A mortgage is a type of loan that a bank or mortgage lending company offers to help borrowers finance the purchase of a house. The house serves as collateral. If the borrower fails to pay the loan, the bank can sell the house and regains some or all of its losses. A mortgage payment is typically made each month and consists of four components: principal, interest, taxes and insurance.
How Does a Mortgage Work? When getting a mortgage, the borrower agrees to the bank's terms and conditions. They indicate how long the borrower has to repay the loan, the amount of the monthly payments and the amount of the down payment due at signing. These terms and conditions also outline the mortgage's interest rate.
The interest of a mortgage can be accrued either at a fixed or adjustable rate. A fixed interest rate means that the rate remains the same until the loan ends while an adjustable interest rate means that the rate varies — increased or decreased — throughout the term of the loan. Some mortgages come with a combination of both types of interest, such as the 7/1 adjustable-rate mortgage, which carries a fixed rate for the first seven years of the loan's term, after which the interest rate will increase or decrease depending on a number of factors.
Borrowers must repay the lender for their mortgage at regular intervals, typically each month. The payments go toward the principal, or the total amount of mortgage, and the interest. The process of paying off a mortgage is known as amortization. If the borrower, for example, gets a mortgage loan of about $100,000 (principal amount) and agrees to pay it back within 25 years with a 3.5 percent interest rate, the total cost of the mortgage is $150,187.07 after adding the interest. This means that the borrower has to pay $500.62 each month. This amount doesn't include the cost he has to pay for homeowners' insurance.
A mortgage is considered a secured loan, meaning it's backed up by an asset in case the borrower defaults. When there's a default, the bank is allowed to foreclose the property to recoup the loss. For this reason, some banks or lending companies require borrowers to purchase either a home insurance, which indemnifies material damage to the house, or a mortgage insurance, which protects the bank in case the homeowner defaults.
Types of Mortgages Aside from the basic mortgage, borrowers have several options to choose from when deciding what's right for them: