Oxford Dictionary

Mortgage [noun] A legal agreement by which a bank, building society, etc. lends money at interest in exchange for taking title of the debtor’s property, with the condition that the conveyance of title becomes void upon the payment of the debt.

ELI5

A mortgage is a type of loan where the borrower is purchasing a property and needs money from a lender, typically a bank, to do so. If the borrower fails to pay back the loan, the lender has the right to take ownership of the property (the lender has a lien on the property). There are a handful of important topics of a mortgage including – principal and interest, mortgage types, and foreclosure.

As with any other loan, the principal has to be repaid with some interest rate. There are two major mortgage types – fixed-interest rate and adjustable-rate mortgage (ARM). They sound fancy, but they really aren’t! For the first, it means you pay a fixed interest rate for the entire term of the loan — typically 15 or 30 years. With ARM, the interest rate stays fixed for an initial variable fixed period of the loan and then will fluctuate with market-based interest rates. The first one is not affected by future changes in mortgage rates, the second one can be beneficial typically for more advanced buyers who can manage their interest rate risk.

The other piece of the puzzle is foreclosure. When a property is foreclosed upon, it means the buyer is not able to or has stopped making the required loan payments to the lender and the lender has the right to repossess the property.

An example would be if Mary and her husband want to purchase a $350,000 home. They have saved a down payment of $50,000, and are targeting a fixed-interest rate mortgage of $300,000. They go to a handful of commercial banks in the area presenting their mortgage request — and are evaluated based on credit score, down payment amount, and employment history. They go with the bank that provides the best interest rate, and Bank ABC gives them a 4% interest rate on a 30-year fixed-interest rate loan. Over the next 30 years, they will pay off the loan in fixed payments and assuming they don’t miss or stop making payments will fully own the house in 30 years.

 

Detailed Definition

There are a handful more terms that are covered when talking about mortgages, let’s dig deeper into some of the aforementioned topics and learn a couple more.

Fixed-interest rate mortgages — where the interest rate on the loan is constant for the period of the mortgage. This is likely the most logical option when buying a house since a buyer has a consistent loan payment that will not fluctuate for the term of the loan. In the process, they are able to plan and budget more consistently and have a peace of mind.

A strategic advantage would be to capitalize on a fixed-interest rate loan when the interest rates are low. In doing so you essentially lock in a low interest rate even if the benchmark interest rate fluctuates. 

For the Adjustable-Rate Mortgage (ARM) – you have a fixed, typically lower than benchmark interest rate for an initial 3-10 year period and after that the interest rate is tied to a benchmark interest rate. The initial lower interest payment proves enticing for many homebuyers making the loan more appealing, but after the initial interest rate expires these loans can become rather expensive. Typically, you will see 3/1 (or 5/1, 10/1, etc.) ARM loans — with the first number indicating the length of the fixed interest period and the second number signifying the interval between interest rate adjustment periods after that (so annually for a 3/1).

Situations where an ARM is more advantageous includes when you know you are going to sell the house or flip the house (as an REI) before the fixed interest period is up. Imagine you are on a 2-year contract for a job and have a family – in that situation it might make sense to sign up for a 3/1 or 5/1 ARM mortgage since you understand there’s a real chance you will leave after the job contract is up.

There are a handful of other loans, but we’ll save them for another day. When dealing with mortgages another term that is commonly thrown around is the amortization schedule. Amortizing a loan is the process of paying off a loan in a series of regular fixed payments composed of interest and principal. As mortgages are a type of loan that involves a series of consistent payments — an amortization schedule is an easy way to understand the interest and principal for each monthly payment for the term of the loan. Key concept in the first ten years of a 30 year mortgage, your payments are all going towards the interest and very little towards paying down principal. You can reduce the payments on a 30 year mortgage to 20 years by making one extra monthly payment at the beginning of each year.

Even though your monthly payment is constant, the ratio between interest and principal in that payment will change during the term of the loan. In most cases, the amortization schedule consists of a higher portion of the payment going towards interest during the early installments while the principal is chiseled away at towards the end.

Last but not least, we have to confront the worst part of mortgages — that is what happens when a homeowner fails to pay them. When the homeowner fails to pay or defaults on their loan – either due to difficult circumstances (sinking under heavy debt obligations, laid off and can’t afford mortgage payments) or neglecting payments, the bank has the right to foreclose and seize the property. Typically, a bank doesn’t want to hold property due to its illiquid nature, and holds an auction to receive cash for the property. If an individual has their home foreclosed upon, their creditworthiness drops significantly and being able to secure another mortgage (or loan) becomes much more challenging.

An example tying together some of the above concepts include the Great Recession of 2008-2009. Several lenders were providing unrealistically low interest rates through ARM’s and interest-only loans (discussed later), so people were capitalizing and scooping up property that they might not be able to afford in the long term. People with low credit scores who likely shouldn’t have received the loans were getting multiple loan offers from bank. Ultimately, by the end of 2008, these people began to default on their loans triggering the start of the downturn.

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