What Is a Mortgage?
A mortgage is a type of loan used to purchase or maintain a home, land, or other types of real estate. The borrower agrees to pay the lender over time, typically in a series of regular payments that are divided into principal and interest. The property then serves as collateral to secure the loan.
A borrower must apply for a mortgage through their preferred lender and ensure that they meet several requirements, including minimum credit scores and down payments. Mortgage applications go through a rigorous underwriting process before they reach the closing phase. Mortgage types vary based on the needs of the borrower, such as conventional and fixed-rate loans.
Key Takeaways
- Mortgages are loans that are used to buy homes and other types of real estate.
- The property itself serves as collateral for the loan.
- Mortgages are available in a variety of types, including fixed-rate and adjustable-rate.
- The cost of a mortgage will depend on the type of loan, the term (such as 30 years), and the interest rate that the lender charges.
- Mortgage rates can vary widely depending on the type of product and the qualifications of the applicant.
How Mortgages Work
Individuals and businesses use mortgages to buy real estate without paying the entire purchase price up front. The borrower repays the loan plus interest over a specified number of years until they own the property free and clear. Most traditional mortgages are fully-amortizing. This means that the regular payment amount will stay the same, but different proportions of principal vs. interest will be paid over the life of the loan with each payment. Typical mortgage terms are for 30 or 15 years.
Mortgages are also known as liens against property or claims on property. If the borrower stops paying the mortgage, the lender can foreclose on the property.
For example, a residential home-buyer pledges their house to their lender, which then has a claim on the property. This ensures the lender’s interest in the property should the buyer default on their financial obligation. In the case of a foreclosure, the lender may evict the residents, sell the property, and use the money from the sale to pay off the mortgage debt.
The Mortgage Process
Would-be borrowers begin the process by applying to one or more mortgage lenders. The lender will ask for evidence that the borrower is capable of repaying the loan. This may include bank and investment statements, recent tax returns, and proof of current employment. The lender will generally run a credit check as well.
If the application is approved, the lender will offer the borrower a loan of up to a certain amount and at a particular interest rate. Home-buyers can apply for a mortgage after they have chosen a property to buy or while they are still shopping for one, a process known as per-approval. Being pre-approved for a mortgage can give buyers an edge in a tight housing market because sellers will know that they have the money to back up their offer.
Once a buyer and seller agree on the terms of their deal, they or their representatives will meet at what’s called a closing. This is when the borrower makes their down payment to the lender. The seller will transfer ownership of the property to the buyer and receive the agreed-upon sum of money, and the buyer will sign any remaining mortgage documents. The lender may charge fees for originating the loan (sometimes in the form of points) at the closing.
Options
There are hundreds of options on where you can get a mortgage. You can get a mortgage through a credit union, bank, mortgage-specific lender, online-only lender, or mortgage broker. No matter which option you choose, compare rates across types to make sure that you’re getting the best deal.
Types of Mortgages
Mortgages come in a variety of forms. The most common types are 30-year and 15-year fixed-rate mortgages. Some mortgage terms are as short as five years, while others can run 40 years or longer. Stretching payments over more years may reduce the monthly payment, but it also increases the total amount of interest that the borrower pays over the life of the loan.
Within the different term lengths are numerous types of home loans, including Federal Housing Administration (FHA) loans, U.S. Department of Agriculture (USDA) loans, and U.S. Department of Veterans Affairs (VA) loans available for specific populations that may not have the income, credit scores, or down payments required to qualify for conventional mortgages.
Fixed-Rate Mortgages
The standard type of mortgage is fixed-rate. With a fixed-rate mortgage, the interest rate stays the same for the entire term of the loan, as do the borrower’s monthly payments toward the mortgage. A fixed-rate mortgage is also called a traditional mortgage.
Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
Adjustable-Rate Mortgage (ARM)
With an adjustable-rate mortgage (ARM), the interest rate is fixed for an initial term, after which it can change periodically based on prevailing interest rates. The initial interest rate is often a below-market rate, which can make the mortgage more affordable in the short term but possibly less affordable long-term if the rate rises substantially.
ARMs typically have limits, or caps, on how much the interest rate can rise each time it adjusts and in total over the life of the loan.
A 5/1 adjustable-rate mortgage is an ARM that maintains a fixed interest rate for the first five years, then adjusts each year after that.
Interest-Only Loans
Other, less common types of mortgages, such as interest-only mortgages and payment-option ARMs, can involve complex repayment schedules and are best used by sophisticated borrowers. These types of loans may feature a large balloon payment at its end.
Many homeowners got into financial trouble with these types of mortgages during the housing bubble of the early 2000s.
