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Learn About Home Mortgages: How Mortgages Work, Different Types of Mortgages, and What Determines Mortgage Rates

Written by MasterClass

Last updated: Oct 2, 2020 • 5 min read

Home buying can be a long and difficult process due to the cost of purchasing a home. Few people can pay for homes upfront, which is why banks and other lenders offer a specific type of loan to increase the affordability of real estate—this loan is called a mortgage.

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What Is a Mortgage?

A mortgage is a loan you take out from a bank, credit union, or other mortgage lenders in order to pay for a home or other piece of property. When you take out a mortgage loan, you put the piece of real estate up as collateral and make monthly payments to secure your ownership of the property.

Understanding How Mortgages Work in 4 Steps

When most people decide to buy a new home, they don’t have enough money in their bank account to buy the house upfront. Rather than save up, the home buyers go to a mortgage lender. This is how a mortgage works:

  1. The lender agrees to loan them the money for the house, and the borrower agrees to pay a down payment (an initial up-front portion of the loan) and then pay the home loan back in monthly installments over a set period of time, plus interest.
  2. When the borrower takes out a mortgage on a house, they can move into the home—but the deed to the home is held by the mortgage lender.
  3. When the borrower finishes paying off the loan, the mortgage lender gives them the deed, and they now own the house.
  4. On the other hand, if the borrower defaults on mortgage payments, the mortgage lender can take the property and sell it to cover the remaining cost of the loan (called foreclosure).

While home buyers use their first mortgage to help them buy a house, it’s actually possible to take out a second mortgage, borrowing against the difference between the house’s value and the amount of the first mortgage (this difference is called “home equity”). For instance, if your home is valued at $350,000 and your mortgage balance is $200,000, there’s a $150,000 discrepancy that you can potentially borrow against, mortgaging either through a home equity loan or a home equity line of credit.

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What Are the Different Types of Mortgages?

There are several different types of mortgages, each with benefits and drawbacks. The most common mortgages are:

  • Fixed-rate mortgages (FRMs). These mortgages offer a fixed interest rate, meaning borrowers pay the same monthly rate for the entire life of the loan. Most FRMs come in terms of 15, 20, or 30 years—most mortgages with longer terms offer lower rates but are overall usually a larger investment, because more years means more interest payments. FRMs are a reliable mortgage and the least risky investment.
  • Adjustable-rate mortgages (ARMs). These mortgages offer variable interest rates, meaning that the interest rate can increase or decrease while you’re paying it off, depending on the market rates. Some ARMs have a fixed initial interest rate for the first few years, then become adjustable after that. Overall, ARMs are riskier than FRMs because interest rates may rise significantly over the course of the loan, but they’re still popular because ARMs often have lower interest rates than FRMs.

There are several less conventional mortgages that are good for specific people or situations:

  • Interest-only mortgages. These allow you to pay only the interest—good for people planning on selling the property in the short-term and paying off the mortgage with the money.
  • Cash-out mortgages. These allow you to refinance an existing mortgage into a second mortgage and take out the difference in cash—some people use these to pay for large expenses like student loans.
  • VA loans. These are special mortgages offered to veterans and service members.
  • FHA loans. These are offered to low-income borrowers.
  • Reverse mortgages. These are available to seniors and allow you to borrow against your home equity, tax-exempt.

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3 Essential Components of a Mortgage Payment

There are three main components to mortgages:

  1. Principal. The principal is the figure that represents the total remaining amount of money that you still owe on your loan. In other words, it’s the original loan amount minus the payments you’ve already made throughout the loan term.
  2. Interest. Mortgage interest is the extra money on top of the principal that you pay to the lender, in exchange for them lending you the money. Your interest rate will vary depending on your loan’s annual percentage rate (APR).
  3. Escrow account. Escrow accounts are usually optional accounts that you can fund each month with your mortgage payments, in order to pay for things like property taxes and homeowner’s insurance.

What Determines Mortgage Rates?

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While mortgages are mostly well-defined and standardized types of loans, there are a few factors that can affect the payment amounts that will be offered to you:

  • Down payment size. Before you start paying monthly mortgage payments, you make a down payment. This means that you pay an agreed-upon amount of money upfront to secure the loan. Larger down payments mean the investment is less risky for the lender, so they will often offer better interest rates than if you make a small down payment. If you make a down payment of under 20 percent of the home price, you’ll typically need to pay for mortgage insurance to protect the lender against default: either private mortgage insurance (PMI) or mortgage insurance premiums (MIP).
  • Credit score. Your credit score is an evaluation of your credit history to determine whether you’re a reliable borrower—namely, if you have experience borrowing with credit cards and if you pay your loans back on time. People with high credit scores can get approved for better interest rates for mortgage loans, while those with lower credit scores may receive higher interest-rate offers.
  • The debt market. The debt market is the part of the economy concerned with borrowing and lending, and it fluctuates with changes in the economy: inflation, deflation, the housing market, and fiscal and monetary policy enacted by governments and central banks. While you can’t control the debt market, there are financial advisors who can forecast the market and recommend the best times to buy.

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