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What Is a Mortgage?

Homeownership is one of the keys to building long-term wealth. And if it weren’t for mortgage loans, most Americans would never become homeowners.

But how does a mortgage work? What are the different types? And how do you decide which one is best for you?  

Let’s take a look and kick off with what a mortgage actually is.

What Is a Mortgage?

A mortgage is a loan that specifically helps a borrower buy a home. The house you get with the loan serves as collateral for your lender so that if you don’t make your monthly payments, they can take your home in foreclosure.

The first thing to know about mortgages is that they aren’t exactly the best way to buy a home. The best way to purchase a house is with cash. That’s right—make a 100% down payment! But most people don’t want to wait that long to buy a home. So, that’s where getting a mortgage comes in.

How Do Mortgages Work?

Mortgages come in all shapes and sizes, but the basic parts and how they work are the same no matter what type of mortgage you have.

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The first part is the down payment. This is a stack of cash you save to put toward the purchase of your home. Your mortgage fills the gap between your down payment and the purchase price of your home.

You’ll also sign a mortgage note—the legal document that sets the terms of the mortgage. This includes the amount, costs your lender will charge you, the repayment plan, the timeline of money to be paid back and all the tiny (but oh-so-important) details.

Then comes the interest. However much money you put down on your future home will affect how much the bank charges you in interest for your mortgage. The less you need to borrow, the less interest you’re required to pay.

Types of Mortgages

You’ll have plenty of options when it comes to how long you want to spend repaying your mortgage, but the most common terms are over 15 years and 30 years. Let’s break down those types of mortgages and find out which ones to steer clear of.  

Conventional Mortgage

Conventional loans generally require a 5% down payment. They’re backed by the mortgage lender themselves—so if you don’t make your monthly mortgage payments, the lender loses money on the loan. Conventional mortgages can be more difficult to qualify for, and they require higher down payments than government-backed loans.

Fixed-Rate Mortgage

Fixed-rate mortgages keep the same interest rate over the life of the loan. You’re locked into your rate once you sign those mortgage documents—regardless of market changes.

These are the two options for fixed-rate mortgages:

  • 15-year fixed-rate mortgage: This is a home loan designed to be paid over a term of 15 years. The interest rate remains the same for the whole period. A 15-year fixed-rate loan will generally have a higher monthly payment, but a lower interest rate than a 30-year mortgage. Because you pay more toward the principal amount each month, you’ll build equity in your home faster, be out of debt sooner, and save thousands of dollars in interest payments.

  • 30-year fixed-rate mortgage: This loan term is set for 30 years, and the interest rate remains the same the entire time. A 30-year fixed-rate loan will generally have the lowest monthly payment amount but the highest interest rates—which means you’ll pay much more over the life of the loan!

Adjustable Rate Mortgage (ARM)

An adjustable rate mortgage (ARM) usually has a set period of time when the interest rate doesn’t change. But after that, your rate can change based on several different factors—like with market trends. ARMs transfer the risk of rising interest rates to you—the homeowner.

A five-year ARM, also known as a 5/1 adjustable rate mortgage, is a home loan designed to be paid over 30 years. The interest rate doesn’t change during the first five years of the loan.

After that time period, it adjusts annually based on market trends until you pay off the loan. The interest rates are similar to those for a 30-year mortgage in the beginning but, with all ARMs, the homeowner doesn’t know what the future holds for their interest rate once that five-year term is over! That’s some scary stuff.

Government Loan

The government provides a few ways to step onto the housing ladder with loans like these:

  • Federal Housing Administration (FHA) loans: FHA loans are backed by the government, which means the bank is insured by the government. If you don’t make your payments, the bank won’t lose money because the government has them covered.These loans require a down payment of as little as 3.5%—and that looks pretty nice for a lot of potential borrowers.

    But buyer beware: A lower down payment now means you'll pay more in interest later. It's wise to wait and save at least 10% for a down payment (but 20% is best to avoid PMI) before you purchase a home.

  • Veteran’s Administration (VA) loans: VA loans are backed by the Veteran’s Administration, and they don’t require down payments or mortgage insurance. This may be tempting, but it’s risky. If you can’t put any money down on your home, you‘ll have high monthly payments—which makes it difficult to keep your home.

  • United States Department of Agriculture (USDA) Loans: This loan is eligible for certain families in rural areas with the aim of encouraging more rural homeownership by offering specialized mortgages with low down payments. 

What’s Included in a Mortgage Payment?

Think of your mortgage payment as a pizza sliced up to serve several different needs. A monthly mortgage payment is made up of these five basic parts:  

1. Principal is the initial amount of money you borrow for your home. The principal portion of your monthly payment is the part that actually goes toward paying your loan amount.

With the way most mortgages work, the interest portion shrinks as you pay down the principal with payments over time. When you make extra payments on your loan (so you can pay off your loan faster) make sure they’re applied to your principal balance.

