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How Does a Mortgage Work?
If you’re trying to buy a home or have purchased a home in the past, you have probably heard the term mortgage thrown around, But what is a mortgage?
Well, a mortgage is a loan agreement between a borrower who is purchasing a home and a lender. In order to borrow the money to buy the home, the borrower agrees to an interest rate and a term — typically 15 to 30 years. The lender then receives its loan payments monthly, with interest, until the home is paid in full.
Most people utilize mortgage loans to help buy houses. It’s tough for the average person to come up with enough cash to pay in full for a home, so mortgage loans make that possible. There are tons of other factors that play into how mortgages work, though, and it’s important to know what they are to fully understand mortgage loan transactions.
What is a mortgage?
A mortgage is an agreement between the person who is buying or refinancing a home and a lender. Most people who are buying a home will make a down payment and then borrow the rest in order to obtain the property. That borrowed amount is what constitutes the principal amount of the mortgage.
In return for lending you the money, the mortgage lender gets to be paid interest on the loan and the right to recoup their money if you stop paying as agreed. Your monthly payment will go toward paying off that principal, or mortgage balance, and interest on the loan. If you default, your mortgage agreement gives lenders the right to foreclose on your property and sell it to make back the money that’s owed to them.
As part of the mortgage process, lenders will calculate how much they’re willing to lend you. This decision is based on a calculated risk as to whether or not you’re likely to pay back your loan in full. When making this decision, lenders will take into account your income, credit score, debt-to-income ratio and other factors that confirm your financial stability and responsible money habits.
Types of mortgages
Mortgages vary based on the type of interest, loan term and other factors. You’ll be given the choice of fixed interest rates or adjustable rates, known as “ARMs,” when borrowing money for a home. Rates on any type of loan can vary over time, so it’s best to do your research to find the best mortgage rates you can get.
Fixed-rate loans typically come in 15- or 30-year terms. These loans are called “fixed” because the interest rate stays the same over the life of the loan. What does change, though, is how much you’re paying each month in interest versus the principal.
When you first take out a mortgage loan, you pay more in interest each month than you do over time. As you pay down the principal, you will owe less interest. The closer you get to the end of your loan term, the higher the percentage of your monthly payment that goes toward your principal. That process is called “amortization.”
Adjustable-rate mortgages, on the other hand, have variable interest rates that kick in after a period of fixed interest. For example, a 7/1 ARM loan gives you seven years of fixed interest followed by the potential for your interest rate to increase or decrease depending on the economy.
You can save a lot of money in interest by choosing an ARM loan, but they’re relatively risky. There’s no telling whether the interest rates will rise or fall several years from now, so you could end up with a loan you can’t afford.
[ See: What Is an ARM Loan? ]
Refinancing is another type of mortgage loan. You can refinance your home loan after a certain period of time to take advantage of lower interest rates, longer or shorter loan terms or the equity you’ve built in your home.
When refinancing, you basically take out a new loan that pays off the existing balance on your mortgage. You then pay back the new loan under the new loan terms.
Refinancing can be a smart option if you want to lower your interest rate and monthly payment or borrow against your equity, but you have to understand the costs that go with it or you could end up paying more than you anticipated for your home.
Shorter mortgage terms vs. longer mortgage terms
Mortgages come with all types of varying terms — 15-, 20- or 30-year loans are standard. Deciding whether you want a longer or shorter loan term should be based on what you can afford and how long you plan to own the property.
A 15-year loan allows you to pay off your balance faster, and typically at a lower interest rate, but it also means you’ll pay more monthly to get the loan paid down in a short period of time. This can be tough to do for most people. You should really make sure you can afford the payments before signing on the dotted line for a 15-year loan.
If you opt for a 30-year mortgage term, you’ll pay a lower amount each month over the course of a longer term. In the long run, though, you’ll pay more overall compared to a 15-year loan since you’ll be paying for interest for twice as long.
If you have the means to do so, a 15-year mortgage will save you money long term, but you’ll have to be able to swing those high monthly payments to pull it off.
Benefits of mortgages
Perhaps the greatest value of a mortgage is that it allows you to buy a home without coming up with the cash upfront to do so. It’s a way to borrow enough money to purchase your home.
Another benefit of a mortgage loan is that it gives you the chance to build equity in your home, which you can borrow against as necessary.
You’ll also be able to borrow that money for your home at a relatively low rate. Interest rates on mortgages have been low overall for the past few years, and they’re very low right now.
[ Next: How APR Affects Your Mortgage ]
Drawbacks of mortgages
One of the drawbacks of a mortgage is that you have to pay interest on the loan. That can add up to a lot of cash over time, even if you get a low interest rate to start with.
You also run the risk of foreclosure if you break the loan agreement. That means you’ll lose your stake in the home or property investment to the lender, who will sell the house to recoup the money they let you borrow.
If you fall on hard times and are late on your payments, you also risk hefty fees and damage to your credit.
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