Usually, interest-only loans are written as parts of adjustable-rate mortgages and are referred to as interest-only ARMs. After the introductory period, some buyers pay off the rest of these loans in one large lump sum, while others take on much higher monthly payments or renegotiate their loan terms.
No matter what size of loan you plan to take out, it’s essential to do your research to get a mortgage that suits your financial situation. Online tools like mortgage calculators can help you plan ahead and understand how much you'll need to save to reach your buying goals.