A mortgage is a type of loan that is secured by real estate. When you get a mortgage, your lender takes a lien against your property, meaning that they can take the property if you default on your loan. Mortgages are the most common type of loan used to buy real estate—especially residential property.
Mortgages are considered relatively safe loans for lenders to make because the lender can take the property if you don’t pay. As long as the loan amount is less than the value of your property, your lender’s risk is low. Even if you default, they can foreclose and get their money back.
A mortgage is a lot like other loans: a lender gives a borrower a certain amount of money for a set amount of time, and it’s repaid with interest.
However, mortgages are also a little bit different than other types of loans because mortgages are loans made against real property. This means that the loan is secured by the property, so the lender gets a lien against it and can foreclose if you fail to make your payments.
Every mortgage comes with certain terms that you should know:
When a lender approves you for a home loan, the mortgage is scheduled to be paid off over a set period of time. However, loans can always be paid back early. In some cases, lenders may charge prepayment penalties for paying back a loan early, but such fees are unusual for most home loans.
When you make your monthly mortgage payment, each one looks like a single payment made to a single recipient. But mortgage payments actually are broken into several different parts.
The two primary parts of every mortgage payment are principal and interest. How much of each payment is for principal or interest is based on a loan’s amortization. This is a calculation that is based on the amount you borrow, the term of your loan, the balance at the end of the loan and your interest rate.
Mortgage principal is another term for the amount of money you borrowed. In addition to the amount you borrowed, your mortgage principal may also include fees you were charged to secure your loan. In many cases, these fees are added to your loan amount and paid off over time.
When referring to your mortgage payment, the principal amount of your mortgage payment is the portion that goes against your outstanding balance.
If you borrow $200,000 on a 30-year term to buy a house, your monthly principal and interest payments may be about $950. Part of that $950 will go toward the $200,000 you owe your lender, and the rest will go to interest. Your total monthly payment will likely be higher, as you’ll also have to pay taxes and insurance.
The interest rate on a mortgage is the amount you’re charged for the money you borrowed. Part of every payment that you make goes toward interest that accrues between payments.
While interest expense is part of the cost built into a mortgage, this part of your payment is usually tax-deductible, unlike the principal portion.
How much mortgage you can afford is typically based on your debt-to-income (DTI) ratio. For most lenders, the maximum DTI to get a conventional mortgage should be no more than 43%.
To calculate your maximum mortgage payment, take your net income each month (don’t deduct expenses for things like groceries). Next, subtract monthly debt payments, including auto and student loan payments. Then, divide the result by 3. That amount is approximately how much you can afford in monthly mortgage payments.
There are several different types of mortgages you can use based on the type of property you’re buying, how much you’re borrowing, your credit score and how much you can afford for a down payment. Your circumstances and the goals for your loan will dictate which option is best for you.
Some of the most common types of mortgages include:
With a fixed-rate mortgage, the interest rate is the same for the entire term of the mortgage. The mortgage rate you can qualify for will be based on your credit, your down payment, your loan term and your lender.
An adjustable-rate mortgage (ARM) is a loan that has an interest rate that changes after the first several years of the loan—usually five, seven or 10 years. After the first adjustment, the rate typically will change about every year thereafter. Rates can either increase or decrease based on a variety of factors.
With an ARM, rates are based on an underlying variable, like the prime rate. While borrowers can theoretically see their payments go down when rates adjust, this is very unusual. More often, ARMs are used by people who don’t plan to hold a property long term or plan to refinance at a fixed rate before their rates adjust.
There are two types of government-backed mortgages: direct-issue and insured. The government offers direct-issue loans through government agencies like the Federal Housing Administration, United States Department of Agriculture or the Department of Veterans Affairs. These loans are usually designed for low-income householders or those who can’t afford large down payments.
Insured loans are another type of government-backed mortgage. These include not just programs administered by agencies like the FHA and USDA, but also those that are issued by banks and other lenders and then sold to Fannie Mae or Freddie Mac. However, these loans must all conform to certain lending standards set by the FHA in order to qualify.
Jumbo loans are just like the conforming loans that are sold to Fannie and Freddie, but with one key difference: They exceed the maximum loan amount for conforming loans. For most areas in the U.S., any home loan that exceeds $510,400 is a jumbo loan and may come with certain restrictions or higher interest rates ($765,600 is the threshold in high-cost areas).
Balloon loans are mortgages that won’t be fully repaid when the term ends if the borrower just makes their normally scheduled payments. These loans are said not to be fully amortized—the payments on the loan are structured for a schedule that lasts longer than the loan term.
When the loan term on this type of mortgage ends, you’ll be required to make a balloon payment. These balloon payments are often refinanced so you don’t have to pay it off all at once, but that isn’t always an option—if your credit score declines, for example.