What is a Mortgage?

Written by: Christy Rakoczy

Mortgages are in the news everyday.  But really, what is a mortgage?  A mortgage is a special type of loan that you can obtain if you want to buy a home. Since most people cannot afford to pay cash in full for the price of a loan, a mortgage makes it possible for people to buy a house and pay for it over time.

Special Features of a Mortgage

A mortgage is different from other types of loans that you might get, such as a credit card or a car loan. There are several key differences associated with a mortgage loan that are helpful to understanding this type of loan.

Secured Loan

The first and most notable feature of a mortgage loan is that it is a “secured” loan. This means that there is an asset (something of value) that is used to guarantee that the loan will be paid back. This asset is the house that you bought with the mortgage, which is referred to as collateral. The collateral protects the lender because if you do not pay back the home, the lender can take the house.

A car loan is a secured loan like a mortgage because the car is the asset/collateral that guarantees the loan will be paid back. The difference, however, is that real estate usually goes up in value over time while a car loses value. This means that a mortgage is an even safer loan for lenders to make than a car loan is since the asset that guarantees the loan is likely to be worth more than the loan is.  If the lender has to take back the house (foreclose), there is a good chance they will get all of the money back they put in (and there might even be some extra made that is distributed back to the homeowner).

Loan-to-Value Ratio

Another special feature of a mortgage is that there is usually a down payment required and a specific “loan-to-value” ratio allowed. This means that when you buy a home, the mortgage lender isn’t going to give you the entire amount it costs to pay for the home. Instead, they will give you a percentage of the cost and you will need to pay the difference.

In most cases, a lender will only lend you 80 percent of what the house is worth and you will have to put in 20 percent of your own money. This is referred to as an 80 percent “loan to value” ratio since it compares the amount of the loan to the value of the home. The required down payment makes the lender even safer because it again increases the chances that the lender will get all of his money back if he has to foreclose.

Interest Rate

Because of these special features, a mortgage usually has a lower interest rate than other loans. The interest rate is the amount that it costs you to borrow the money. This is normally described in terms of a percentage. For instance, a 3 percent interest rate means that you will pay to the lender each year an amount equal to 3 percent of what you owe on the loan.

Credit card interest rates (the cost of carrying a balance on your credit card) can sometimes be as high as 30 percent, while mortgage interest rates are almost always below 7 percent (interest rates change based on what the economy and real estate market is doing).

Mortgage interest for a first home can seem expensive since you are borrowing a large amount of money to buy the house. Fortunately, for your primary residence, mortgage interest is tax deductible.

Repayment of your Mortgage

Finally, another special feature of a mortgage to consider is that it typically has a much longer repayment period than other types of debt. It is common to have 30 years to pay off your mortgage. This makes sense because you are borrowing such a large amount of money, and it makes it possible to have reasonable monthly payments on the home.

Getting a Mortgage

When you are ready to buy a house, it is time to start the process of getting a mortgage. You can get a mortgage through a bank, a credit union or with the help of a professional called a mortgage broker (who usually will charge you for his services).

You will need to provide information on your credit score, your income and the amount of debt you have. The lender will evaluate your finances to determine how likely it is that you will pay back the money you borrow. Lenders do not want your mortgage payments to exceed a certain percentage of your income, so they will also tell you the maximum you can borrow based on your monthly payments vs. your monthly income (this is referred to as your debt-to-credit ratio).

In many cases, it is a good idea to have the lender evaluate you before you start house hunting. This is called getting “pre-approved” and it allows you to find out exactly what the lender will allow you to borrow.

The Appraisal Process

Once you have found an actual home, then the next step is for the lender to decide how much it will lend you for that particular house. The lender will usually do an appraisal to see what the house is worth on the market. This determines the “value” they will use. The lender will typically then lend you 80 percent of whatever the appraised value is.

The appraised value, which is determined by looking at what similar properties (comps) sold for, may not be equal to the exact amount you are paying for the home since homes on the market are not always priced perfectly. If the house appraises for less than what you are paying for it, you will have to put down more money to make sure the loan-to-value ratio stays at 80 percent.

Finishing Steps

Finally, understanding what is a mortgage will help you when you decide to get a mortgage to finance the purchase of your next home. There are different types of mortgages including a fixed rate (your payments stay the same over the entire life of the loan) and an adjustable rate mortgage (the interest rate changes after a certain amount of time and is linked to some type of financial index). In most cases, a 30-year fixed mortgage is the best and safest option to choose.

You will then pay monthly payments to your mortgage over time, slowly paying down more of what you borrowed until the home is finally your own.


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What is a Mortgage?

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