What Is a Mortgage?

The term mortgage refers to a loan used to purchase or maintain a home, land, or other types of real estate. The borrower agrees to pay the lender over time, typically in a series of regular payments that are divided into principal and interest. The property serves as collateral to secure the loan. A borrower must apply for a mortgage through their preferred lender and ensure they meet several requirements, including minimum credit scores and down payments. Mortgage applications go through a rigorous underwriting process before they reach the closing phase. Mortgage types vary based on the needs of the borrower, such as conventional and fixed-rate loans.

Key Takeaways

  • Mortgages are loans that are used to buy homes and other types of real estate.
  • The property itself serves as collateral for the loan
  • Mortgages are available in a variety of types, including fixed-rate and adjustable-rate.
  • The cost of a mortgage will depend on the type of loan, the term (such as 30 years), and the interest rate the lender charges.
  • Mortgage rates can vary widely depending on the type of product and the qualifications of the applicant.
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What Is A Mortgage?

How Mortgages Work

Individuals and businesses use mortgages to buy real estate without paying the entire purchase price upfront. The borrower repays the loan plus interest over a specified number of years until they own 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 on the property.

For example, a residential homebuyer pledges their house to their lender, which then has a claim on the property. This ensures the lender's interest in the property should the buyer default on their financial obligation. In the case of a foreclosure, the lender may evict the residents, sell the property, and use the money from the sale to pay off the mortgage debt.

The Mortgage Process

Would-be borrowers begin the process by applying to one or more mortgage lenders. The lender will ask for evidence that the borrower is capable of repaying the loan. This may include bank and investment statements, recent tax returns, and proof of current employment. The lender will generally run a credit check, as well.

If the application is approved, the lender will offer the borrower a loan of up to a certain amount and at a particular interest rate. Homebuyers can apply for a mortgage after they have chosen a property to buy or while they are still shopping for one, a process known as pre-approval. Being pre-approved for a mortgage can give buyers an edge in a tight housing market because sellers will know that they have the money to back up their offer.

Once a buyer and seller agree on the terms of their deal, they or their representatives will meet at what's called a closing. This is the time the borrower makes their down payment to the lender. The seller will transfer ownership of the property to the buyer and receive the agreed-upon sum of money, and the buyer will sign any remaining mortgage documents.

Types of Mortgages

Mortgages come in a variety of forms. The most common types are 30-year and 15-year fixed-rate mortgages. Some mortgage terms are as short as five years while others can run 40 years or longer. Stretching payments over more years may reduce the monthly payment, but it also increases the total amount of interest the borrower pays over the life of the loan.

The following are just a few examples of some of the most popular types of mortgage loans available to borrowers.

Fixed-Rate Mortgages

With a fixed-rate mortgage, the interest rate stays the same for the entire term of the loan, as do the borrower's monthly payments toward the mortgage. A fixed-rate mortgage is also called a traditional mortgage. 

Adjustable-Rate Mortgage (ARM)

With an adjustable-rate mortgage (ARM), the interest rate is fixed for an initial term, after which it can change periodically based on prevailing interest rates. The initial interest rate is often a below-market rate, which can make the mortgage more affordable in the short term but possibly less affordable long-term if the rate rises substantially.

ARMs typically have limits, or caps, on how much the interest rate can rise each time it adjusts and in total over the life of the loan.

Interest-Only Loans

Other, less common types of mortgages, such as interest-only mortgages and payment-option ARMs, can involve complex repayment schedules and are best used by sophisticated borrowers.

Many homeowners got into financial trouble with these types of mortgages during the housing bubble of the early 2000s.

Reverse Mortgages

As their name suggests, reverse mortgages are a very different financial product. They are designed for homeowners 62 or older who want to convert part of the equity in their homes into cash.

These homeowners can borrow against the value of their home and receive the money as a lump sum, fixed monthly payment, or line of credit. The entire loan balance becomes due when the borrower dies, moves away permanently, or sells the home.

Average Mortgage Rates 2020

How much you'll have to pay for a mortgage depends on the type of mortgage (such as fixed or adjustable, its term (such as 20 or 30 years), and interest rates at the time. Interest rates can vary from week to week and from lender to lender, so it pays to shop around.

Mortgage rates were at near-record lows in 2020. According to the Federal Home Loan Mortgage Corporation, average interest rates looked like this as of August 2021:

  • 30-year fixed-rate mortgage: 2.87%
  • 15-year fixed-rate mortgage: 2.15%
  • 5/1 adjustable-rate mortgage: 2.44%

A 5/1 adjustable-rate mortgage is an ARM that maintains a fixed interest rate for the first five years, then adjusts each year after that.

Your mortgage may represent only a portion of your monthly mortgage payment if your lender also requires you to pay your property taxes and homeowners insurance through an escrow account.

How to Compare Mortgages

Banks, savings and loan associations, and credit unions were virtually the only sources of mortgages at one time. Today, a burgeoning share of the mortgage market includes nonbank lenders, such as Better.com, LoanDepot, Rocket Mortgage, and SoFi.

If you're shopping for a mortgage, an online mortgage calculator can help you compare estimated monthly payments, based on the type of mortgage, the interest rate, and how large a down payment you plan to make. It can also help you determine how expensive a property you can reasonably afford.

In addition to the principal and interest, you'll be paying on the mortgage, the lender or mortgage servicer may also set up an escrow account to pay local property taxes, homeowners insurance premiums, and certain other expenses. Those costs will add to your monthly mortgage payment.

Also note that if you make less than a 20% down payment when you take out your mortgage, your lender may require that you purchase private mortgage insurance (PMI), which becomes another added monthly cost.

Why Do People Need Mortgages?

The price of a home is often far greater than the amount of money most households save. As a result, mortgages allow individuals and families to purchase a home by putting down only a relatively small down payment, such as 20% of the purchase price, and obtaining a loan for the balance. The loan is then secured by the value of the property in case the borrower defaults.

Can Anybody Get a Mortgage?

Mortgage lenders will need to approve prospective borrowers through an application and underwriting process. Home loans are only provided to those who have sufficient assets and income relative to their debts to practically carry the value of a home over time. A person's credit score is also evaluated when making the decision to extend a mortgage. The interest rate on the mortgage also varies, with riskier borrowers receiving higher interest rates.

What Does Fixed vs. Variable Mean on a Mortgage?

Many mortgages carry a fixed interest rate. This means the rate will not change for the entire term of the mortgage (typically 15 or 30 years) even if interest rates rise or fall in the future. A variable or adjustable-rate mortgage (ARM) has an interest rate that fluctuates over the loan's life based on what interest rates are doing.

How Many Mortgages Can I Have on My Home?

Lenders generally issue a first or primary mortgage before they allow for a second mortgage. This additional mortgage is commonly known as a home equity loan. Most lenders don't provide for a subsequent mortgage backed by the same property.

Where Can I Get a Mortgage?

Mortgages are offered by a variety of sources. Banks and credit unions often provide home loans. There are also specialized mortgage companies that only deal specifically with home loans. You may also employ an unaffiliated mortgage broker to help you shop around for the best rate among different lenders.