Let’s say you want to buy a car. But you don’t have enough money sitting around to pay for the car in one payment.
So you take out an auto-loan. This loan provides you borrowed money with the explicit designation that it be used to purchase the vehicle.
Here is a second example. Imagine you want to buy a wedding ring but don’t have enough funds to pay for the ring up front today. What do you do? You get a small loan.
Sounds simple, right?
A mortgage is the exact same thing, except applied to a property (a home or building). In simple terms, a mortgage is a type of loan, just like an auto-loan or financing for jewelry.
Specifically it is a loan in which a person borrows money to buy or refinance a house. That’s it.
A loan can be used to describe many different types of financial transactions. You can have a student loan, or per the example above, a loan to buy a car.
If you are borrowing money to buy a home, you will need a home loan. And home loans are called mortgages.
Who needs a mortgage?
Most people buying property require a mortgage to complete the transaction. That is because most people don’t have enough money available to spend hundreds of thousands or millions of dollars at one time.
If you don’t have the cash upfront, a mortgage is the loan type you will leverage to complete the transaction.
Because a mortgage is usually paid back over many years (30 is typical) it enables buyers to make a purchase using borrowed money.
As the years go on, the mortgage is repaid. If you are unable to make your mortgage payments, the lender can take the home in a process called foreclosure.
This is because mortgages are “secured” by the asset being purchased (that is, a home).
How is a mortgage structured?
There are different types of mortgages. But to use simple math, let’s assume that an average American home costs $300,000.
If you want to put down 20%, you will need $60,000 in cash. This $60,000 represents the down payment. The size of the down payment will depend on many variables - your credit score, the type of loan you are applying for, and the value of the property itself.
The rest of the purchase price - or $240,000 - will be financed by the mortgage. When borrowing this $240,000, you will need to agree to different terms of repayment.
Common terms will include the time that the loan must be paid back, the interest rate of the loan, and what happens if you fail to make loan payments on time.
The common parties involved in this transaction include:
- The lender: this is the bank or financial institution that is providing you money.
- The borrower: the person getting the loan.
- Loan servicer: the organization in charge of providing monthly mortgage statements and processing payments, and so on.
How to pay back your mortgage
As you are thinking about a mortgage - and if you should apply for one (and the size) - you will want to think about how much the loan will cost you. When borrowing money you need to be prepared to pay it back with interest.
One way to think about this interest is using a framework called the “cost of capital”.
In other words, how much is it costing you to borrow this money? The cost of capital is the cost of debt if your home is financed solely through debt.
When paying back a mortgage you will have four costs:
- Principal (paying back the principal of what was borrowed)
- Interest (paying the interest on the loan itself)
- Insurance (most common for people who put down less than 20% of the home value)
Some mortgages use fixed rates and others adjustable rates. Fixed rates are conceptually easiest to understand: you will pay a fixed (or constant) rate until the mortgage is paid back in full.
Using the $240,000 example from above and an interest rate of 3.5% over 30 years, you will need to pay $1,078 a month, every month, to pay the loan back.
Variable interest rates are slightly more complex. The interest rate is not fixed but rather benchmarked to a reference rate.
Sometimes people start their mortgage payment with a fixed interest rate followed by a variable one.
How the mortgage process works
Conceptually, there are three steps to getting a mortgage. This article is not the definitive guide, by any means, and there are complex nuances I am overlooking.
Step 1: Get approved for a mortgage. Sometimes this requires pre-approval. In short, its an agreement by a bank to loan you money,
Step 2: Find a home you want to buy, make an offer, and figure out how much money you will need to borrow to purchase this property.
Step 3: Get final approval and close on the loan.
Bringing It All Together: A Mortgage and Its Value
A loan is when money is given to you in exchange for repayment of the loan amount plus interest. One type of loan is a mortgage.
If you ever get confused and need a simpler example, just think about the example of buying a ring: you borrow money today to buy something you want or need.
And then you pay back that loan over time.
How much you borrow and on what terms (interest rate, length of repayment time table, and so on) are important considerations to understand before moving forward with this type of financial instrument.