What is a mortgage?

A mortgage is a loan extended to you by a lender for buying a home. You have many years to pay back the mortgage, but it will accrue interest during that time.

Elissa

Elissa Suh

Published January 16, 2020

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KEY TAKEAWAYS

  • A mortgage is a home loan, meaning a mortgage lender will extend you money that you need to pay back

  • Principal, interest, taxes, and insurance are important components of a mortgage payment

  • Mortgages rates can be fixed or variable and are influenced by the economy and the borrower’s financial standing

  • The most common mortgages are 15-year and 30-year fixed rate mortgages

A mortgage is a loan extended to you by a lender, like a bank or credit union, for the purpose of buying a home. Typically, the borrower has many years to pay back the mortgage, but it will accrue interest during that time. If you stop repaying your mortgage, the lender may repossess the house.

Since buying a house costs a lot of money, for most people a mortgage is the only way to become a homeowner. However, owning a home is one major way to build personal wealth. Once your mortgage is paid off, you’ll likely own an asset that has considerably appreciated in value.

Mortgages aren’t one-size-fits-all – they vary based on the length of the loan, who the lenders are, and, of course, how rates are set. Mortgage interest rates are largely dependent on the borrower’s financial standing, but tend to track with economic factors on average. Monthly mortgage payments are also comprised of other costs, like mortgage insurance and taxes. Most mortgage lenders will also require you to get homeowners insurance, too.

To know how much mortgage you can afford, check out our mortgage calculator. If you’re a first-time home buyer, keep reading to learn all about how a mortgage works.

How does a mortgage work?

A mortgage consists of the principal, interest, insurance, and taxes. There are also extra closing costs. We’ll go through each of the major components of a mortgage.

Principal

The principal is the amount you still owe on the mortgage. The principal amount decreases over time as you repay the loan.

Interest

When you make mortgage payments, you’re not just paying down the principal amount – you’re also paying interest. The APR, or annual percentage rate, is the percent that you pay the lender for extending you such a large amount of money. APR includes interest as well as other costs.

The interest rate can vary and might be flat or fixed based on what type of mortgage you have. (We’ll discuss how mortgage payments are calculated later.)

You can get the average mortgage rates and analysis on a weekly basis here.

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A mortgage makes a house your own. Insurance protects it.

Policygenius can help you find a homeowners insurance policy that fits your needs and your budget.

Taxes

Homeowners must also pay transfer taxes, recording fees, and property taxes. Property taxes are set by the state, city, and county, and a certain amount may be due when you close on the house.

Homeowners insurance

Homeowners insurance protects your property and your personal belongings against hazards, or perils. The lender typically requires the borrower to get a policy as a condition of taking out a mortgage. Insurance payments, or premiums, are usually paid directly to the insurance company. The costs are based on a few different factors (like credit score and build quality of the home) and vary by location and provider, so it’s important to shop around. (Policygenius can actually let you compare homeowners insurance quotes for free.)

Mortgage insurance

If you make a down payment of less than 20%, you’ll have to pay private mortgage insurance, or PMI. Mortgage insurance is basically insurance for the lender in case the borrower fails to make monthly payments. Borrowers can usually stop paying PMI after they’ve established enough equity in their home (by paying enough of the mortgage off).

Government loans have something called a mortgage insurance premium (MIP), instead of PMI. MIP functions similarly to PMI, but has several crucial differences. We’ll talk about the differences in loan types later.

Mortgage insurance is usually paid monthly to the lender, who also determines how much you pay (you can’t shop around), but a certain amount may be due at signing as part of closing costs, which we’ll discuss next.

Closing costs

You’ll also need to pay some additional fees involved with applying for the mortgage in the first place. Before you sign the mortgage documents, but sure to look out for the following closing costs:

  • Down payment: A lump sum payment equal to a percentage of your loan amount. You can usually choose how much you pay: The higher the down payment, the less you’ll have to pay in overall mortgage costs over time.
  • Origination fees: The lender’s costs for processing your application. Usually a percentage of your loan amount (called discount points), plus set dollar amounts for the application, underwriting, credit check, appraisal, and titling fees.
  • Inspection fees: Home inspection, pest inspection, and survey fees.

Types of mortgages

Mortgages can be categorized in a few different ways, regarding the loan term (length of the loan), the interest rates (fixed rate or adjustable rate), size (conforming or nonconforming), and whether or not it’s insured by the government.

Here are a few of the most common types of mortgages that you’ll encounter:

1. Fixed-rate mortgage

With a fixed-rate mortgage, your interest rate stays the same throughout the lifetime of the loan. Borrowers don’t need to worry about the economy, volatile markets, or mortgage rates. The 15- and 30-year fixed-rate mortgages are among the most common types of mortgage loans.

2. Adjustable-rate mortgage

Adjustable-rate mortgages (ARMs) have an interest rate that may go up or down, depending on changes in market rates. Also known as a variable-rate mortgage, an ARM starts with a low interest rate that increases years later. Check with your lender about the highest possible interest rate (the cap) and the lowest possible interest rate (the floor) to make sure you’re getting the right deal.

Learn more about adjustable-rate mortgages ARM.

3. Hybrid ARM mortgage

Borrowers can actually pay both fixed and variable interest rates with this type of mortgage. For example, the 5/1 ARM has a fixed interest rate for five years, after which the interest rate can change annually. (The “1” in 5/1 means that lender can only adjust the interest rate once a year.) Mortgage lenders may offer 10/1 ARMs, 7/1 ARMs, and other combinations.

