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How Mortgages Work

Understanding how mortgages work is essential for anyone in the market for a new home. Entering a mortgage agreement is a huge obligation. Since a  mortgage is a 15 to 30 year long commitment, it is important to make sure that you fully understand what you are getting into prior to the purchase of your home. One mistake can cost you thousands of dollars over the course of 30 years.

Getting to know everything about a mortgage can be overwhelming, as well as confusing, which is why many people attend seminars or classes prior to buying a home. The basics are complex and include an understanding of what a mortgage is, how it is different than a standard personal loan, the different types of mortgages, and how to choose a lender.

What is a mortgage?

A mortgage is much different than a credit card or personal loan, because it is considered a secured loan. This means that the bank considers the home as collateral and uses it to back your loan. During the course of your mortgage, the bank holds the title. This remains true until the home is paid off. At that time, the home truly becomes yours and the bank signs the title over to you.

If you default on your mortgage, the lender can foreclose the property and take its possession away from you. The bank will then sell the home to recoup the money that they lost.

In addition to your initial home mortgage, if you have equity in the property, you can take out a home equity loan, also known as a second mortgage, these are generally used for home repairs, improvements, or for other personal reasons.

Types of mortgages

  1. Fixed rate mortgage – It is the most common type of home mortgage. Borrowers with fixed rate mortgage payments agree to pay a set amount of money for a predetermined amount of time. This is generally a term of 15 to 30 years. The mortgage payment remains the same over the course of the loan unless the homeowner decides to refinance. The longer the term of the loan is, the lower the payment will be. Homeowners can always decide to pay off their loan early at no penalty.
  2. Adjustable rate mortgage – Also known as an ARMs mortgage, it has a payment structure that is set up to change over the course of the loan. These loans generally start off with extremely low interest rates. The low interest rate is set for a predetermined amount of time, which is typically two to three years. Once this time expires, the rate varies according to the index it is tied to. The rate can drastically rise, and tremendously increase the mortgage payment. ARMs mortgages were responsible for the most recent housing market crash and caused many people to lose their home.
  3. Interest only loan – It only requires the homeowner to pay the interest on their home for a predetermined amount of time. This makes their initial mortgage payment extremely low. After the set amount of time passes, the homeowner must begin to pay on both the interest and the principle.

Understanding mortgages can be difficult, but, with a little research, you can find out all you need to know and make the best decision.