What Is a Mortgage and How Does it Work?

Fran
Fran Majidi
February 14, 2020

If you want to own a home, you may need to take out a mortgage to pay for it in monthly payments. A mortgage is a contract between a lender (bank or mortgage lender) and a borrower (you). A mortgage enables a lender to loan money to the borrower to buy real estate property based on a promise to repay the loan. Mortgages are also called “liens against property” or “claims on property.” There’s not much difference between taking out a mortgage and financing a car. There’s usually interest affixed to the loan too, so you’re paying the bank/mortgage lender more than the cost of the home. If you don't make the agreed-upon monthly payments, the lender can foreclose the home and take possession of the home. During a foreclosure, the lender can legally evict you for not making payments and sell the home to clear the debt.

What Kinds of Mortgages Are There?

Some mortgages are as short as five years old and some as many as 50 years or more. The longer you extend a mortgage, the less you pay monthly but the more you pay in interest in the long-run.

What’s the Most Popular Type of Mortgage Loan?

The 30-year fixed and 15-year fixed mortgages are the most popular types of mortgages. They are also the most traditional. What makes fixed-rate mortgages more popular is that the borrower pays the same interest rate for the duration of the loan. This is significant because if interest rates rise in the market, they can heavily impact mortgage payments.

With an adjustable-rate mortgage (ARM), the interest rate is fixed in the beginning, usually for a short period of time and at a very low rate but then fluctuates with market interest rates. Often, people choose this type of loan because it’s easier to afford the mortgage the first few years, but in the long-run, the mortgage may become unaffordable. However, interest rates can also drop, but you’re never sure which way they will go with an ARM.

There are other more complex mortgages like interest-only mortgages and payment-option ARMs, but they can cause problems if you’re not finance savvy. These are the types of mortgages that were in trouble during the housing crisis of the early 2000s when many homes were foreclosed.

Mortgage Lenders vs Banks: Which Is Better?

Both non-bank mortgage lenders like Quicken Loans and SoFi and big banks like JPMorgan Chase and Citibank offer home mortgages. Both have their pros and cons. Mortgage lenders offer more types of loans, so your loan options are more extensive. For people with not-so-great credit, these types of institutions may be the only option.

Banks have stricter criteria for lending money, but if you already are a customer of a bank, you may be able to get discounts or special in-house options that are tailor made for a specific demographic, like self-employed home buyers, for example.

Loans from banks often take longer to close than loans from mortgage lenders. But you’ll probably pay lower rates through a bank if you have good credit, despite the additional fees.

What Are Mortgage Rates Today?

This is an important question you should ask yourself because you may get stuck with a high mortgage rate if you’re not careful, thereby increasing payments considerably. For this reason, people often lock in their mortgage rates when they can.

What Is a Mortgage Rate Lock?

A mortgage rate lock freezes the interest rate. The lender (whether it’s a bank or other institution) will guarantee that your rate will not go up regardless of changes in market interest rates for a specified amount of time. Remember that once you lock in a rate, you won’t be able to lower it if interest rates fall. However, you will be protected from a spike in rates.

Consider locking your rate when it’s at a comfortable one. Predicting home loan interest rates is like predicting the stock market. If there was a specific formula to it, everyone would be rich. Even well-respected economists make mistakes in their predictions.

Your loan adviser will probably offer you a rate lock but if he/she doesn’t, you can ask for one.

Mortgage Payment Calculator

It seems everyone has a mortgage payment calculator, Zillow being one of them. It’s always a good idea to figure out how much you can afford to spend on a house. Some mortgage payment calculators will add on homeowners association fees, which are an additional monthly charge you pay to the condo association or homeowners association. If the calculator you use doesn’t, consider it as well as annual taxes and homeowners insurance on top of other closing costs. Avoid having the lender choose your home insurance for you. More on this below.

Homeowners Insurance

Compared with the other expenses associated with buying a home, homeowners insurance is the least of them, but it’ll still be a few thousand dollars a year. If you have a mortgage, having home insurance is mandatory.

Not only is it important to have the right coverage to protect your most important asset (your new home!), you’ll want to make sure you’re not paying more than you need to when choosing the best plan out there. When it’s time to get insured it’s best to compare home insurance quotes here.

You should never pay to shop homeowners insurance rates. Also, you should never leave it to your lender to choose a home insurance plan for you. While the lender has a vested interest in protecting the home as much as you do, they are not as concerned about saving you money on a policy.

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