What is mortgage and its types? | How they works with example

A mortgage is a type of loan that is used to buy real estate. For many individuals, a mortgage provides the cornerstone of the home purchasing process. When you take out a mortgage, you receive money from a lender to buy a property and agree to repay the loan, together with interest, over a specified amount of time. The period is usually 15, 20 or 30 years depending on the mortgage agreement. The property you are buying typically acts as collateral. If you do not keep up the mortgage payments, the lender has the right to take back the property and recuperate their investment. Understanding the mortgage terms before committing is paramount.

What is a Mortgage?

A mortgage is a type of loan that you obtain to purchase a property, such as a house, condo or apartment. Since most people do not have enough money saved to buy a home in one payment, they borrow an amount from a bank or lender to pay for the home. In exchange for lending you the money to buy a home, the lender has a type of interest called a “lien” on the property. While you are technically the owner of the property, if you do not make your regular payments over the years, the lender has the right to take the property back, which is called foreclosure. In short, a mortgage is your agreement to pay for the property over time, typically 15-30 years, instead of in one payment.

Types of Mortgages

Interest-Only Mortgage:

An interest-only mortgage is a kind of home loan that means you bother paying only the interest amount for a set period of time – this results in lower monthly payments at the beginning, because you’re not paying back the original amount you borrowed. For example, if you had a loan for $200,000, at the end of the interest-only portion, you would still have a total amount owed of $200,000, which is the original loan amount. The interest portion typically lasts for 5 to 10 years. After that, your payments can go up significantly because you’re not only starting to pay the original loan amount back, you’re paying off the original amount plus interest. It can be helpful to use this type of loan if your income changes, but it could be riskier too, because you eventually owe a big amount.

• $240K loan → $1,200/month (interest only), then $2,000+ later.

Adjustable-Rate Mortgage (ARM):

In an Adjustable-Rate Mortgage (ARM), the interest rate changes with time. ARMs start with a fixed, lower rate for a certain period, which could be 5, 7, or 10 years, so your early payments will be less expensive. After that set period, the interest rate will adjust to reflect market conditions, which means that your payments could increase or decrease. While an ARM might save you money in the early years, it can lead you to higher payments later, making the overall cost less certain than a fixed-rate mortgage would.

• 5/1 ARM: 4% for 5 years → $1,150/month, then adjusts (could rise to $1,800+).

Reverse Mortgage:

A reverse mortgage is a loan for homeowners that is 62 years of age or older, where equity in the homeowner’s property is converted to cash. The homeowner receives cash from the bank as a lump sum, monthly payments, or a line of credit instead of making monthly payments to the bank as in a traditional mortgage. So the homeowner uses the home equity to pay cash for toiletries and groceries at the grocery or pharmacy with the bank debit card. The homeowner doesn’t have to repay the loan until they have moved away or sold the property. The bank gets paid back as the loan balance rises over time with interest and fees. Upon sale of the property, the bank will be paid back first before the homeowner.

• 70-year-old gets $800/month from home equity.

Fixed-Rate Mortgage:

A fixed-rate mortgage is a reliable home loan that charges a stable interest rate for the whole term of the loan. Your monthly payment of principal and interest is fixed, making it predictable and easy to budget. A fixed-rate mortgage protects you from increasing mortgage interest rates, keeping your housing expense constant.

• 30-year fixed at 6% → $1,440/month forever.

VA Loan:

The VA Loan is a mortgage benefit made available to veterans, some active-duty service members, and certain surviving spouses. The VA, or United States Department of Veterans Affairs, offers a guarantee on a mortgage loan, encouraging private lenders to develop mortgage loans that have great terms. The most significant advantages typically are that there is no down payment and no monthly mortgage insurance, which benefits buyers and ultimately provides a more affordable home-buying experience.

• $300K home → $0 down, lower rates.

Jumbo Loan:

A jumbo loan is a mortgage to borrow more than the limit of a “conforming” mortgage; they are designed for high-end homes. They are considered riskier for lenders, therefore it is harder to qualify for one; often, this means having a good credit score, larger down payment, and verification of savings, and income that is higher than average income.

• $1M home → $800K loan (jumbo).

FHA Loan:

An FHA loan is a kind of mortgage that is backed by the government so that people can buy homes, particularly people who would have trouble getting a loan in the typical way. An FHA loan typically requires a lower down payment of around 3.5% of the value of the home, and it is more lenient of your credit score. In addition to the monthly mortgage payment, borrowers are also required to purchase mortgage insurance, which while protecting the lender, also adds a small amount of cost to the monthly payment.

• $300K home → $10,500 down. Must pay mortgage insurance.

USDA Loan:

A USDA loan is a government-backed mortgage intended to assist low-to-moderate income families to purchase a home in certain suburban and rural areas. It typically has no down payment, which means you can finance 100% of the prices of the house. The home must be in USDA eligible areas, and the borrower’s income must be less than the income limit for that area.

• $200K home in qualifying area → $0 down.

How mortgage loan works with example

A mortgage is a loan specifically for buying real estate, where the property itself serves as collateral for the money you borrow. You repay this loan with interest over a set number of years through monthly payments.

A Step-by-Step Example

Let’s follow Sarah, who wants to buy a $300,000 house.

Step 1: The Down Payment
Sarah doesn’t have $300,000, so she makes a down payment. Let’s say she puts down 20%, which is $60,000. This shows the lender she’s invested in the property and reduces the amount she needs to borrow.

Step 2: The Loan Amount
The bank agrees to lend Sarah the remaining money.

• House Price: $300,000
• Minus Down Payment: – $60,000
• Loan Amount (Principal): $240,000

Step 3: The Terms
Sarah gets a 30-year fixed-rate mortgage with an interest rate of 6%. This means she has 30 years (360 months) to pay back the $240,000, and the 6% annual interest rate will not change.

Step 4: The Monthly Payment
The bank calculates her monthly payment to be $1,439. This payment is split into two parts:

1. Interest: The cost of borrowing the money.
2. Principal: Paying down the original $240,000 loan.

Step 5: How the Payments Break Down (Amortization)
This is the most important part. The split between interest and principal changes every month.

• First Payment:
  • Total Payment: $1,439
  • Interest Portion: The bank calculates 6% annual interest on the $240,000 for one month. This equals $1,200.
  • Principal Portion: The rest of her payment ($1,439 – $1,200 = $239) goes toward reducing the loan amount.
  • New Loan Balance: $240,000 – $239 = $239,761
• Payment a Few Years Later:
  • After making payments, her loan balance is now $220,000.
  • Total Payment: Still $1,439
  • Interest Portion: 6% on the now smaller $220,000 balance is lower—let’s say $1,100.
  • Principal Portion: Now a larger chunk, $1,439 – $1,100 = $339, goes toward the principal.
• Final Payment (in year 30):
  • Almost the entire $1,439 payment goes toward paying off the last bit of the principal, with only a few dollars going to interest.

Conclusion

Ultimately, understanding mortgages and their different types is crucial for anyone looking to purchase property, as it impacts affordability, long-term financial planning, and the overall home-buying experience.

FAQs