What is a Mortgage?
A mortgage is a loan – provided by a mortgage lender or a bank – that enables an individual to purchase a home. While it’s possible to take out loans to cover the entire cost of a home, it’s more common to secure a loan for about 80% of the home’s value.
The loan must be paid back over time. The home purchased acts as collateral on the money an individual is lent to purchase the home.
Types of Mortgages
The two most common types of mortgages are fixed-rate and adjustable-rate (also known as variable rate) mortgages.
Fixed-rate mortgages provide borrowers with an established interest rate over a set term of typically 15, 20, or 30 years. With a fixed interest rate, the shorter the term over which the borrower pays, the higher the monthly payment. Conversely, the longer the borrower takes to pay, the smaller the monthly repayment amount. However, the longer it takes to repay the loan, the more the borrower ultimately pays in interest charges.
The greatest advantage of a fixed-rate mortgage is that the borrower can count on their monthly mortgage payments being the same every month throughout the life of their mortgage, making it easier to set household budgets and avoid any unexpected additional charges from one month to the next. Even if market rates increase significantly, the borrower doesn’t have to make higher monthly payments.
Adjustable-rate mortgages (ARMs) come with interest rates that can – and usually, do – change over the life of the loan. Increases in market rates and other factors cause interest rates to fluctuate, which changes the amount of interest the borrower must pay, and, therefore, changes the total monthly payment due. With adjustable rate mortgages, the interest rate is set to be reviewed and adjusted at specific times. For example, the rate may be adjusted once a year or once every six months.
One of the most popular adjustable-rate mortgages is the 5/1 ARM, which offers a fixed rate for the first five years of the repayment period, with the interest rate for the remainder of the loan’s life subject to being adjusted annually.
While ARMs make it more difficult for the borrower to gauge spending and establish their monthly budgets, they are popular because they typically come with lower starting interest rates than fixed-rate mortgages. Borrowers, assuming their income will grow over time, may seek an ARM in order to lock in a low fixed-rate in the beginning, when they are earning less.
The primary risk with an ARM is that interest rates may increase significantly over the life of the loan, to a point where the mortgage payments become so high that they are difficult for the borrower to meet. Significant rate increases may even lead to default and the borrower losing the home through foreclosure.
Mortgages are major financial commitments, locking borrowers into decades of payments that must be made on a consistent basis. However, most people believe that the long-term benefits of home ownership make committing to a mortgage worthwhile.
Mortgage payments usually occur on a monthly basis and consist of four main parts:
The principal is the total amount of the loan given. For example, if an individual takes out a $250,000 mortgage to purchase a home, then the principal loan amount is $250,000. Lenders typically like to see a 20% down payment on the purchase of a home. So, if the $250,000 mortgage represents 80% of the home’s appraised value, then the homebuyers would be making a down payment of $62,500, and the total purchase price of the home would be $312,500.
The interest is the monthly percentage added to each mortgage payment. Lenders and banks don’t simply loan individuals money without expecting to get something in return. Interest is the money a lender or bank makes back on the money they provide to homebuyers.
Mortgage payments include the property tax the individual must pay as a homeowner. Taxes are calculated based on the value of the home.
Mortgages also include homeowner’s insurance, which is required by lenders to cover damage to the home (which acts as collateral), as well as the property inside of it. It also covers specific mortgage insurance, which is generally required if an individual makes a down payment that is less than 20% of the home’s cost. That insurance is designed to protect the lender or bank if the borrower defaults on his or her loan.
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