Mortgages 101 - How Does a Mortgage Work?
Do you know how mortgages work? If you don’t, you’re not alone. Most first-time homebuyers find mortgages more than a little confusing. Many homeowners — as in, people who HAVE mortgages — don’t fully comprehend what they’ve signed up for.
That’s exactly why “How does a mortgage work?” is a terribly good question, as well as a terribly important thing for you to get your head around. Whether you’re a first-time homebuyer or an existing homeowner, it pays to understand how mortgages work. Learning about the variables, options, and considerations can save you money and headaches. It can even help you pay off your mortgage faster.
And so, dear reader, welcome to part two of our Mortgages 101 series, “How Does a Mortgage Work?” This installment spells out everything you really need to know about mortgages, including the basics of how they work, the different types of mortgages, the additional costs involved, and what’s involved in paying off a mortgage.
Before you dive in: ICYMI, check out Covered’s “Guide to Understanding Basic Mortgage Terms.” In plain English that won’t put you to sleep, we explain all the mortgage industry lingo you’ll want to know before embarking on the mortgage-shopping process. So that you can quickly look up any unfamiliar terms, why not keep our guide to mortgage terms open in another tab? (Yes. We ARE full of swell ideas. Thanks for noticing.)
What Is a Mortgage?
Most regular Joes and Josephines can’t afford to buy entire houses outright. That’s why mortgages exist. A mortgage is a special type of loan that helps you finance your home, paying for it over time.
How Does a Mortgage Work?
How mortgages work boils down to the following:
- A mortgage lender offers you a mortgage loan, and you sign a mortgage agreement. The size and requirements for the loan will depend on your verified income, savings, credit score, and other factors. You’ll be required to make an up-front down payment (traditionally ≥20%) that reduces the overall loan amount.
- You now “own” your home conditionally. Homeownership is subject to you following the terms of your mortgage loan agreement. That means on-time payments and sticking to all requirements. (Nitty-gritty state-by-state nuances you can skip if you want: If you live in a “lien theory” state, you legally hold the deed/title to your home, but your mortgage lender attaches a lien to it. If you live in a “title theory” state, things are a little different. Officially, the lender owns the deed/title/property for now, but they let you occupy it as if you own it.)
- The home you’re buying is your collateral. So if you don’t keep your promise to make your payments, your lender has the right to claim the home and sell it to someone else. That’s called “foreclosure,” and you don’t want it. In a foreclosure, you give up all rights to your home.
- Your mortgage lender makes money by charging you interest on your loan. In addition to paying toward the principal, or remaining balance, of your mortgage, your monthly payments will include interest based on an agreed-upon interest rate.
- You build “equity” as you pay off more of your principal. Equity is your home’s current market value minus what you still owe for it.
- Once you pay off your mortgage in full (satisfying all mortgage agreement requirements), you own your home outright. Either the lien is removed or the deed/title is transferred to you. No remaining strings attached.
What Are the Different Types of Mortgages?
To grasp how mortgages work, it’s best to start by looking at their three primary variables:
- Interest rates. As a condition of loaning you the money you need to buy your home, banks charge you interest. Your interest rate determines how much interest you’ll pay over time.
- Terms. The term of your loan is how long it will take you to pay off your loan.
- Loan type. Your mortgage loan may or may not be insured by the US government. If it is, it’s insured by the Federal Housing Administration (FHA) or another special government program. If it isn’t, it’s called a “conventional loan.” Most loans are conventional loans.
Read on to learn more about each of these mortgage loan variables. Check out the Consumer Finance Protection Bureau’s loan calculator to calculate monthly payments for different types of mortgages. You can experiment with loan amounts, interest rates, and terms, testing out a range of scenarios.
With mortgage loan interest rates, you choose between two options:
- Fixed-rate mortgage. This type of mortgage has an interest rate that won’t change for the term of the loan. Since you’re locked in, your rate won’t ever go up. This lower-risk option generally means a higher interest rate. But it also means you’re not in for any big surprises, which is why this option is chosen by the majority of homeowners.
