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What is a mortgage? It's a home loan most homeowners take out to pay for a house or other property. It's important to choose the right mortgage and take advantage of the best mortgage rates. This guide will cover what a mortgage is so you can choose the home loan that's right for you.
What is a mortgage?
A mortgage is a loan used to buy property, such as land or a home. It can also be used to purchase a condo or townhouse. A mortgage loan is a secured loan, with the property acting as collateral. Your mortgage will be issued by a financial institution, such as a bank, credit union, or online lender. A mortgage comes with lower interest rates than other loans, and mortgage interest may be tax deductible.
What does a mortgage payment include?
Once a homebuyer signs their mortgage agreement and pays the closing costs, they need to make monthly mortgage payments for the term of the loan. Monthly payments consist of four or five separate components.
Principal
The amount you borrow is your principal balance. The entire amount must be repaid by the end of your loan term. If you take out a 30-year mortgage, your lender determines the amount of principal you must pay in each of your 360 individual payments for your balance to be paid in full at the end of three decades.
Interest
You pay interest to borrow. Your lender calculates the amount of mortgage interest owed and adds that amount onto your monthly payment.
Property taxes
In most parts of the U.S., you owe property taxes. Lenders want to ensure they're paid, so they divide your annual tax bill by 12 and tack that amount onto your monthly payment. They collect put the funds into an escrow account. Your property tax bill is sent to your lender to pay out of that account.
Not everyone pays property taxes as part of their mortgage payment. Sometimes it's possible to waive escrow and pay them yourself.
Homeowners insurance
Lenders also want to ensure you maintain insurance to protect the value of their collateral. They'll divide the cost of your annual premium by 12 and add that amount to your monthly mortgage payment. The money is put into an escrow account and the lender pays the homeowners insurance.
Like property taxes, not everyone pays their insurance as part of their mortgage. If you waive escrow, you won't include this in your mortgage payment but must pay the insurer directly.
Mortgage insurance
If you make less than a 20% down payment, you'll likely have to pay mortgage insurance premiums as part of your monthly payment. What is a mortgage insurance premium? It pays for insurance that protects lenders from loss in case of foreclosure.
Premiums vary by lender and loan type but could be up to 2% of your loan's value. VA loans don't generally require mortgage insurance. However, other types of loans, such as FHA mortgages, may require it for the life of the loan. With most conventional loans, you pay private mortgage insurance premiums until your loan amount falls to 78% of your property's value.
Who uses a mortgage?
Most people use a mortgage to buy property, including individuals and businesses. Mortgages make it possible to borrow at an affordable rate. Borrowers may also be able to refinance to a new mortgage with a lower interest rate if refinance rates are below what they currently pay.
Types of mortgages
There are two mortgage types: conventional mortgages and government-backed ones. A conventional mortgage doesn't come with a guarantee while government-backed loans are insured by agencies such as the FHA.
An FHA loan, VA loan, or USDA loan may have more flexible qualifying requirements. For example, a borrower may be able to make a lower down payment or be eligible even with a lower credit score.
Conventional mortgages are often sold on the secondary market to Fannie Mae and Freddie Mac, which are government-sponsored entities. However, some large loans -- called jumbo mortgages -- are too big for them to buy. A mortgage lender will either keep a jumbo loan on their own books or sell it to private investors.
Both conventional and government-backed mortgages come with different loan repayment periods, such as 15, 20 or 30 years. Generally, 15-year mortgage rates are the lowest of the three. That means 20-year mortgage rates fall in the middle of the pack. The more-popular 30-year mortgage has 30-year mortgage rates that are slightly higher than both the 15-year and 20-year.
For most borrowers, a fixed-rate mortgage makes sense because rates and payments won't change over the life of the loan. However, there are also variable rate options called adjustable-rate mortgages (ARMs). A 5/1 ARM mortgage has a fixed rate for the first five years but rates (and payments) can adjust each year thereafter. A 7/1 ARM, meanwhile, has a fixed rate for the first seven years but then rates can change annually.
Finding the best mortgage
"What is a mortgage?" isn't the most important question. The most important question is how to find the best mortgage. This process involves making sure you're as well-qualified as possible by raising your credit score and maintaining a steady income. Then, get mortgage rate quotes from at least three different lenders to make sure you get the best rate available to you.
Still have questions?
Here are some other questions we've answered:
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FAQs
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A mortgage is a secured loan used to purchase property that acts as collateral to guarantee repayment. Mortgages are issued to qualified buyers by banks, credit unions, and online lenders. Most are repaid over 15, 20, or 30 years. They tend to have lower rates than other loans and interest is tax deductible for some borrowers.
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A mortgage payment includes the amount of principal and interest necessary to pay off your loan during your repayment term. Many lenders also collect money for property taxes and insurance, which is put into an escrow account and used to pay these annual costs.
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A mortgage is a type of loan that can only be used to buy property, such as a house, condo, or land. It's secured by the value of the home. In contrast, many other loans are unsecured and don't have collateral to guarantee the loan. Mortgages are repaid over a longer time than a lot of other loans, and a home loan typically comes at a reduced interest rate.
Our Mortgages Expert
Christy Bieber is a full-time personal finance and legal writer with more than a decade of experience. She has a JD from UCLA as well as a degree in English, Media and Communications with a Certificate in Business Management from the University of Rochester. In addition to writing for The Ascent and The Motley Fool, her work has also been featured regularly on MSN Money, CNBC, and USA Today. She also ghost writes textbooks, serves as a subject matter expert for online course design, and is a former college instructor.
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