Introduction to Understanding Mortgage: Mortgage Definition
The first step to understanding mortgage is to know what the word means. Dictionary.com defines mortgage as:
- a conveyance of an interest in property as security for the repayment of money borrowed.
- the deed by which such a transaction is effected.
- the rights conferred by it, or the state of the property conveyed.
In everyday language, this just means that a mortgage (also known as a “deed of trust”) is a legal document that says the lender may take away your home if you don’t repay the loan you took out with them. Originally, that loan will be to buy the house in the first place. But that isn’t always the case, as you’ll see.
When you sign the mortgage documents, you’ll also sign a promissory note. This is where you make the promise to repay the money you’ve loaned when taking out your mortgage. A lot of people get confused between the two because they think the mortgage is where you make the promise to repay.
Understanding Mortgage Payments
Part of the reason some people get confused between their mortgage and their promissory note is that “mortgage” is also used to describe the payments you make. When it comes to understanding mortgage, it’s good to know what these payments are:
- Principal – the principal balance is the amount of money you still owe on your mortgage. With amortizing mortgages (like a fixed-rate mortgage), some of your payment reduces the principal while some of it pays the interest.
- Interest – your mortgage’s interest rate is what determines how much you pay the lender as an extra fee for loaning money from them.
- Homeowner’s insurance – most mortgage lenders require you to pay homeowner’s insurance. They will use it to cover damages from accidents, fires, storms, and other catastrophes. (Confused by insurance terminology? Read our guide on understanding insurance!)
- Mortgage insurance – if you can’t afford to make a downpayment of at least 20%, most lenders will ask that you pay for the premiums on mortgage insurance. This helps mortgage lenders against losing all their money if you default on payments. There are two types of mortgage insurance: Private Mortgage Insurance (PMI) and those required for government-backed loans.
The Second Mortgage: When Mortgage Gives Way to Mortgage Debt
Earlier, we said that mortgage isn’t always used for loans toward buying a house. A lot of people take out a mortgage debt in order to borrow money for something else, like your small business or college fees.
If you already have a mortgage on your house, then this loan is a second mortgage. Also called a junior lien, you only need to pay this loan after your primary mortgage.
Fixed-Rate vs Variable Rate Mortgage
When it comes to understanding mortgages, it’s important to know that there are two main types.
Fixed-rate mortgages have a set interest rate that remains the same.
Variable-rate mortgages, on the other hand, have an interest rate that changes over time. Many variable-rate mortgages have a lower starting interest rate than fixed-rate mortgages. But after an introductory period, the interest rate increases. Some variable-rate mortgages put a limit on how high your interest rate will go, but this is not the norm. Variable-rate mortgages tie to an index of interest rates. When that index increases, so do your interest rates.
That’s why it’s usually better to choose a fixed-rate mortgage if you have the option.