Investment Glossary – Mortgage
When I was a kid, I was a Monopoly prodigy. My strategy? Get either the reds or the yellows, mortgage everything else, and build houses and hotels. It was a really good strategy. But I had no idea what a mortgage actually was, other than some money I got when I flipped over a property and no longer received rent on it. So today, we’re going to tell you what a mortgage actually is.
A mortgage is a loan that someone gives to you (usually a bank), and in return, they expect you to pay that loan back over time, with interest attached to the amount you borrowed. That loan is also attached to a specific piece of real estate, such as a primary residence, second home, rental property, open land, or any other type of real estate you can imagine. The property attached to the loan acts as collateral, meaning that if you don’t pay that loan back as you are expected to, the bank could eventually attempt to take the property from you if your pattern of bad payments reaches a certain point.
Here’s a practical example of how a mortgage works. You want to buy a property that costs $200,000. But you only have $40,000 today. The money you have obviously isn’t a large enough sum for you to buy the property, so you go to a bank and try to take out a loan. The $40,000 you have can be used as a down payment, or money that you put towards the home upon the purchase. But you are going to have to borrow the additional $160,000 from the bank to pay the full $200,000 price.
The 30-year mortgage is the most common mortgage, in which you are then expected to pay that $160,000 back over a 30-year time period. Mortgages can be other lengths as well, with 15-year and 10-year mortgages being relatively common as well, though nowhere near as popular as 30-year ones. However, a key component here is that banks aren’t going to lend you that money for free. They are going to charge you interest, because if they are giving you money, it means they can’t invest it somewhere else to earn a return on it. The interest they charge you is called a mortgage rate. So you don’t just need to pay back that $160,000 over 30 years, you need to pay it back with interest.
Banks use a tool called amortization to calculate how to do this evenly, so that the interest you pay is built right into the monthly payment you make every month. Typically, the biggest components of that monthly payment are principal and interest, though many lenders also require your property taxes and home insurance payments to be escrowed in that monthly payment as well. Interest rates are usually fixed on most mortgages, meaning that if a bank lends you money at 5%, the interest rate stays at 5% for the length of the loan. However, you can also choose to use an adjustable-rate mortgage (ARM), in which the interest rate may fluctuate over the course of the loan. Adjustable-rate mortgages may have lower rates than fixed rate mortgages initially, but the risk you take is that the interest may adjust higher for the duration of the mortgage.
By looking at interest rates and home prices, you can start to figure out how much you should spend on a home, as most people typically require a mortgage to buy a property. Be sure to factor in other expenses that go into buying a house as well, because when you are buying a house, you’re making what is typically the biggest purchase of your life, and you’re not just playing with Monopoly money.