What is a Mortgage?
A mortgage loan, also known as a mortgage, is a legal agreement between a borrower (sometimes called a “mortgagor”) and a lender (or “mortgagee”). In exchange for advancing money to the borrower, the lender charges interest. The borrower puts up real estate as security (also called “collateral”) for the loan. If the borrower fails to repay the lender according to the terms of the loan (which is called “default”), the lender can foreclose, taking and selling the property to pay off the loan.
Most mortgages are what is called “fully-amortizing.” Amortization means the borrower repays the loan in a series of monthly installments. These installments are structured so that they cover the interest that is due for that month, and the rest of the payment goes toward reducing the principal balance. Every month, the principal balance gets a little smaller, so less of the payment is required for interest and more can be applied toward the principal. At the end of the loan’s term, the balance is zero.
Types of Mortgages:
Mortgages come in several types and can be classified in many ways. Here are some of the most common:
- Fixed or adjustable. Fixed-rate mortgages (FRMs) have interest rates that do not change. The principal and interest payment remains the same through the entire life of the loan, which makes budgeting easier. The most common terms for fixed-rate mortgages are 15 years and 30 years. Adjustable rate mortgages (ARMs) usually come with lower interest rates, but these rates are not permanent. The rate an ARM starts with may be fixed for a period of one month to ten years, depending on the loan. At that point, the rate can change according to the conditions specified in the loan documents.
- Jumbo or conforming. Conforming mortgages are loans that can be bought and sold by Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs) that were created to increase the availability of mortgage financing and to expand home ownership in the US. Loans that conform to the requirements established by the GSEs are called “conforming loans.” One of these requirements is loan size. Loans that are too big to qualify for Fannie Mae or Freddie Mac are called “jumbo” or “non-conforming” mortgages.
- Conventional or government-backed. Several government agencies have created loan programs to make home ownership easier for different groups of citizens. FHA mortgages, for example, are administered and backed by HUD, the Department of Housing and Urban Development. Because HUD guarantees these loans, lenders are willing to approve loans to qualified applicants with just 3.5 percent down. Similarly, the Department of Veteran’s Affairs backs its VA loan program. Eligible service members and veterans can purchase homes with no down payment through this program. And the US Department of Agriculture (USDA) funds zero-down Rural Housing loans to eligible buyers in less-populated areas through its Rural Housing program. All mortgages that are not backed by a government agency are called “conventional loans.”
- Prime and non-prime. Mortgages can also be classified by the type of borrower they are designed to help. Prime mortgages are the most common, and are the first choice of borrowers with good credit and easy-to-verify income buying “normal” houses. Other financing alternatives may be called “sub-prime,” “non-prime,” “Alt-A” or “hard money” loans. These loans usually require larger down payments and come with higher (in some cases much higher) fees and interest rates. Borrowers may have lower credit scores, their income might be harder to verify or the properties might be atypical.
Mortgage Features
In addition to types of loans, borrowers can choose to customize their loans with additional features. Here are a few of the most common:
- Interest-only payments. Home buyers who want to have lower payments for a few years may choose interest-only options. Instead of the typical fully-amortizing payment, these payments cover only the interest expense for each month. For example, the fully-amortizing payment for a $300,000 mortgage at 5.00 percent is $1,610. The interest-only payment is $360 less. However, this arrangement can’t go on forever, or the lender would never be repaid. So after a number of years (five is typical), the loan becomes fully-amortizing and the payment can increase sharply. For example, after five years, the payment for the $300,000 loan above jumps from $1,250 to $1,754!
- Balloon payments. The balloon mortgage is a way to borrow with a shorter term (and pay a lower interest rate), but make a lower payment. For example, if a 30-year fixed rate loan has a 5.00 percent interest rate, but a seven-year balloon mortgage has a rate of 3.5 percent, the borrower could borrow for seven years, make a payment based on a 30-year term with a 3.5 percent rate, and pay the loan off at the end of seven years – by selling the home, perhaps, or refinancing.
- Cash out refinance. The cash-out refinance replaces a mortgage with a larger home loan. The difference is paid to the borrower. So a homeowner who owes a $250,000 balance might choose to refinance it with a $300,000 mortgage and take the difference in cash.
All of these options are considered riskier than the typical mortgage terms. They are not very popular and often come with extra costs, tougher underwriting standards, or both.
Mortgage FAQs
