Mortgage is a loan agreement that enables a person to borrow money to purchase a house or other property. A person typically obtains a mortgage from a bank, credit union, mortgage company, or savings and loan association. Because mortgage loans involve larger sums of money, lenders require some security for these loans. Security is something of value that a lender can take if a borrower defaults on (fails to pay back) his or her loan. The property being purchased with the mortgage has value, and that property is usually used as security for the loan.
Most mortgage agreements require the borrower to repay the loan in monthly installments, usually for a period of 15 or 30 years. Payments are divided into principal and interest. The principal is the amount that was actually borrowed from the lender. Thus, on a $100,000 loan, the initial amount of principal would be $100,000. The interest on a mortgage is the money paid to the lender over and above the amount borrowed—that is, the price paid to the lender for the use of the money borrowed. A buyer typically pays part of the purchase price of the property as a down payment, and takes out a mortgage for the remainder. If a borrower had a 30-year mortgage for $100,000 with an interest rate of 6 percent, the total interest over 30 years would be $116,000. (The reason the amount of interest is not $180,000 is because principal payments are being paid to the lender that diminish the amount of principal owed, and thus the amount of interest owed, over time.) Therefore, on this 30-year mortgage, the borrower would pay a total of $216,000 to repay the principal and interest. As the borrower pays off the loan, more of each monthly payment goes toward the principal, and less toward the interest. The borrower gradually increases his or her equity, which is the value of the property above the amount of principal owed on it.
The interest rate charged on a mortgage reflects the lender’s risk. People with a better credit rating have a lower statistical risk of defaulting on a loan and will therefore pay a lower interest rate than do people with a poor credit rating.
If the borrower misses a number of payments or violates another condition of the agreement, the lender may foreclose on the mortgage. Foreclosure is a legal procedure by which the lender takes over the mortgaged property. The lender may then sell the property, keeping the amount owed on the mortgage and giving any money left above that amount to the borrower. More than one mortgage may be placed on a property. If foreclosure occurs, the holder of the second mortgage gets nothing until the claims of the first have been met.
The two basic types of mortgage are fixed rate and adjustable rate. A borrower with a fixed-rate mortgage pays the same rate of interest over the entire term of the loan. Interest rates for an adjustable-rate mortgage (ARM) are periodically increased or lowered based upon a specific market index. These indexes are calculated to measure market conditions for a given period. In the United States, one common mortgage index used is the Treasury Bill Index.
Since the late 1900’s, lenders have introduced a variety of innovative mortgages. For example, one newer mortgage, called a hybrid adjustable-rate mortgage, features a fixed interest rate for a limited period, after which the interest rate becomes adjustable. With another type of loan, known as a graduated-payment mortgage, the borrower makes lower monthly payments for the first few years and higher payments later. In a growing-equity mortgage, monthly payments increase yearly until the balance is paid. In a balloon-payment mortgage, payments are lower for the first few years and then a large, single payment is due for the remaining balance. In an interest-only mortgage, the payment consists of interest only for a limited period of time.
Many of the more innovative features of mortgages are found in subprime mortgages. Such mortgages are offered to customers with below-standard credit histories or documentation (records that prove such things as wages). Subprime mortgages are a greater risk to the lender and therefore carry a higher interest rate. Some finance experts are also concerned that many of the borrowers for subprime loans may be subject to unfair lending practices that lead them to take out loans they cannot afford.
In the United States, several programs make mortgage lending easier and promote home ownership. Two government agencies, the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA), offer loans with low down payments and guarantee some home mortgage loans against loss to the lender. Private mortgage insurers guarantee other mortgages.
The Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac) are government-sponsored enterprises that buy mortgages from banks and other lenders. These mortgage insurers then issue bonds (certificates promising repayment) that are backed (guaranteed) by the mortgages. Investors buy the bonds. Traditionally, investments backed by mortgages are safe, because few people default on a mortgage. During the economic crisis that began in 2007, however, risky investments based on mortgages played an important role in triggering a severe financial downturn. The Consumer Financial Protection Bureau, a federal agency, guards consumers against deceptive practices involving mortgages and other forms of loans.
