Let’s start with the ultra basic: “What is a mortgage?”
You’ve undoubtedly heard the word “mortgage” thrown around a million times. In the literal sense, it means “death pledge” in the French language, meaning the pledge is effectively terminated when paid off or the property is repossessed (foreclosed) if not paid as agreed.
A mortgage can be referred to in a variety of different ways, with the most common being a “home loan.” Some may refer to a mortgage as a “lien”, which is the amount of money a borrower owes on a property. Whatever is left over from the original loan amount is referred to as the existing lien.
Others might refer to the mortgage as a trust deed, or deed of trust, which is a legal document that outlines the terms of the agreement.
How Mortgages Work
Regardless of the many terms and variations, a mortgage is essentially an agreement between a bank and a borrower to lend money in exchange for a piece of property. It’s a fairly simple concept.
Instead of paying for a home with cash, which most of us can’t manage, you take out a loan with a bank and repay it over a long period of time, typically 30 years. The lengthy term allows payments to be affordable.
Bank/Mortgage Lender —> Mortgage —> Borrower/Homeowner
Generally, you must also provide a down payment for a portion of the sales price at the time of purchase, such as 5-20%.
Assuming you qualify for a mortgage, the bank will grant you a loan and you will go into contract with that bank and begin making regular monthly payments until your mortgage is paid in full or refinanced by another bank or lender.
The property acts as collateral in exchange for the mortgage. So if you don’t make your mortgage payments on time, the issuing bank has the right to take your home. This is known as foreclosure.
If you sell your home before the mortgage term ends, the proceeds of the sale will be used to pay off the remaining mortgage debt.
There are four main types of mortgage transactions:
While you’re here, you may also want to learn more about how refinancing works.
Most Mortgages Have 30-Year Terms
Most mortgages are due in full in 30-years and also based on a 30-year amortization. That is, the total loan amount, or lien(s) will need to be paid off in 30 years, or in 360 months.
Amortization refers to how the mortgage is paid off. It is essentially the way your mortgage payments are distributed on a monthly basis, detailing how much interest and principal will be paid off each month for the duration of the mortgage term.
In the case of a 30-year fixed mortgage, the mortgage is paid off in equal amounts every month until the mortgage balance is zero. At that point, you would have full ownership of the associated property.
The difference between the mortgage balance and the value of the property is known as home equity, which you can access via sale, refinance, or home equity line of credit.
Also note that there are other less common loan terms such as 15-year, 20-year, 40-year, and even 50-year loan programs. But for the sake of simplicity, let’s focus on the 30-year amortization type, which is far and away the most popular.
There Are Plenty of Mortgage Options Out There
When searching for a loan program, you will be presented with a variety of options from a six-month ARM to a 30-year fixed product. Both are based on 30-year amortization, but they differ greatly in rate.
The 30-year fixed product is pretty clear. It’s simply a fixed rate for the entire 30 years of the loan. It never changes, and the rate you pay the first month is also the rate you will pay the last month, or the 360th month to be exact. Learn more about fixed-rate mortgages.
The six-month product is a bit more complicated. For the first six months, the interest rate will not change. But after those initial six months, the rate will become variable (adjustable), though it will still be based on a 30-year amortization. The loan program will be tied to a mortgage index, such as the LIBOR (London Interbank Offered Rate) and will also contain a margin agreed upon by the bank or lender.
When you combine the two, you will find your fully-indexed rate. The margin doesn’t adjust, but the index will do so on a daily basis, which will affect your monthly payment. Learn more about how adjustable-rate mortgages work.
If you’re looking for quick definitions to other mortgage-related terms, check out my mortgage glossary. And if you’re not sure what mortgage to go with, see my article on which mortgage is right for me.