Learn more about the 5/1 ARM.

4. Interest-only mortgage

The borrower pays only interest for the first several years and then has to start paying back the principal and the interest. Interest-only mortgages are no longer widely available. While giving the borrower financial flexibility, interest-only loans can leave an unprepared borrower in a bind, since the monthly mortgage payment would skyrocket after the initial phase ends.

Learn more about interest-only mortgages.

5. Government-backed mortgage

Certain borrowers can get a loan backed by the government like

  • Federal Housing Administration (FHA loan)
  • Department of Veterans Affairs (VA loans)
  • USDA mortgage

These government loans are capped at a certain mortgage amount, but they have lower closing costs, including lower down payments, than conventional loans. (However, you may have to pay mortgage insurance for the lifetime of the loan.)

Learn more about FHA loans.

6. Jumbo loan

A mortgage for a very large loan amount – specifically larger than the max set by Freddie Mac and Fannie Mae – is a jumbo loan. For this reason, they are considered nonconforming mortgages. As of 2020, the maximum conforming mortgage amount is $510,400. Anything larger is a jumbo loan.

7. Reverse mortgage

A reverse mortgage is when the bank extends you a loan using the equity of your home, and you don’t have to pay it back as long as you keep living on the property. Reverse mortgages are only available for borrowers who are over 62 years old and have paid off most or all of their mortgage entirely. (If you’re a first-time homebuyer, you don’t need to worry about reverse mortgages just yet.)

Learn more about reverse mortgages.

8. Second mortgage

The more you pay your mortgage, the more equity your home has. (Roughly, your home equity = amount your home is worth - remaining mortgage balance. That means it’s sometimes possible to have negative equity.) Once you have enough equity in your home, you can actually borrow against the value of the mortgaged property by taking out a second mortgage.

People take out second mortgages when they’re in a bind and need cash. (If you're a first-time buyer, you probably don't need to worry about second mortgages just yet.) They might get all the money up front as a lump sum, or draw from a set amount as they need it like a credit card — the difference between a home equity loan vs a home equity line of credit). Second mortgages have closing costs and fees, just like the original mortgage.

Learn more about second mortgages.

Applying for a mortgage

The most important thing about applying for a mortgage is being able to afford it. All lenders, including mortgage lenders, want a financially stable borrower who won’t have trouble making the monthly payment.

Borrowers can get a head start by getting preapproved. Preapproval is an estimate for how much one lender thinks you can afford (often because you have a high credit score). Just as with credits cards, you may even receive flyers in the mail or see notices in your online banking platform that you’re preapproved for a mortgage loan.

If you aren’t preapproved, you can still reach out to a loan servicer — like a credit union, a bank, or even an online bank. Preapprovals can help you negotiate better mortgage rates with other lenders.

Once you’ve found your dream home and put in an offer, you’ll fill out the loan application to get actual approval. The rates may change as the lender learns more about your finances, including income, assets, debts and liabilities. Borrowers should also be prepared to show a few supporting documents, too, like pay stubs, bank statements, W-2 forms, or tax returns.

The lender will process your application and when you’re approved, you’ll sign the commitment letter, which means you’re ready to close on the mortgage. At the closing, everyone involved in the mortgage process – the borrower, the co-signers, the lender’s closing agent, and both the buyer and seller’s real estate agents – will sign the closing documents. The house will be transferred to you, which is called titling.

Learn more about the mortgage process.

How do monthly mortgage payments work?

While your projected monthly payment is the same each month, the percentage of it that goes toward the interest versus the principal changes. In the beginning your payments will cover more interest, but eventually, you’ll be paying off more of the principal amount.

This process is called amortization, and your lender will use a table that shows precisely how much of your payment goes toward which component each month.

Here's a brief look at how your monthly mortgage payment goes toward principal and interest at various points during for a 30-year fixed-rate mortgage for $350,000 with a 4.0% APR.

Payment #Monthly paymentPrincipalInterestRemaining balance
1$1,670.95$504.29$1,166.67$349,495.71
6$1,670.95$512.75$1,158.21$346,948.95
12$1,670.95$523.09$1,147.86$343,836.37
36$1,670.95$566.58$1,104.37$330,745.54
60$1,670.95$613.69$1,057.27$316,566.30
120$1,670.95$749.31$921.64$275,743.86
180$1,670.95$914.90$756.05$225,899.80

You can take a more in-depth look at how mortgage interest works here.

How to pay off your mortgage

One of the fundamental ways to lower your mortgage payment is to make a larger down payment. If you pay a bigger lump sum up front, then you don’t have to take out as large of a loan. You may even be able to pay off your mortgage in five years. Also keep in mind that your first mortgage payment is not due at closing.

What if I stop making mortgage payments?

When you miss a mortgage payment, you won’t necessarily see any negative results right away. Some lenders offer grace period to make the payment; depending on your lender, a late fee may apply during that time, but not always.

But if the mortgage payment becomes 60 days past due, then you could start to see some severe consequences — like a dramatic drop in your credit score. In fact, becoming delinquent on your mortgage is one of the worst things you can do to your credit score. That’s in addition to high late fees that you’ll definitely need to pay.

If you keep missing payments you may face foreclosure, which is when the bank seizes your home and kicks you out.

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Personal Finance Editor

Elissa Suh

Personal Finance Editor

Elissa is a personal finance editor at Policygenius in New York City. She writes about estate planning, mortgages, and occasionally health insurance. In the past she has written about film and music.

Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.

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