What Is A Mortgage?—The Basics For Beginners

A mortgage is a loan that helps you buy a home or property without paying the full price upfront. You repay the loan over time, including the original amount (the principal) and interest. The interest rate is the percentage of the loan you pay the lender each year.

Here are the three main types of mortgages:

Fixed-rate mortgages: The interest rate stays the same the whole time.
Adjustable-rate mortgages (ARMs): The interest rate can change over time.
Government-issued mortgages: Loans backed by the government for eligible buyers

Table of Contents

How Mortgages Work

The mortgage process has two main steps: getting the loan and paying it off. This guide explains the whole process in detail later on.

Getting a Mortgage Loan

If you are a prospective property owner, also called a buyer or borrower, you apply for a mortgage loan from a lender—a bank or other financial institution specializing in mortgage loans. Most lenders will ask you to make a down payment, usually 20% of the home’s price. The loan covers the rest of the price. For example, if a house costs $200,000 and you pay $40,000 as a down payment, the loan (principal) would be $160,000.

Paying Off a Mortgage

Once you get a mortgage, you repay the principal plus interest in monthly mortgage payments over a set period, called a term (usually 15 or 30 years)
The 30-year fixed-rate mortgage is the most common type of mortgage

The Contents of a Typical Mortgage Payment

Most mortgage payments include these parts:

Principal: You repay some of the original loan balance in each payment.
Interest: You pay some interest on the loan in each payment.

Property Tax: Homeowners pay property tax to their local government. The amount depends on where the property is located. Most lenders allow you to conveniently include property tax payments in your monthly mortgage.

Private mortgage insurance (PMI): If you make a down payment of less than 20% of the property’s purchase price, you must pay for PMI, which protects the lender if you fail to make payments or abandon the property.
Fees: Most lenders charge annual account maintenance fees bundled into each mortgage payment. The specific amount of these fees varies according to the loan terms.

The Amortization of a Fixed-Rate Mortgage

Amortization is how you’ll repay the loan, including the principal and interest, over time. At the beginning of a mortgage, most payments go toward interest, with only a tiny amount going toward the principal. Gradually, over the life of the mortgage, the mix shifts the other way: later payments are made primarily of principal and just a bit of interest.
For a 30-year fixed mortgage with a 6% interest rate and a loan of $200,000, you would need to make 359 monthly payments of $1,199.10 and then a final payment of $1,200.16. The table below shows the amount of principal and interest paid in each monthly mortgage payment after specific intervals and the effect those payments have on the remaining loan balance.

Payment No. Interest Principal Balance

1 $1,000.00 $199.10 $199,800.90

12 (1 year) $988.77 $210.33 $197,543.99

60 (5 years) $931.88 $267.22 $186,108.80

120 (10 years) $838.66 $360.44 $167,371.60

240 (20 years) $543.32 $655.78 $108,007.66

360 (30 years) $6.00 $1,194.16 $0.00

There are a few key points to take away from this table:

The time required to pay off the principal: Favoring interest over the principal means paying down the principal takes a long time. In this example, it takes over 20 years to pay off just half of the loan amount.
The amount you pay in interest: Over this loan’s 30-year term, you would pay $431,676.00 in interest, more than double the principal amount. Most borrowers pay similar amounts in interest (relative to principal) unless they pay down more of the principal sooner. Most loans let you pay off the loan amount (principal) whenever you want.

You can pay off a loan a year early and save enormous amounts by paying even a tiny extra monthly principal. If, in the previous example, you made additional principal payments of only $100 per month, the loan would be paid off in less than 25 years, and you would save $49,000 in interest charges.

Mortgage Interest Rates

Lenders set the interest rate for your mortgage based on three things: how risky the loan is, the size of the loan, and current interest rates:

The riskiness of the loan: This depends on your financial stability and reputation as a borrower. Financial stability includes your income, savings, and whether you’re self-employed. Your credit score shows your reputation, which tells lenders how reliable you are at paying back loans. Borrowers with high credit scores (usually above 700) and good financial stability get the lowest interest rates.
Size of the loan: Mortgage loans that total more than $417,000 (as of 2007) are called jumbo loans; loans below this amount are called conforming loans. (Two exceptions: in Alaska and Hawaii, jumbo loans are $625,500 and up.) Typically, interest rates on jumbo loans are higher than those on conforming loans.
Current interest rates: The U.S. government sets various interest rates based on economic factors, including mortgage interest rates. Over the past 25 years, rates have ranged from roughly 5% to 18%.

Why Get a Mortgage?

Mortgages make homeownership possible for people who otherwise could not afford the entire purchase price of a home. (In 2006, the average single-family home cost $307,000; the average home of any type cost $230,000.) There are two other important reasons to get a mortgage:

Avoid tying up your money in your home: Money spent on a home can’t be “withdrawn” until you sell the house. With a mortgage, you only need to pay the down and monthly payments. You don’t have to spend all your money on the home upfront. Instead, you can use that money for your monthly mortgage and other bills. You can also invest it in mutual funds or stocks, which might make more money over time than real estate.

Please take advantage of tax benefits: To encourage people to become homeowners, the government allows most homeowners to deduct 100% of the mortgage interest and property tax they pay annually from their income taxes. If you’re in the 28% federal income tax bracket and have a mortgage payment that currently includes $1,000 in interest and property tax, you’ll pay only 72% of that $1,000, or $720 after tax deductions. These tax benefits can save you thousands of dollars every year. However, you can’t get any tax deductions for your rent payments if you rent. Similarly, buying a property without a mortgage can only deduct property tax payments.

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