Reverse Mortgages
As their name suggests, reverse mortgages are a very different financial product. They are designed for homeowners age 62 or older who want to convert part of the equity in their homes into cash.
These homeowners can borrow against the value of their home and receive the money as a lump sum, fixed monthly payment, or line of credit. The entire loan balance becomes due when the borrower dies, moves away permanently, or sells the home.
Within each type of mortgage, borrowers have the option to buy discount points to buy their interest rate down. Points are essentially a fee that borrowers pay up front to have a lower interest rate over the life of their loan. When comparing rates, make sure you are comparing rates with the same number of discount points for a true apples-to-apples comparison.
Average Mortgage Rates
How much you’ll have to pay for a mortgage depends on the type of it you want (such as fixed or adjustable), its term (such as 20 or 30 years), any discount points paid, and interest rates at the time. Interest rates can vary from week to week and from lender to lender, so it pays to shop around.
Mortgage rates were at near-record lows in 2020, with rates bottoming out at a 2.66% average on a 30-year fixed-rate mortgage for the week of Dec. 24, 2020.5 Rates continued to stay stably low throughout 2021 and have started to climb steadily since Dec. 3, 2021 (see the chart below). According to the Federal Home Loan Mortgage Corp., average interest rates looked like this as of July 2022:
- 30-year fixed-rate : 5.30%
- 15-year fixed-rate : 4.45%
- 5/1 adjustable-rate: 4.19%6
How to Compare Mortgages
Banks, savings and loan associations, and credit unions were virtually the only sources of mortgages at one time. Today, a burgeoning share of the mortgage market includes non-bank lenders, such as Better, loan-depot, Rocket Mortgage, and SoFi.
If you’re shopping for a mortgage, an online mortgage calculator can help you compare estimated monthly payments, based on the type of mortgage, the interest rate, and how large a down payment you plan to make. It also can help you determine how expensive a property you can reasonably afford.
In addition to the principal and interest that you’ll be paying on the mortgage, the lender or mortgage services may set up an escrow account to pay local property taxes, homeowners insurance premiums, and certain other expenses. Those costs will add to your monthly payment.
Also, note that if you make less than a 20% down payment when you take out your mortgage, your lender may require that you purchase private mortgage insurance (PMI), which becomes another added monthly cost.7
If you have a mortgage, you still own your home (and not the bank). Your bank may have loaned you money to purchase the house, but rather than owning the property, they impose a lien on it (the house is used as collateral, but only if the loan goes into default). If you default and foreclose on your mortgage, however, the bank may become the new owner of your home.
Why do people need mortgages?
The price of a home is often far greater than the amount of money that most households save. As a result, mortgages allow individuals and families to purchase a home by putting down only a relatively small down payment, such as 20% of the purchase price, and obtaining a loan for the balance. The loan is then secured by the value of the property in case the borrower defaults.
Can anybody get a mortgage?
lenders will need to approve prospective borrowers through an application and underwriting process. Home loans are only provided to those who have sufficient assets and income relative to their debts to practically carry the value of a home over time. A person’s credit score is also evaluated when making the decision to extend a mortgage. The interest rate also varies, with riskier borrowers receiving higher interest rates.
Mortgages are offered by a variety of sources. Banks and credit unions often provide home loans. There are also specialized mortgage companies that deal only with home loans. You may also employ an unaffiliated mortgage broker to help you shop around for the best rate among different lenders.
What does fixed vs. variable mean on a mortgage?
Many mortgages carry a fixed interest rate. This means that the rate will not change for the entire term of the mortgage—typically 15 or 30 years—even if interest rates rise or fall in the future. A variable or adjustable-rate mortgage (ARM) has an interest rate that fluctuates over the loan’s life based on what interest rates are doing.
How many mortgages can I have on my home?
Lenders generally issue a first or primary mortgage before they allow for a second mortgage. This additional mortgage is commonly known as a home equity loan. Most lenders don’t provide for a subsequent mortgage backed by the same property. There’s technically no limit to how many junior loans you can have on your home as long as you have the equity, debt-to-income ratio, and credit score to get approved for them.
Why it called a mortgage?
The word “mortgage” comes from Old English and French meaning “death pledge.” It gets that name since this type of loan “dies” when it is either fully repaid or if the borrower defaults.
The Bottom Line
Mortgages are an essential part of the home buying process for most borrowers who aren’t sitting on hundreds of thousands of dollars of cash to buy a property outright. Different types of home loans are available for whatever your circumstances may be. Different government-backed programs make it possible for more people to qualify for mortgages and make their dream of home-ownership a reality.
