What is a Mortgage?
A mortgage is a debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments. Mortgages are used by individuals and businesses to make large real estate purchases without paying the entire purchase price up front. Over many years, the borrower repays the loan, plus interest, until he or she owns the property free and clear. Mortgages are also known as "liens against property" or "claims on property." If the borrower stops paying the mortgage, the lender can foreclose.
BREAKING DOWN Mortgage
In a residential mortgage, a homebuyer pledges his or her house to the bank. The bank has a claim on the house should the homebuyer default on paying the mortgage. In the case of a foreclosure, the bank may evict the home's tenants and sell the house, using the income from the sale to clear the mortgage debt.
Mortgages come in many forms. With a fixed-rate mortgage, the borrower pays the same interest rate for the life of the loan. The monthly principal and interest payment never changes from the first mortgage payment to the last. Most fixed-rate mortgages have a 15- or 30-year term. If market interest rates rise, the borrower’s payment does not change. If market interest rates drop significantly, the borrower may be able to secure that lower rate by refinancing the mortgage. A fixed-rate mortgage is also called a “traditional" mortgage.
With an adjustable-rate mortgage (ARM), the interest rate is fixed for an initial term, but then it fluctuates with market interest rates. The initial interest rate is often a below-market rate, which can make a mortgage more affordable in the short term but possibly less affordable in the long term. If interest rates increase later, the borrower may not be able to afford the higher monthly payments. Interest rates could also decrease, making an ARM less expensive. In either case, the monthly payments are unpredictable after the initial term.
Other less common types of mortgages, such as interest-only mortgages and payment-option ARMs, are best used by sophisticated borrowers. Many homeowners got into financial trouble with these types of mortgages during the housing bubble years of the mid-2000s.
When shopping for a mortgage, it is beneficial to use a mortgage calculator, as this tool can give you an idea of the monthly payments for the mortgage you're considering. Mortgage calculators can also help you calculate the total cost of interest over the life of the mortgage so you'll know what buying a property will really cost you.