Mortgages are what have made home ownership possible in America and around the world. A mortgage is essentially an agreement between a borrower and a bank, where the bank lends money to the borrower for the purpose of buying a home.
Mortgages were more difficult to obtain in earlier times, and it was developments such as the deductibility of mortgage interest (introduced in 1913) and the creation of the Federal Housing Administration in 1934, which helped more Americans own homes.
Today more than two-thirds of Americans own homes, compared to less than 50% between 1900 and 1940.
Four Parts of a MortgageMost mortgages share the following common components.
The down payment: Lending banks like for borrowers to start out with an ownership stake in the property, so a down payment is usually expected. It's typically 20% of the property's purchase price, but it can be higher or lower.
Principal: This is the sum that's borrowed, or the original value of the loan.
Interest: While the borrower benefits from a mortgage by ending up owning a home, the lender benefits by charging interest on the loan. Interest rates have been quite high at times, such as well above 12% for the average 30-year fixed-rate loan in the early 1980s, and quite low, such as below 5% for most of the time from 2010 through 2014. When taking out a mortgage, the better your credit rating, the lower the interest rates you'll be offered.
Collateral: As with many loans, mortgages entail collateral: The property itself is the collateral. If the borrower defaults, the bank repossesses the home.
Types of MortgagesThere are a wide variety of mortgages, but here are some key distinctions to understand.
Fixed-rate or adjustable-rate: A fixed-rate mortgage sports an interest rate that remains unchanged for the duration of the loan. The interest rate for an adjustable-rate mortgage (ARM) will fluctuate, usually after an initial fixed period. For example, it might be fixed at a certain rate for the first three, five, or seven years, and then will rise or fall annually to correspond with prevailing interest rates.
30-year or 15-year: The most common duration of a mortgage is 30 years, but 15-year loans are also common. The longer loans will have lower payments and will extract much more interest from the borrower, while shorter-term loans feature higher monthly mortgage payments, but less interest paid and faster equity building. Not many people realize it, but you're not limited to just one or the other kind of loan. Mortgages can be secured for 10 years, or 40 years, and other time periods, too.
EligibilityNot everyone will be approved for a mortgage, even though the house will serve as collateral. That's because most lenders want some assurance that the borrower will be able to keep up with payments. Thus, lenders use formulas to determine how much you can borrow, based on your income and debt obligations. Your credit record also factors into the decision, with a good credit history leading to more generous terms.
AmortizationA five-syllable word to understand regarding the mortgage process is amortization. In the home-buying context, it's the process by which you make loan repayments over time, according to a fixed schedule. Typically, early payments will mostly consist of interest, and later ones will mostly consist of payments against the principal of the loan.
Mortgages may be complicated, but they're well worth it if they get you into a home of your own.
The article What Is a Mortgage? originally appeared on Fool.com.
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