2. Interest is the fee your lender charges you for borrowing money at a predetermined rate known as your interest rate.Usually, shorter-term mortgages have lower interest rates, but your monthly payments are higher.  That’s why it’s always better to pay off a mortgage in a shorter period of time instead of a longer period at a higher interest rate.

3. Taxes are the property taxes you pay as a homeowner. They’re calculated based on the value of your house and vary by location and home price. First, your lender estimates how much your taxes will be.

Then, that estimated cost is divided over a 12-month period to be added to your monthly mortgage payments. Your lender holds those funds in an escrow account and makes your property tax payment for you.

4. Homeowner’s insurance covers the cost of your home if something disastrous (like a tornado or a fire) were to happen. Nearly all lenders require homeowner’s insurance.

5. Private mortgage insurance (PMI) protects your loan if you put down less than a 20% down payment. It’s required to protect your lender if you don’t pay your mortgage.

PMI is calculated annually as a percent of your original mortgage amount based on your credit rating and down payment. PMI also bumps your monthly mortgage payment, so you should try to avoid it if you can! Aim to make a 20% down payment.

Other Mortgage Fees

There are other fees related to getting a mortgage and once you start paying one. Here are some of them:

  • Closing costs: These are all the fees associated with closing and setting up a mortgage including an appraisal of the property, home inspection, the real estate agent’s commission, prepaid insurance and property taxes. These vary from lender to lender, so pay close attention and don’t be afraid to negotiate lower closing costs.

  • Prepayment penalties: If you want to make extra payments so you can pay off your mortgage before the end of your loan term or if you want to sell your home before the end of your loan term, you may come across prepayment penalties. Never sign up for a mortgage with prepayment penalties.

  • Interest rate vs. annual percentage rate: Don’t be fooled. Your interest on your loan isn’t all you actually pay. The total rate you pay annually on your loan is your APR, which considers your interest rate and other fees charged over the life of your loan—like loan processing fees.

  • Balloon payments: These are large, lump-sum payments due at the end of some loan terms. You’ll see these with super short-term loans usually from nonbank lenders. While we usually associate balloons with celebrations, these are some balloons you want to avoid! You don’t want to be on the hook for a large payment due all at once when you could be paying a little bit at a time.

  • Negative amortization: If you fail to make your loan payments or only pay enough to cover the interest amount due, what you owe will be added to your loan’s principal. This will make your principal larger and your payments even bigger. The lesson here is this: Don’t miss your payments!

What Type of Mortgage Should I Get?

Your best bet is to avoid paying thousands extra in interest by getting a 15-year fixed-rate loan instead of a 30-year mortgage. A 15-year mortgage may come with a higher monthly payment, but you’ll save more in the long run by avoiding all that interest!

Speaking of interest, finding a low interest rate is important when you’re comparing mortgages. Fixed-rate mortgages often have slightly higher interest rates than the initial interest rates for ARMs.

But unlike ARMs, you’ll never have to worry about paying more for your loan than you initially planned. That’s why we recommend fixed-rate mortgages over ARMs.

Look at it this way: Borrowing $200,000 to buy a home sounds intimidating enough. But the thing is, you’re not committing to pay back just $200,000.

You could easily be committing to pay an amount along the lines of $350,000 (or even more) depending on your interest rate and the length of the mortgage!

Where Do I Get a Mortgage?

Now that you’ve got the idea of what a mortgage is, where do you go to get one? A bank might be your first point of call when it comes to a mortgage lender. But there are a few different routes to get to your mortgage destination. Here are some of them:

Mortgage Brokers: A mortgage broker is basically the middleman between you and a mortgage lender. They look over your loan application and say, “It looks like you can afford this much mortgage. I’ll find you a good lender.” Then, they work with several different lenders and banks to match you with a loan that meets your needs.

Banks: It’s worth checking out loan offerings at multiple banks. If you have a good, long-standing relationship with your bank, they may lower your closing costs and interest rate.

As with direct lenders and credit unions, banks process their mortgages in-house. Be careful with some of the big banks, though. They might offer a variety of financial services—not just mortgages. So they may not give you the best customer service.

Credit Union: Credit unions are not-for-profit organizations. Members own the credit union and, to become a member, you need some kind of invitation—like from your company or church.

Credit unions will give out mortgages, but here’s the thing: You have to be a member to get one. If you are a member, there’s a good chance you might have lower closing costs and a better interest rate. 

Direct Lender: A direct lender’s job is to make and fund mortgages. Unlike mortgage brokers, direct lenders approve your mortgage applications and loan you money directly because they are the lender.

One of the biggest advantages of going with a direct lender is that they take care of the whole mortgage process. Once you've found the home you want with your real estate agent, your lender is going to do everything from processing your loan application and giving you a mortgage preapproval to underwriting your mortgage. 

If you’re looking for a lender who will help you understand the ins and outs of mortgages so you can make the best decision for your budget, check out Churchill Mortgage. They’ve helped thousands of people like you understand and finance their home the smart way.

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.

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