What Is a Mortgage?

A mortgage is a loan to buy a home. Once it's paid off, you own the home free and clear.

Holden LewisNovember 24, 2020
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A mortgage is a loan used to buy a home or to refinance a home loan. You make regular payments on a mortgage until it’s paid off after a set number of years.

More precisely, a mortgage is the legal document that permits your lender to take the home if you don't repay the loan as agreed. In some states, this document is called a deed of trust.

Once you pay off the mortgage, you own the home outright, or "free and clear." The lender's legal right to repossess your home goes away.

What a mortgage payment includes

Your monthly mortgage payments can cover several costs, including:

Principal

"Mortgage principal" means two things. It can refer to the amount you borrowed. It also can refer to the amount you owe after you have made payments.

For example, if you borrowed $200,000 and repaid $24,000, the remaining principal balance is $176,000. A portion of each mortgage payment is applied toward your principal, reducing the total amount owed over time.

Interest

The interest rate on your mortgage determines how much you’ll pay the lender in exchange for borrowing the money.

Some of each monthly payment reduces the principal owed and some goes toward interest. In the first years of the loan, most of each payment pays interest and not much goes toward principal; in the final years, most of the payment reduces principal. This process is called amortization.

Taxes

Your lender may collect property taxes along with your mortgage payment and keep the money in an escrow account until your property tax bill is due, paying it on your behalf at that time.

Homeowners insurance

Homeowners insurance, which can cover damage from fires, storms, accidents and other catastrophes, usually is required by mortgage lenders. They may collect the premiums with your mortgage payment and then pay the insurance bill out of your escrow account when it’s due.

Mortgage insurance

When you make a down payment of less than 20%, lenders typically require you to pay for mortgage insurance.

Mortgage insurance protects the lender against the risk that you’ll default on the loan. There are two types: private mortgage insurance, or PMI, and forms of mortgage insurance required for government-backed loans, such as FHA loans (insured by the Federal Housing Administration). The premiums may be billed in your monthly mortgage statement.

Mortgage types

There are two kinds of mortgages.

  • Fixed-rate mortgage. The interest rate doesn't vary. The vast majority of home loans are fixed-rate mortgages.

  • Adjustable-rate mortgage, or ARM. The interest rate can change at intervals specified in the loan paperwork. Your monthly payment might go up or down as the interest rate changes.

There are several types of mortgage programs, which allow you to choose either a fixed-rate or adjustable loan.

Conventional mortgages meet underwriting standards set by Fannie Mae and Freddie Mac, and conform to limits on loan amounts, set by the Federal Housing Finance Administration, or FHFA. They require a credit score of 620 or higher and a down payment of at least 3%.

FHA loans are insured by the Federal Housing Administration. Borrowers with credit scores as low as 580 may qualify for an FHA-insured mortgage with a down payment of at least 3.5%.

VA loans are guaranteed by the Department of Veterans Affairs. They usually require no down payment. That's right, a zero percent down payment. VA loans are available to qualified U.S. veterans, active-duty military personnel and some surviving spouses.

USDA loans require a zero percent down payment and are available to homebuyers who meet income requirements in designated rural and suburban areas. They are guaranteed by the U.S. Department of Agriculture.

Jumbo loans are mortgages that exceed the limits on loan amounts set by FHFA. These "conforming limits" are adjusted annually. The limits vary by county, and are higher where housing is expensive.

What a second mortgage is

A second mortgage is another loan on a home that already has a first, or primary, mortgage. Also called "junior liens," second mortgages are a way to access the equity in your home as spendable funds, without selling or refinancing.

Home equity loans and home equity lines of credit are two types of second mortgages.

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