How Your Mortgage Works

Chapter One. If buying a home is in your future, you'll need to become acquainted with mortgage loans and everything that comes along with them.

This page:

  • Briefly outlines what a mortgage is and how it works

  • Describes what goes into a mortgage payment

The first part of this guide explains what a mortgage is, what the differences are between various types of mortgages and briefly explains how to choose the best loan for you.

The second part of this Mortgage Basics Guide describes what goes into your mortgage package: rates, points, insurance, etc.

So, what exactly is a mortgage?

A home mortgage is any long-term loan that a borrower obtains to purchase a residential property.

Even more simply put, a mortgage is a loan to buy a home.

In return for the loan, the lender gains a lien, or a formal legal claim to ownership, against the property. If the terms of the mortgage agreement are not satisfied according to specifications, the lender can foreclose on the loan and repossess the property. (All bad things.)

But, of course, lenders aren't looking for liens. They're looking to make money by charging interest on their loans.

So now we ask:

How much interest will you pay?

It depends on many factors (length of your loan, interest rate, etc.) but a few things are always true:

  • Mortgage payments are amortized, meaning the loan's interest is spread over many payments. This makes buying a house more affordable.

  • Each mortgage payment includes interest on the balance of the loan.

  • At the beginning of a mortgage term, almost all the money paid goes towards interest. While at the end, interest payments are very small.

So, the longer you pay, the lower the balance, the less you pay in interest (and the "more" of your home you own, with is called building equity).

Many people unfamiliar with mortgages assume that primarily they'll be paying for the actual cost of their home (called the principal). In fact, nothing could be further from the truth:

Under almost every mortgage plan, the vast majority of the cost to the buyer is taken up by interest.

Under some mortgages (like the 15-year FRM), the total cost of interest is less than the cost of the house. In most other cases (like any 30-year mortgage), the amount of interest you pay will be much higher than the value of the home. In general, you can expect to pay between 70% and 150% of your home's value in interest.

Sidebar
Now you know why a low interest rate is so important on a home mortgage. A few tenths of a point can make a huge difference! Eloan guarantees the lowest rates in the country for prime borrowers, whereas if you have poor credit, you can get pre-approved at FullSpectrum in seconds.

What else is in a mortgage payment?

Monthly mortgage payments, (sometimes referred to as "PITI payments" in legalese) cover a portion of the Principal owed to the lender, Interest on that principal, real estate Taxes, and property Insurance.

The last two are sometimes paid annually, in which case they will not figure into your monthly payments.

Depending on the terms of your mortgage, you may also be required to pay private mortgage insurance (this is often the case if you have a low down payment or poor credit rating).

We'll talk about all these things later (see the index) but for now let's take a closer look at how mortgage interest rates are decided.

Next: Who decides how much interest you'll pay?

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