A mortgage is a loan that a borrower obtains for the purchase of real estate. A mortgage is obtained from a financial institution and sometimes even the property seller. Typically, the lender will loan as much as 80% of the value of the property to the borrower. The building/s and/or the land purchased by the borrower are the collateral for the loan. If the borrower fails to make the payments stipulated in the contract, the lender can seize the home through a process known as foreclosure.
Mortgages tend to be very large loans and as such, borrowers usually pay them off over long periods, often between 15 and 30 years. With each monthly payment, a mortgage pays interest on the loan, and usually some of the principal, so that gradually over time, the loan is payed off. By spreading the payments over a long period of time, financial institutions make real estate affordable.
The amount of each payment that goes toward interest and principal changes as the loan is paid down. Typically, in the early stages of paying off a mortgage, the payments are mostly interest with very little going toward paying down the principal. As time passes and more payments are made, the percentage that goes toward interest declines and the percentage that goes toward principal increases. By the end of the mortgage, the monthly payment goes almost entirely toward the principal with very little interest being paid. Once the mortgage has been payed off in full, the borrower has full equity in the property.
While this is how a typical mortgage works, known as a repayment mortgage, there is also another type of mortgage called an interest only mortgage. With an interest only mortgage, you only pay the interest on the amount you borrowed, so you will still owe the entire principal of the loan at then end of the mortgage and you’ll need to plan how to pay this off. Interest only mortgages can be a good choice for those who are unable to afford a repayment mortgage, but expect to have more money in the future to pay down the principal.
Once you have decided whether you want an interest only or a repayment mortgage, there are many variations to choose from. Two major types of mortgage are fixed rate and variable or adjustable rate mortgages. With a fixed mortgage rate, the interest rate is set for the entire term of the loan. This means that the monthly payments do not fluctuate, enabling the long-term borrower to budget and plan their finances over the long term.
By contrast, under variable or adjustable-rate mortgages (ARMs), the interest rate will periodically go up or down based on a predetermined index. This means that the borrower’s monthly payment may fluctuate over time. This type of mortgage is more of a gamble, since the borrower will pay more if interest rates rise or less if interest rates fall.
Unlike fixed-rate mortgages, some ARMs give borrowers the opportunity to pay off the principal amount early without penalty. To protect the borrower, there is usually a maximum limit that interest rates can rise in a year or over the term of the mortgage. In addition, borrowers are often offered a fixed interest rate for the initial period of the mortgage before rates start to fluctuate. Since ARMs transfer the risk from the lender to the borrower, lenders often offer very low initial rates, making this type of mortgage attractive to short-term investors.
There are several other types of mortgages available. A negative amortization mortgage enables the borrower to pay back less interest each month than is owed. The interest that is not paid is added to the total that the borrower owes the lender. This is also known as a deferred interest or graduated payment mortgage.
A discounted rate mortgage is one in which the lender offers a discount off its standard variable rate mortgage for a period of time, typically two years. Once the period has elapsed, the rate is reverted to the standard variable rate. This is ideal for young home-owners and first-time buyers who believe that when the discount period ends, they will be able to afford the higher payments.
Another type of mortgage is known as the balloon payment mortgage. Under this type of mortgage, borrowers get lower rates and payments for some time, typically three to ten years. At the end of that time, the borrower has to pay the principal in full, making the final payment much larger than the regular monthly payments. This mortgage is ideal for those who plan on selling, refinancing or selling their home before the balloon payment is due.
Refinancing is paying off your existing mortgage with proceeds from a new mortgage. Refinancing your mortgage is a way of replacing high interest debt with a loan that has a lower interest rate, or to withdraw equity they have built up in their home. Refinancing can also enable you to switch from a fixed to a variable rate mortgage and vice versa.