- Adjustable rate mortgage, or ARM. This higher-risk mortgage option comes with an interest rate (generally lower to start) that may change over time based on current interest rates. Usually, however, there’s a cap on how high your interest rate can get.
If interest rates get lower, you may have the option of refinancing (essentially replacing your existing mortgage with a new one) to take advantage of more favorable interest rates or terms.
When you choose a mortgage loan, you’ll decide how long a period of time you want to pay it off in full — its “term.” The most common mortgage terms are 15 years and 30 years. When choosing the term of your mortgage, it’s important to consider the pros and cons:
- Longer-term loans:
- Pros: Lower monthly payments.
- Cons: Higher interest rates. More interest paid over time = higher total cost.
- Shorter-term loans:
- Pros: Lower interest rates. Significantly less interest paid over time = lower total cost.
- Cons: Higher monthly payments.
- Government-backed loans. The most common type of government mortgage loan is the FHA loan, which is a loan insured by the US Federal Housing Administration. The US Department of Veterans Affairs, US Department of Agriculture, and some state and local governments also offer other government-backed mortgage loan programs.
- Conventional loans. Most mortgage loans take this form. Since these loans are not insured by the government, they’re considered higher-risk.
“Which type of mortgage is right for me,” you’re asking? The answer depends on many variables, including your income, credit score, how much of a down payment you can afford, and whether you’re a first-time homebuyer. For example, FHA loans — with their reduced financial requirements and lower down payments — are designed to help lower-income or first-time homebuyers afford a home. But FHA loans also require upfront and ongoing mortgage insurance payments (see below). If you have a high credit score and stable income, a conventional loan may get you the lowest monthly payment.
What Other Costs Come with a Mortgage?
Beyond principal and interest, several other costs accompany a mortgage, including:
- Closing costs. Homebuyers, sellers, and lenders all have to pay costs and fees to close on your mortgage (e.g., escrow fees, title insurance, recording fees, transfer taxes, realtor commissions, mortgage lender origination fees). Your agreement will spell out all closing costs.
- Taxes. As a homeowner, you’re required by law to pay annual property taxes. Most mortgage lenders make these payments on your behalf, using an escrow account you pay into over time.
- Homeowners insurance. Most likely, your lender will require you to purchase homeowners insurance. This helps to ensure that their investment — your home — will be protected from loss or damage for the duration of your loan agreement. Typically, homeowners insurance is also paid on your behalf by your mortgage servicer using your escrow account.
- Private mortgage insurance, or PMI, MAY also be required by your lender. This insurance is only required for higher-risk mortgage loans. It helps protect lenders from financial loss in the event you default on making payments. This, too, will be lumped in with your monthly payments. (Note: Borrowers with PMI may be able to get rid of it after meeting certain requirements.)
How Does Paying Off a Mortgage Work?
Your monthly mortgage payments will pay different amounts toward principal and interest over time. Lenders’ very fancy word for this schedule is “amortization,” and here’s what it looks like:
- At first, the bulk of your payment will go toward paying off interest. That’s because your loan balance is still so high. When you calculate your interest using your agreed-upon interest rate, it’s just a big chunk o’ change.
- Eventually, more of your payment will go toward paying off your principal. Over time, you’ll owe less interest on your remaining loan balance.
- You can reduce the overall interest you pay by paying off a mortgage faster. Depending on the requirements of your agreement, you may be able to pay off your loan faster than your agreed-upon term. If you pay more money toward your mortgage each month, that naturally reduces the amount of interest you’ll pay over time. (When you’re shopping for a mortgage, ask if there’s a prepayment penalty. Avoid having one if possible.)
- Bottom line, the longer it takes you to pay off your loan, the more interest you’ll pay. So, if it’s within your capacity, paying off a mortgage faster is worth the effort
And that, dear reader, is everything you really need to know about how mortgages work. That wasn’t so hard, was it?