Ravi Chandran
Mortgage is a property pledge to a creditor as security for the payment of a debt. In plain English, a mortgage is a loan.
By: Hitesh Khan/
For many people, property pledge is the biggest loan they will ever borrow. With a regular loan, there’s no explicit collateral. The lender looks at your credit history, your income and your savings, and determines if you’re a good risk.
With a mortgage, the collateral for the loan is the house itself. This is why it is called a property pledge.
If you don’t pay back the loan (along with all of the fees and interest that are included with it), then the lender can take your house.
Banks are the traditional mortgage lender. You can either apply for a mortgage at the bank you use for savings accounts, or you can shop around to other banks for the best interest rates and terms. If you don’t have the time to shop around yourself, you can work with a mortgage broker, who sifts though different lenders to negotiate the best deal for you. Banks are not the only source of mortgages, though: Credit cooperatives, financial institutions and some private funds also offer mortgages.
Like other loans, mortgages (or a property pledge), carry an interest rate, either fixed or adjustable, and a length or “term” of the loan, up to 30 years. Unlike most other loans, mortgages carry a lot of associated costs and fees. Some of those fees only happen once, such as closing costs, while others are tacked onto the mortgage payment every month.
The down payment on a mortgage is the lump sum you pay upfront that reduces the amount of money you have to borrow. You can put as much money down as you want. The traditional amount is 20 percent of the purchasing price. The more money you put down, though, the less you have to finance — and the lower your monthly payment will be.
With a fixed-rate mortgage, your monthly payment remains roughly the same for the life of the loan. What changes from month to month and year to year is the portion of the mortgage payment that pays down the principal of the loan and the portion that is pure interest. The gradual repayment of both the original loan and the accumulated interest is called amortization.
If you look at the amortization schedule for a typical 30-year mortgage, the borrower pays much more interest than principal in the early years of the loan. The advantage of amortization is that you can slowly pay back the interest on the loan, rather than paying one huge balloon payment at the end. The downside of spreading the payments over 30 years is that you end up paying more than 2 times for that original loan. Also, it takes you longer to build up equity in the home, since you pay back so little principal for so long. Equity is the value of your home minus your remaining principal balance. But that doesn’t mean that fixed-rate, 30-year property pledge is a bad thing.
A fixed-rate mortgage offers an interest rate that will never change over the entire life of the loan. Not only does your interest rate never change, but your monthly mortgage payment remains the same for 20 or 30 years, depending on the length of your mortgage.
The interest rates tied to fixed-rate mortgages rise and fall with the larger economy. When the economy is growing, interest rates are higher than during a recession. Within those general trends, lenders offer borrowers specific rates based on their credit history and the length of the loan. Here are the benefits of 30, 20-year terms:
- 30-year fixed-rate — Since this is the longest loan, you’ll end up paying the most in interest. While that might not seem like a good thing, it also allows you to deduct the most in interest payments from your taxes. This long-term loan also locks in the lowest monthly payments.
- 20-year fixed-rate — These are harder to find, but the shorter term will allow you to build up more equity in your home sooner. And since you’ll be making larger monthly payments, the interest rate is generally lower than a 30-year fixed mortgage.
There is a long-term stability to fixed-rate mortgages that many borrowers find attractive – especially those who plan on staying in their home for a decade or more. Other borrowers are more concerned with getting the lowest interest rate possible. This is part of the attraction of adjustable-rate mortgage.
An adjustable-rate mortgage (ARM) has an interest rate that changes — usually once a year — according to changing market conditions. A changing interest rate affects the size of your monthly mortgage payment. ARMs are attractive to borrowers because the initial rate for most is significantly lower than a conventional 30-year fixed-rate mortgage.
If you’re considering an ARM, one important thing to remember is that intentions don’t always equal reality. Many ARM borrowers who intended to sell their homes quickly during the real estate boom were instead stuck with a “reset” mortgage they couldn’t afford. Many of them never fully understood the terms of their ARM agreement.
Then there is a riskier property pledge called a balloon mortgage. A balloon mortgage is a short-term mortgage (five to seven years) that’s amortized as if it’s a 30-year mortgage. The advantage is that you end up making relatively low monthly payments for five years, but at the end of those five years, you owe the bank the remaining balance on the principal, which is going to be awfully close to the original loan amount. This “balloon” payment can be a killer.
