What is a mortgage?

By May 22, 2015Blog

The following post was excerpted from Personal Finance For Beginners In 30 Minutes, Vol. 1, by Ian Lamont. All rights reserved.

If you’ve purchased a house or condo, you probably had to take out a mortgage. What is a mortgage? In a nutshell, mortgages are loans from banks that help homebuyers pay the difference between the cash they have available to pay for a home and the actual cost of the home.

Typically, mortgages have to be paid back in monthly installments over 15, 20, or 30 years. The monthly payments are usually equal (exceptions include adjustable rate mortgages, described below), and include principal as well as interest that the bank charges.

The size of the monthly payment depends on the amount of the principal, the length of the mortgage, and the interest rate offered by the bank at the time the mortgage started. Here’s how a $200,000, 30-year mortgage at a fixed 6% interest rate breaks down:

Monthly principal and interest payments: $1,199
Annual principal and interest: $14,389
Total interest over 30 years: $231,676
Total payments over 30 years: $231,676 + $200,000 = $431,676

The principal declines gradually over 30 years, until the mortgage is paid off:

What is a mortgage example

This is a greatly simplified view of mortgage payments. Not shown in the data above:

  • Even though the monthly payment never changes, interest payments are high during the early years of a mortgage. Toward the end of the 30 years, most of the payments will be paying back principal.
  • Local real estate taxes are not included.
  • There are fees related to setup, late payments, and other situations.
  • Lenders are required to reveal the annual percentage rate (APR), which is the mortgage rate plus fees, points, and some closing costs. If there is a big difference between the quoted rate and the APR, watch out!

Another risky situation that can lead to serious pain down the road involves monthly payments which “balloon” after a set number of years, which is typical of adjustable rate mortgages (ARMs). Here’s a typical ARM offer:

What is an ARM mortgage example
The initial rate is low, but the rate after the first 5 years is unknown. There is a real risk that the rate could more than double in the 6th year, which would greatly increase monthly payments.

You should always understand the terms of a mortgage based on the printed documents you sign as well as professional advice from an accountant, housing counselor, or experienced real estate lawyer.

This post was excerpted from Personal Finance For Beginners In 30 Minutes, Volume 1:
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