How does a mortgage work?
Oddly enough, people often sign up for mortgage loans without really understanding how they work. After all, you are the borrower, not the lender, right? You might only be doing this the one time, so how much do you need to know about the details?
Well, think of it differently. A mortgage is likely to be the largest and longest loan you ever take out. The more you understand about how a mortgage works, the more it could save you money and give you financial flexibility down the road.
So, here are some basics of how a mortgage works, followed by some key details:
How does a mortgage work: the basics
A mortgage is a loan for which a house or other property is used as collateral. Like most loans, the two main components are principal and interest. Principal is the amount of money you owe, and interest is a percentage rate you are charged for borrowing the principal. The interest rate is applied to the remaining principal, and your monthly payment consists partly of principal you are paying back, and partly of the interest charged on the remaining balance over the past month. Those payments are scheduled to continue for a specified repayment period until the loan is completely paid off.
One important aspect of how this works is that in the early years of the loan when you have a large principal balance remaining, the interest component is larger as a result so your monthly payments consist more of interest than principal. As a result, mortgage borrowers tend to build equity slowly at first, with the pace quickening as they get more years into the loan. An amortization schedule can show you how the payments lay out over the life of the loan, including how they break down between principal and interest. This is important for understanding how quickly you will build equity, and how much total interest you will pay.
Interest rates can be fixed or adjustable. A fixed rate of interest means you will pay the same rate of interest over the life of the loan, so your monthly payments will not vary. An adjustable mortgage rate is subject to change periodically in response to market interest rate conditions. This means you could benefit if rates fall, but you could also see your monthly payments get more expensive if interest rates rise.
Mortgages are made by banks as well as non-bank lenders. Even government-sponsored programs such as FHA and VA loans are made by private lenders, so you have a choice of where you get your mortgage. Exercising that choice carefully is important, because mortgage terms vary from one lender to another. Shopping around can make a big difference.
One more basic concept about mortgages: because they are collateralized loans, the property you are buying is used as security against your failure to repay the loan. That means if you do not keep up with your payments, the lender has the right to initiate proceedings to take possession of your home. That process is known as foreclosure, and avoiding foreclosure is one reason it is very important to understand what you are getting into from the start.
How does a mortgage work: some key details
Beyond those basics, here are some of the key details you should understand before you agree to a mortgage
- The down payment. This is a portion of the purchase price you pay upfront. While low down payment mortgages can get you into a home with less of an initial investment, a more substantial down payment helps you build equity faster. This can impact your ability to refinance later on. A higher down payment may also give the lender confidence to offer you a lower interest rate.
- Closing costs. Besides the down payment, there is a variety of other fees and charges associated with initiating a loan. Ask any potential lender to itemize these for you, and make sure you have budgeted adequately for them.
- Mortgage insurance. Lenders sometimes reduce their risk by requiring borrowers to pay for mortgage insurance. This insures the lender against losses if the borrower fails to meet the loan's obligations. This insurance can help you qualify for a loan, but it can also represent a significant ongoing cost.
- The length of the loan. 30-year mortgages are most common, though 15-year home loans are also pretty popular. The length of a loan represents an important trade-off: the longer the loan is, the more affordable your monthly payments will be, but a longer loan will also result in you paying more interest over the life of the mortgage.
- Pre-payment penalties. This is a detail new borrowers often overlook, but it can be important. Your mortgage might have a provision that requires you to pay extra if you pay the loan off within the first few years. This can include refinancing or selling your home, so watch out for pre-payment penalties - they can limit your financial flexibility.
While mortgage loans generally operate on the same basic structure of a rate of interest charged on principal which is paid back over a specified number of years, the interest rate and other details can vary. For a large loan paid back over a long time, little variations can add up to a big difference, so make sure you compare competing loan offers and understand all the details before you sign up.